TCJA Will Affect Foreign Investments In US Real Estate
By Brad Wagner, CPA, and Justin Wood, CPA. Wagner, Duys & Wood, LLLP, Bethesda, Maryland
In December 2017, Congress passed the Tax Cuts and Jobs Act (“TCJA”) and the President signed it into law on December 22, 2017. The tax act has made significant changes that affect foreign investors in United States real estate (“FIRPTA”) utilizing the blocker corporation structure.
FIRPTA generally taxes nonresident alien individuals and foreign corporations on their dispositions of United States Real Property Interests (“USRPIs”). A USRPI includes any interest in United States real property itself and any interest in a United States corporation that predominantly owns real estate (“USRPHC”). The USRPHC is also known as a blocker corporation.
In the typical FIRPTA structure, the foreign investors contribute capital to a foreign corporation in a nontax jurisdiction such as the Cayman Islands. The foreign corporation then contributes the funds as capital or capital and debt to a wholly owned US C Corporation, known as a blocker corporation. The blocker corporation can purchase the real estate directly, but typically does so with a joint venture partner utilizing an LLC, with the LLC owning the real estate. The blocker corporation is a US taxpaying C corporation. It blocks the foreign individual investor from paying US taxes, or any filing disclosures in the U.S. Utilizing the foreign corporation as the wholly owned parent of the US blocker corporation allows the foreign investors to avoid US estate taxes.
Corporate tax rate reduction for C corporations. The Federal corporate income tax rate was reduced from a graduate tax rate structure with a maximum tax rate of 35% to a flat tax rate of 21% of taxable income. The effective date is for tax years beginning after December 31, 2017.
Net Operating Losses. Under prior law, net operating losses (“NOL”) could be carried back 2 taxable years and forward 20 taxable years and offset 100% of taxable income for regular income tax. Under the tax act, there is no net operating loss carryback and an indefinite net operating loss carryforward. However, under the current law, losses incurred in taxable years after December 31, 2017 can only offset 80% of taxable income in the current year. Net operating losses incurred in years before 2018 are grandfathered and can offset 100% of taxable income in the current year.
The 80% NOL limitation can cause inequitable results. For example, blocker corporation owns property purchased for $40 million in 2018 and has breakeven cash flow for 10 years. Blocker has a tax loss of $1 million a year for 10 years based on depreciation, amortization and accrued expenses. Blocker corporation sells the property in year 11 for $39 million, which is a $1 million economic loss. However, current year taxable income is $9 million ($39 million sales price less $30 adjusted basis). The NOL offsets $7.2 million ($9 million times 80%). Taxable income after the NOL is $1.8 million. At a tax rate of 21%, the tax due is $378,000, on a deal that lost money. Taxpayer was better off under the old law with a 100% NOL at a higher 35% corporate income tax rate.
Repeal of the corporate AMT. The corporate AMT was repealed in the tax act. This makes the AMT NOL inapplicable. Under the old law, an AMT NOL could be carried back 2 years and forward 20 years and could offset 90% of the taxable income in a tax year.
Planning with new NOL limitations. With the new NOL law only allowing post 2017 NOLS to offset up to 80% of current year taxable income, careful planning must be undertaken to minimize taxes. NOL carryforwards incurred before 2018 are grandfathered and are 100% tax deductible.
The blocker corporations’ goal will be to have small tax losses each year to avoid tax, to defer deductions, decelerate depreciation and increase the real estate cost basis to avoid the 80% NOL limitation in the year of the property disposition. To effectuate this, ADS (discussed further below) depreciation will decelerate the depreciation expense in the rental years and the adjusted basis of the property will be maximized for the gain on sale calculation. New deals may elect ADS, and existing deals may convert to ADS. Cost segregations will probably be avoided to decelerate the depreciation. Taxpayers may try and capitalize as much as they can under the repair regulations to increase the adjusted basis for the sale. If possible, greater allocations to land will occur on the purchase of real estate.
If there is taxable income in a tax year after 2017, tax is paid and cannot be offset with an NOL carryback. This is no longer a timing issue, it is permanent.
To avoid the 80% NOL limitation, it might be advantageous to have interest expense limited and carried forward indefinitely until it is used in the year of the property sale (see discussion below).
