Alert January 30, 2017

Impact of Tax Reform Proposals on REITs and Real Estate

Summary

This alert focuses on various tax reform proposals and their potential impact on REITs and the real estate industry. Tax reform is high on the agendas of both the House Ways and Means Committee and the Trump administration. This alert summarizes key aspects of their tax reform proposals and their implications for REITs and the real estate industry.

Current Proposals

Currently there are two significant tax reform frameworks interested parties can use as a guide to assist them in understanding likely reform initiatives and to better comprehend at this juncture the impact these initiatives might have on the real estate industry and REIT stock values. One such framework is embodied in  “A Better Way for Tax Reform,” a comprehensive tax reform blueprint which House Speaker Paul Ryan and House Ways and Means Committee Chairman Kevin Brady advanced in June 2016 (the “House GOP Blueprint” or “Blueprint”).[1]  The other framework, of course, is found in the Trump tax proposals (the “Trump Plan”).[2] Additional clarity on the Trump administration’s tax reform proposals is likely to be provided in February 2017 when the new administration submits its FY2018 budget to Congress. We fully expect that organizations such as the Real Estate Roundtable and NAREIT will be (and have been) actively involved in advancing the real estate industry and REIT markets’ views on tax reform.[3] 

Other members of Congress also have pursued tax reform that could impact real estate and REITs. Senate Finance Committee Chairman Orrin Hatch is focused on the integration of corporate and shareholder taxation, including a proposal that would ensure one level of tax on dividend income through a dividends paid deduction similar to that used in the REIT and mutual fund market context. This type of corporate integration proposal, if advanced, would likely fit within a comprehensive tax overhaul package. In addition, the House GOP Blueprint expressly references H.R. 4377, the American Business Competitiveness Act  of 2015 (the “ABC Act”), a bill introduced in January 2016, by Representative Devin Nunes, a member of the House Ways and Means Committee, which would provide for a business cash-flow tax, as a model for its capital expensing proposal, and H.R. 5076, the Main Street Fairness Act, a bill introduced by Ways and Means Member, Representative Vern Buchanan, which aims to eliminate disparities in the taxation of business income by capping the tax rate on non-corporate business income at the maximum corporate tax rate.[4]

Senate Majority Leader Mitch McConnell and Speaker Ryan both have publicly outlined plans to use the budget reconciliation process to advance tax reform, which could expedite tax reform if it is revenue neutral.[5] 

Impact on REITs and Real Estate

To date, the House GOP Blueprint and the Trump Plan are limited to high-level descriptions of potential reforms. No formal legislative proposals have yet been formulated, and many details remain open. Set forth below, however, are particular areas of focus and discussion which we thought would be of interest.

1. Tax Rates for Corporations and Individuals

  • House GOP Blueprint - The House GOP Blueprint would reduce the corporate tax rate to a 20% flat rate and eliminate the corporate alternative minimum tax (“AMT”). The Blueprint also would broaden the corporate tax base by eliminating certain “special-interest deductions and credits,” but gives no details regarding which deductions would be eliminated. Net operating losses (“NOLs”) could no longer be carried back, but the Blueprint would allow NOLs to be carried forward indefinitely and increased by an interest factor that compensates for inflation and a real return on capital to maintain the value of amounts that are carried forward. The deduction allowed for carried-forward NOLs in any year, however, would be limited to 90% of taxable income for such year determined without regard to the carryforward.  

    The Blueprint calls for three  income tax brackets for individuals – 12%, 25% and 33% – and, to eliminate current law bias against savings, would allow individuals to deduct 50% of their net capital gains, dividends and interest income. The Blueprint would repeal the 3.8% tax on investment income and the individual AMT.
  • Trump Plan - The Trump Plan would lower the corporate tax rate to 15% and eliminate the corporate AMT. Most corporate credits and deductions would be eliminated, though no specific list is available at this time. Individuals would be subject to the same three graduated income tax brackets as under the House GOP Blueprint, but the Trump Plan would retain the existing capital gains rate structure for individuals, with a maximum rate of 20%. Like the House GOP Blueprint, the Trump Plan would repeal the 3.8% tax on investment income and the AMT.

