as published in
Financing is the lifeline of all real estate investments and leverage allows development to continue without putting one’s own capital further at risk. The new Tax Cuts and Jobs Act places some limitations on the deduction of business interest, however, which could put a kink into development going forward.
In the past, investors often relied on mezzanine financing because it gave them some flexibility. But if the interest on financing no longer provides tax benefits, this could lead to greater interest and reliance on private equity financing, which comes with its own business and tax considerations.
Under the new tax law, business interest expense in excess of 30 percent of adjusted taxable income for the year cannot be deducted. For tax years through 2021, the allowable depreciation, amortization and depletion is added back in to the calculation of adjusted taxable income. After 2021, there is no addback. Any interest expense that is disallowed is carried forward to the next tax period.
So it may look like the real estate industry caught a break by potentially being exempt from the limits on business interest deductions. If you pull back the curtain, though, the picture is not so rosy. In order for real estate owners to be exempt, they would have to elect to use a different depreciation method for their real property which is much slower than the standard. In essence, the depreciation deduction would be less each period than if the standard depreciation method was in use.
The election makes the real estate owner ineligible to take bonus depreciation on the real estate (including qualified improvement property as soon as congressional technical corrections are implemented) in the current year. In addition, this has an impact throughout the life of the real estate improvements. Future guidance should clarify the impact of any election on future real estate purchases.
This drag on depreciation and the forgone bonus depreciation could result in the loss of significant deductions, so electing this route should only be made after careful analysis and planning with tax advisers.
Some taxpayers may feel that they are exempt from the interest deduction limitation due to annual gross receipts of $25 million or less for the last three years. But this test is not as clear as it appears, mainly because the aggregation rules apply here. This will force taxpayers to look at their ownership structure and consider the gross receipts of their partners and affiliates. When these partners happen to be REITs or other institutional investors, it can be arduous to quantify and very easy to exceed the $25 million threshold. The proper calculation will be needed to support the exempt position.
When it comes to private equity, new concerns arise, since now you are taking on a partner. That partner may not be a silent one. The private equity’s goals may not mirror your own. Who makes the decision on managing the property? What happens to the typical revenue streams of leasing commissions, development and management fees? How long is the hold period for the private equity investor? Most private equity investors have a defined investment period with goals of certain yields.
Prior to entering into such a marriage, certain due diligence needs to be done by both parties. Whose expertise is required to successfully deliver on the project? Local knowledge of building codes, available labor and specific costs are necessary. Different types of real estate investments will require different leasing and operating knowledge. There needs to be a delineation of the responsibilities. Like all pre-nuptial agreements, the remedies for a partner’s failure to execute needs to be spelled out prior to the union. The reporting requirements for a private entity may be as onerous as those of a public one. Is the infrastructure in place for such regimented reporting? New departments may need to be created and qualified personnel may need to be hired.
Tax considerations are also quite different for a private equity investment than a straight financing. There are issues of whether or not the transaction is considered a sale, which triggers a recognition of gain. An allocation of tax attributes to the private equity investor has tax ramifications for the existing owners. The loss of tax attributes is probably not on an owner’s mind when looking for a source of funds—but it should be. Again, any alternative financing option should be carefully discussed and vetted with tax advisers.
Mezzanine financing versus private equity takes on new resonance in this business environment. Careful consideration needs to be given to each scenario.