Blocker corporations should consider maximizing their 2017 tax loss which is grandfathered from the 80% limit, when taking their positions on their tax return. At the passthrough level, depreciation should be accelerated, including a cost segregation study, maximize deductions under the repair regulations and write off retired and obsolete assets.
Limitation on Interest Expense
The earnings stripping rules under section 163(j) were repealed. The earnings stripping rules limited a deduction for disqualified interest paid or accrued by a corporation to a related foreign person in a tax year if the payors debt to equity exceeded 1.5 to 1.0 and the payor’s net interest expense exceeded 50% of its taxable income before interest expense, net operating losses, depreciation and amortization.
Under the new law, interest expense paid to a related or nonrelated party is limited to 30 percent of “adjusted taxable income (“ATI”), which is taxable income before depreciation, amortization, interest (EBIDTA). For tax years after 2021, the limitation will be on taxable income before interest and taxes (after depreciation and amortization) (EBIT). Disallowed interest is carried forward indefinitely. Therefore, if the property is sold at a significant gain, all of the interest should be utilized.
In the unleveraged blocker scenario, the 30% limitation on business net interest expense is applied at the LLC level. The interest expense passed through to the blocker corporation would not be subject to a second limitation. Any disallowed interest is carried forward by the blocker corporation but can only be deducted against excess taxable income attributed to the blocker corporation by the LLC’s activities that gave rise to the excess business interest carryforward. In the leveraged blocker scenario, presumably, the computation is based on aggregating the interest expense and adjusted taxable income at the LLC and blocker levels.
There is an exemption for taxpayers with average annual gross receipts of $25 million for the 3 preceding tax years. This exception does not apply to partnerships or LLCs where 35% or more of its losses are allocated to limited partners or limited entrepreneurs (members of an LLC that do not manage the LLC). This exception may prevent many FIRPTA clients from qualifying for this exception.
Real property trades or businesses, can avoid the interest limitations if they elect to use the alternative depreciation system (“ADS”) to depreciate real estate. A real property trade or business includes real property development, construction, acquisition, rental operations, hotel operation, management and leasing. ADS depreciable life is 30year straight line for residential real estate instead of 27.5 years under the general depreciation system. ADS depreciable life is 40year straight line for nonresidential real estate instead of 39 years under the general depreciation system. We expect many FIRPTA taxpayers to use the ADS exception to avoid the interest expense limitations.
A deduction is denied for any disqualified related party amount paid or accrued pursuant to a hybrid transaction or a hybrid entity. Hybrid entities are those whose classification as a flow through entity or corporation differs for US Federal income tax purposes and foreign income tax purposes. A hybrid transaction is one that involves a payment that is treated as an interest payment for US purposes that is not treated as an interest payment by the country of residence of the foreign recipient. The concept is to deny a deduction to a US entity when there is no corresponding inclusion in income to the related party under the tax law of its country.
The effective date for the interest limitations is for interest paid or accrued for tax years beginning after December 31, 2017. Existing loans before 2018 are not grandfathered.
Blocker corporations that make distributions to the shareholders must withhold a Federal nonrefundable, noncreditable withholding tax of 30% (unless reduced by treaty) of the distribution to the extent the blocker corporation has current or accumulated earnings and profits (“E&P”). E&P is the measure of a corporation’s economic ability to pay dividends to its shareholders. In calculating E&P, there are a few adjustments from taxable income.
A potential adjustment calculating E&P from taxable income will be disallowed interest. It is deductible for E&P in the year it is incurred even though disallowed for regular tax. The disallowed interest will be carried forward in computing taxable income. In a subsequent year that it is allowed for regular tax, it will be disallowed in calculating E&P.
Depreciation Real estate is depreciated over 27.5 years straight line for residential real estate and 39 years straight line for nonresidential real estate. Under the tax act, after tax year 2017, ADS will be elected by many FIRPTA taxpayers to avoid the interest limitation and to minimize the NOLs subject to an 80% limit, as discussed above. For deals acquired before 2018, an accounting method change would be made to convert to ADS on the 2018 tax return. Before the tax act, the ADS life was 40 years for all real estate. Under the new tax act, the ADS depreciable life is 30 years straight line for residential real estate and 40 years straight line for nonresidential real estate.
