as published in
When the biggest tax changes in a generation become law, it’s tempting to act as quickly as possible.
Yet the Tax Cuts and Jobs Act lacks many concrete provisions, and the IRS is still waiting on technical corrections from Congress to many of its bare-bones rules. As such, 2018 has evolved into an interim period that may verify the wisdom of a wait-and-see approach.
That might sound counterintuitive, but the best strategy for real estate entities may be to avoid the hefty professional fees of restructuring (and then possibly undoing the restructuring) until they can be assured such outlays won’t be nullified by subsequent provisions taking effect.
5 Reasons to Delay Action
The tax law doesn’t necessarily discourage real estate development, but it may prompt new financing options in an industry that historically has been highly leveraged. Before real estate and finance entities proceed on any front, however, it’s important to understand the tax law’s rules and potential for future clarification.
Here are five gray areas of the law where an immediate response may be unwise. Until these uncertainties are closed, think twice about:
1. Preferred Partnership Interests
Large real estate entities, based on average gross receipts, can now only deduct interest expense against 30 percent of adjusted taxable income (i.e., NOI) and this limitation tightens after 2021. As a result, equity arrangements, such as preferred partnership structures, may be more favorable than other sources of financing. In a preferred investor structure, the common investors, the more prominent funding source, will get less allocation of income so in essence the common investors may receive a deduction that is greater than the limited interest amount. However, it may be wise to wait for the tax law to clarify the “related party rules” with respect to application of average gross receipts —specifically, how a large entity, based on its gross receipts as well as the gross receipts of its affiliates and investors affect the tax liability of all partners.
2. Depreciation Trade-Offs
Developers can still fully deduct interest expense if they elect a longer depreciation period for certain fixed assets. This strategy can offer a larger tax benefit than possibly being subject to the 30 percent limit on interest deduction, but there’s a glitch in the new law. If the developer owns non-residential real property, any interior improvements (i.e., tenant or common area improvements) —such as lighting, floor coverings, and woodwork—are technically no longer eligible for faster depreciation. These improvements also will face a 39-year depreciation life, even though Congress originally intended a 15-year period in this regard in addition to immediate expensing. Until that technical inaccuracy is addressed, it may be wise to hold off on any short-versus-long-term depreciation decisions.
3. Overhauling Payroll Systems
The tax law’s 20 percent deduction on pass-throughs has been well-publicized. While entities can maximize the deduction by meeting certain W-2 requirements, most real estate concerns do not have a sufficient number of salaried employees. Also, a management company collecting fees on behalf of a real estate enterprise may not even qualify for the deduction, because the law currently disallows certain “service” entities. In light of lack of clarity of how expansive the definition of a “service” business is and the requirement of incurring direct or allocated W-2 wages, immediately restructuring and/or reallocating W-2 employees may be a wasted effort until Congress defines what a “service business” is. Additionally, will real estate management companies be allowed to be “grouped” as one activity with related non-service companies? Also, moving wages from one entity to another could have employee benefit, health insurance, and other related ramifications.
4. Capturing Capital Gains as a C Corporation
The tax law left capital gains treatment for carried interest allocations largely unchanged, with one exception. To qualify for the 20 percent long-term capital gains rate (plus 3.8% investment tax), entities must now hold assets for three years rather than one. A sponsor entity might thus consider holding assets for a longer period or further deferring payment of the “promote” to meet the three-year provision. It could also restructure as a C corporation with the attempt of avoiding the three year holding requirement. Also, the impact of re-characterizing capital gains as short-term is minimized through the 21 percent corporate tax rate. However, one needs to be aware that any restructuring to C corporate status could result in more overall tax on an annual basis (i.e., distributions) or upon a liquidation. C corporations are easy to get into but difficult and costly to undo.
5. Restructuring in Either Direction
Corporate and pass-through entity structures have their plusses and minuses. Utilizing pass-through status can sidestep C corporations’ double taxation trap and a potential Federal tax rate of over 40 percent. On the flip side, pass-throughs may be the better option even if the entity can’t claim the 20 percent deduction. Any change requires careful consideration of all the relevant factors because of the difficulty of reversing whatever option is chosen.
With a tax law that’s still in flux, these factors suggest the wisdom of speaking with your tax professionals, understanding when immediate action is warranted or waiting until technical corrections are issued which could be the best option. While delaying action can be frustrating, unnecessarily incurring professional fees is an even less satisfying strategy especially if the technical corrections require certain restructuring to be undone. The best action now is to meet with your tax adviser to obtain an understanding of the tax law’s opportunities and unclear areas, perform financial modeling for different scenarios, and be ready to act when the corrections come down the pike.