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Article Prepared by FGMK Tax Partner Fuad Saba
The Tax Cuts and Jobs Act of 2017 (the Act) represents the largest change to the Internal Revenue Code (the Code) of the United States since the Tax Reform Act of 1986. Non-US investors in US real estate (often called “inbound” real estate investors) will be affected by the changes brought by the Act. Although some uncertainty exists at this time regarding the application of the interest-stripping provisions in particular, we have summarized below the portions of the Act that are likely to impact the typical inbound real estate investment structure, particularly those from countries that do not have an income tax treaty in place with the United States (including many countries in the Middle East and North Africa, Asia, and Latin America.)
The Portfolio Interest Exception
Non-treaty investors have made extensive use of the so-called “portfolio interest” exception from US withholding taxes on outbound payments of interest. The typical non-treaty inbound investment structure makes use of US C-Corporations, known as “blockers,” to “block” the flow-through of income from real estate investments from the foreign investor so that the foreign investor doesn’t have a US return filing obligation. The blockers typically are held by companies established in tax haven jurisdictions such as the BVI or the Cayman Islands. Funding of the blocker comes in the way of equity investments, as well as debt that qualifies for the portfolio interest exception. The blocker then typically invests in US real estate, either directly or via partnerships with US real estate companies/managers/promoters. Qualifying for the portfolio interest exception means that the interest payments made on the foreign debt funding of the blocker will be exempt from the US 30% federal withholding tax (in the case of a non-treaty lender, or a lower rate if a treaty applies). At the same time, the interest expense serves to reduce the taxable income of the US real estate investment business, and thus provides a partial tax “shield.” Notably, the Act made no changes to the portfolio interest exception, so that this manner of inbound funding remains viable for 2018 and beyond.
Earnings Stripping Rules
For taxable years ending on or before December 31, 2017, interest expense incurred by a US blocker was potentially subject to deduction limitations under the “earnings stripping” provisions of Code section 163(j) (in its form prior to the enactment of the Act) when the offshore funding companies were closely held by a small number of owners. The Act replaced the former Section 163(j) provisions with new rules that disallow net interest expense deductions by a U.S. business in excess of 30% of adjusted taxable income (generally, taxable income without regard to interest, net operating losses, the new pass-through deduction (see below) and, before 2022, depreciation and amortization). Interest would be disallowed whether it was paid to a related party or a third party, and whether it was paid to a US party or a foreign party, under these new rules. Any disallowed interest can be carried forward indefinitely. Although the Act provides that this interest deduction limitation does not apply to blockers investing in real estate, directly or through a limited liability company, by election of the investor, it is unclear whether this exception will apply when a blocker invests in US real estate through a partnership vehicle that carries on a real estate business. Investors are looking to the IRS to provide clarification in this regard. Assuming there are no interest deductibility restrictions on investing in US real estate via partnerships under the new rules, inbound investors will enjoy the benefits of the full interest deduction combined with the absence of withholding under the portfolio interest exception (see above). Note that the election of the real estate business to opt out of the new 163(j) provisions comes at the cost of adopting ADS depreciation instead of MACRS.
Reduction in Federal Corporate Income Tax Rate
The blocker is subject to US corporate income taxation on its annual taxable income and on any net gain realized on the sale of the US real property in which the blocker has invested. The Act lowered the federal corporate income tax rate from a range of rates topping out at 35%, to a single 21% rate, for years beginning after 2017. The new lower rate applies to annual taxable income as well as net gain realized on the sale of the US real property.
Limitation on the Use of Net Operating Losses
The Act imposes a limit on the use of Net Operating Losses (NOLs) incurred after 2017. NOLs may no longer be carried back, but can be carried forward indefinitely (instead of the previous 20-year term limit). However, the blocker’s NOL that is deductible in any one tax year is limited to 80 percent of taxable income for that year. In particular, although logic might argue that the NOL should not be limited in the year when all of the US real property is sold and the blocker liquidates, there is no indication in the Act that this would be the case. Accordingly, blockers may be exposed to a greater level of federal income tax with this new NOL limitation.
The Act eliminated like-kind exchanges under Code Section 1031 for all but real property, so that like-kind exchanges of personal property no longer are available. However, the Act does permit tax-free like-kind exchanges for real property assets that are not “held primarily for sale.”
Pass-through Tax Rate for Investors in Pass-Through Entities
Since it is common for a corporate blocker to invest in US real estate through a partnership, or an LLC taxed as a partnership, investors should note that partnership investors - but not a corporation such as the blocker - will be allowed to deduct 20% of domestic Qualified Business Income (i.e., the net of a taxpayer’s items of income, gain, deduction, and loss related to such taxpayer's business). Ordinary dividends from a REIT or publicly-traded partnership are eligible for a straight 20% deduction. For taxpayers earning income from an S-Corporation or Partnership, the deduction will be limited to the greater of either a) 50% of the business's W-2 wages, or b) 25% of the business's W-2 wages plus 2.5% of the unadjusted basis of all qualified property used in the trade or business (i.e., tangible property subject to depreciation). The deduction is not available to Specified Service Businesses (e.g., health, law, accounting, etc.), except for taxpayers with taxable income not exceeding $315,000 for married filing jointly, $157,500 for other individuals, and will be phased in for income over $315,000 over the next $100,000 of taxable income for married filing jointly and $50,000 for other individuals. Notably, Specified Service Businesses do not include engineering or architectural firms. Additionally, the Act suggests that many real estate management companies would not be considered Specified Service Businesses either.
Partnership interests received in connection with the performance of services in managing assets, including real estate, will be subject to a three-year holding period in order to be treated as long-term capital gains rather than the current one-year holding period. Carried interest in respect of an investment in a portfolio company that does not satisfy the three-year holding period will be treated as short-term capital gains taxed at the higher ordinary income rates. Carried interest resulting from “qualified dividend income” would remain eligible for the lower applicable tax rate.
Base Erosion Tax (BEAT)
The Act limits deductions for payments by domestic corporations (including blockers) to foreign related parties by imposing a ten percent minimum tax (five percent in 2018 and 12.5 percent after 2025) on the blocker’s “modified taxable income” (computed without regard to deductible payments made to foreign related parties). A 25 percent foreign shareholder of a blocker is considered “related” for these purposes, as well as any other foreign entity that is under common control with the blocker. However, the new base erosion tax applies only to a blocker that is a member of a group with $500 million or more in annual gross receipts (averaged over a three year period) that has made related party deductible payments totaling at least three percent of the blocker’s total annual deductions. Considering the $500 million threshold, most inbound blockers will not be subject to the BEAT. However, ownership aggregation rules apply under the BEAT that may treat multiple blockers as one “person” for purposes of the $500 million threshold, if the voting stock in each blocker is owned by the same inbound investor, so that care should be exercised before assuming that the BEAT will not apply.
With the potential exception of the NOL 80% annual limitation, most of the changes brought by the Act should be beneficial to non-treaty inbound investors in US real estate, and we would expect to continue to see a flow of such investments into the US.
The summary information in this document is being provided for educational purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.