Under the tax act, 100% bonus depreciation is allowed for qualified improvement property (“QIP”), which are improvements to the interior of nonresidential property placed in service after September 27, 2017 and before January 1, 2023. If the taxpayer makes the real estate trade or business election to allow deduction of interest expense, this 100% bonus depreciation is not allowed. If the election is made, the QIP is depreciated over the ADS life of 20 years.
Blocker corporations that make distributions to the shareholders must withhold a Federal nonrefundable, noncreditable withholding tax of 30% (unless reduced by treaty) of the distribution to the extent the blocker corporation has current or accumulated earnings and profits (“E&P”). E&P is the measure of a corporation’s economic ability to pay dividends to its shareholders. In calculating E&P, there are a few adjustments from taxable income. One is that depreciation is computed under the ADS system. Use of the ADS eliminates the depreciation adjustment in calculating earnings and profits (“E&P”).
Like Kind Exchange. Tax deferred link kind exchanges are still allowed for US real estate exchanged for other US real estate not held primarily held for resale. The like kind exchange rules were repealed for exchanges of personal property. If a cost segregation study is utilized, the personal property will not be eligible for like king exchange treatment. This needs to be weighed before a cost segregation is pursued.
Carried Interest for fund executives. Under old law, the holding period for carried interest was one year to receive long term capital gain treatment and pay 23.8% in Federal capital gains tax and net investment income tax, Under the new law, the holding period for carried interest is 3 years. The effective date is carried interest gains after December 31, 2017. Existing deals are not grandfathered. If a deal is sold before a 3 year holding period, the fund executive will have a short term capital gain taxed at ordinary income tax rates which can be high as 37%, plus the 3.8% net investment income tax. The short term capital gain can be offset with short term or long term capital losses in the current year or carryforwards from prior years.
An open issue is whether, a real estate business could generate long term capital gain by holding section 1231 assets for more than one year. This is not covered in the carried interest language of the tax act. Treasury regulations may provide guidance on this.
Base Erosion Anti Abuse Tax (“BEAT”). In some instances, US blocker corporations with foreign parents stripped out some of its earnings using intercompany loans. The strategy was used when the foreign parent had a lower tax rate or no tax in its home country, and the interest was exempt from US withholding under the portfolio exemption rule or treaties. The BEAT tax was enacted to address this.
The BEAT tax applies to interest payments made or accrued by the blocker corporation to the related foreign party lender which represent 3% or more of the corporation’s deductible expenses. The BEAT tax rate is a 10% minimum tax (5% in 2018) on the corporation’s taxable income excluding the interest payment. The BEAT tax is a minimum tax and only applies to the extent it is higher than the regular income tax.
The base erosion tax does not apply to corporations with average annual gross receipts of less than $500 million for the three preceding tax years. The gross receipts of a controlled group of blocker corporations must be aggregated in determining whether the $500 million gross receipts threshold is met. To determine if there is a controlled group, a related party is any person who owns at least 25% of the total voting power of all classes entitled to vote or who owns at least 25% of the total value of all classes of stock of the blocker corporation.
In calculating gross receipts, a blocker corporation would presumably use its share of gross receipts from the LLC that owns the property, rather than its share of the distributable taxable income or loss from the LLC.
Interest payments subject to US withholding tax are not subject to BEAT tax. The rule applies on proportionate basis if treaty allows a rate lower than 30%.
The effective date of the provision is for base erosion payments paid or accrued in tax years beginning after December 31, 2017. Loans made before this date are not grandfathered,
States nonconformity rules. Some state tax codes automatically conform to the Federal tax law (rolling conformity). Other states, may update to conformity. Given the state budget deficits, many states may decouple from favorable Federal provisions, such as bonus depreciation.
The most likely state nonconformity will be NOLS, as many states were not in conformity before 2018. Some states may allow NOL carrybacks, may not allow an indefinite carryforward, may not have an 80% NOL limit on offsetting current year taxable income, and may not grandfather NOLS incurred before 2018. Also, states may not conform to the new depreciation rules and interest expense carryforward rules. States that conform to the NOL and interest expense carryover provisions will need to enact rules to determine whether the carryovers will be applied on a pre or post apportionment basis.
The BEAT appears to be inapplicable to the states since it does not affect the calculation of Federal taxable income, which is the starting point in calculating state taxable income in most states.
Conclusion. With the new tax law changes affecting the firpta blocker structure, tax planning and tax projections for the life of the deal will be required to minimize income taxes.