ASSESSING THE IMPACT OF REAL ESTATE TAX REFORM 30 with average annual gross receipts that do not exceed $25 million. In calculating gross receipts, the gross receipts of all related entities are aggregated under complex attribution rules. As a general matter, entities with more than 50% common ownership will be aggregated. • Lending businesses (including mortgage REITs). While lending businesses are not specifically carved out, the business interest limit does not apply unless business interest expense exceeds business interest income, thus effectively exempting many (if not most) mortgage REITs and other taxpayers engaged in a real estate lending business, such as certain debt funds. PRACTICAL OBSERVATIONS • Real property trade or business election. Careful consideration will need to be given to whether or not a real property trade or business will wish to elect out of these new interest limitation rules, taking into account the correlative longer depreciation periods and the fact that the election is irrevocable. However, our expectation is that many real estate businesses will make the election if and when the new limitation on deductibility would otherwise apply. The lost interest deduction is potentially permanent, while the extended depreciation life is often primarily a timing difference. In addition, slower depreciation could benefit some corporate taxpayers by preventing or limiting the accrual of an NOL in early years, which after the TCJA is useable only against 80% of taxable income. Businesses otherwise required or that elect to use ADS (such as partnerships with significant tax exempt partners and many REITs seeking to limit return of capital distributions) should have relatively little downside to making the election. • Considerations and uncertainties regarding the real property business election. There are many uncertainties and computational questions relating to how, whether and when to elect out of the new business interest limitations. Uncertainties include: (i) whether all investments held by a fund, a REIT or an operating partnership constitute a single trade or business, (ii) the extent to which or whether differences in properties may result in separate trades or businesses, (iii) the effects of conducting activities or holding investments through various subsidiary and joint venture structures and (iv) the proper allocation of interest expense among activities, such as where a partnership or REIT uses a credit facility to fund numerous investments (e.g., pro rata based on fair market value or pursuant to rules that “trace” the use of debt proceeds to specific investments). In addition, mere ownership of interests in a REIT subsidiary typically would not be viewed as a real property trade or business. As a result, investors that hold real property indirectly through REIT subsidiaries, such as leveraged corporations found in many fund structures, will want to weigh the potential benefits of investing through the REIT structure against the potential application of the interest deductibility limitations in assessing whether to restructure an investment to avoid those limitations. We expect the election for 2018 will be part of the taxpayer’s 2018 tax return, and hopefully Treasury and the IRS will provide additional guidance in time to help taxpayers assess how, whether and when to make the election. • Mitigation Strategy – Preferred Equity. Mezzanine financing on real estate is not infrequently structured as preferred equity. If properly structured to qualify as equity, rather than debt, for tax purposes, the return on preferred equity financing issued by an entity taxed as a partnership is effectively deductible without limitation under the new rules and without the need for the real property trade or business election. The dividend paid on preferred stock issued by a REIT also can function like interest that is deductible without limitation under the new rules. However, numerous commercial, regulatory and tax considerations may limit the use of preferred equity financings as debt substitutes. • Aggregation rules may make it challenging to rely on the small business exception. In many cases, it will be difficult to determine whether ownership relationships exist that would require aggregation for purposes of the small business exception. Especially challenging may be situations when an unrelated investor owns more than 50% of a fund entity or a JV, so that gross receipts of certain affiliates of the investor, unrelated to the fund or JV, have to be included in measuring whether gross receipts exceed $25 million. PASS-THROUGH DEDUCTION In addition to reducing the maximum individual rate to 37%, the TCJA creates a new deduction (the “Pass- Through Deduction”) for non-corporate taxpayers of up to 20% of “qualified business income” from pass- through entities (partnerships, S corporations, and sole proprietorships) plus up to 20% of most ordinary REIT dividends and qualified publicly traded partnership income. When the full deduction is available, it reduces the top effective tax rate on such income (before any additional 3.8% Medicare tax) to 29.6%. The Pass- Through Deduction will expire after 2025. “Qualified business income” generally means income that is “effectively connected” with any U.S. trade or business, other than the business of being an employee, exclusive of certain investment income such as capital