Impact on REITs and Real Estate - While neither plan addresses REITs directly, lowering corporate tax rates (as both plans do) would impact the cost-benefit analysis for businesses considering the REIT structure. REITs enjoy a substantial tax benefit (escape from corporate level tax), but those tax savings come at some cost—such as the inability to retain earnings (to meet REIT distribution requirements) and compliance with REIT  income and asset requirements (including, for example, the 100% penalty tax on dealer gains and the need to outsource property management in certain asset classes (such as hotels)). If the corporate tax rate goes down, the benefit REITs derive from avoiding corporate tax becomes less valuable.

The House GOP Blueprint does not specify whether its reduced tax rates on individuals’ dividends and capital gains (through the 50% exemption) would apply to dividends and capital gains derived from REITs. Although REITs are not specifically addressed, the language of the House GOP Blueprint suggests that its reductions in corporate and individual tax rates are intended to work together to mitigate double taxation for income earned indirectly by individuals through taxable corporations; if this is the intent, we expect that the reduced rates on dividends would not be available in respect of ordinary REIT dividends. By apparently retaining the current capital gain rates for “qualified dividend income,” which does not include REIT dividends, the same would be true under the Trump Plan. Furthermore, neither plan suggests that the proposals for taxation of pass-through entities (see below) would apply to REITs. As a result, under either plan, the combined corporate level taxes and individual level taxes on earnings distributed by a regular corporation to individual investors could be comparable to the individual level taxes paid by individual investors on ordinary REIT dividends. For other investors, however, such as tax-exempt and foreign investors, the REIT structure could still produce substantial tax savings notwithstanding a convergence of REIT and non-REIT combined tax rates for individual investors. Lower corporate tax rates would also make use of a TRS less costly.

2. Taxation of Certain Pass-Through Entities 

  • House GOP Blueprint - The House GOP Blueprint would apply a maximum tax rate of 25% to “business income” received by an individual from a sole proprietorship or “pass-through entity.” Partnerships, limited liability companies and S corporations are specifically referenced as examples of pass-through entities; REITs are not. “Business income” does not include amounts paid (or treated as paid) as reasonable compensation to the owners of a pass-through business. The intent of this change is to reduce “distortions and inequities” arising from the difference between corporate tax rates, and ordinary income of partnerships taxed at the top marginal rates when included in income of individual partners.
     
  • Trump Plan - The Trump Plan indicates that the 15% corporate rate would be available to “all businesses, both small and large, that want to retain the profits within the business.” Reports[6] and recent testimony by Treasury Secretary nominee Steven Mnuchin indicate that distributions from “large” pass-through businesses received by owners who elect the 15% flat rate would be taxed as dividends, but no details have been provided on how the size of pass-through businesses would be determined. 

Impact on REITs and Real Estate - The apparent goal of both plans is to create parity between the treatment of corporate income and pass-through business income (although the 25% pass-through rate under the House GOP Blueprint would be less than the Blueprint’s combined corporate and individual tax rate). Both plans would reduce the effective tax rate on “business income” for owners of partnerships and certain other pass-through entities and, therefore, absent changes to align the treatment of REITs with such proposals, reduce the comparative tax benefits of REITs in respect of business income.   

3. Election to Expense Capital Investments and Disallow Current Deduction for Interest Expense

One of the most far-reaching aspects of the tax reform proposals relates to the treatment of capital expenditures and interest expense.

  • House GOP Blueprint - The House GOP Blueprint would allow businesses to expense the cost of all business investments in tangible property (such as equipment and buildings, but not including land) and in intangible assets in the year of the expenditure (rather than capitalizing and depreciating/amortizing those costs over time as under current law). As a counterpart to this proposal, the deduction for net interest expense would be repealed (i.e., interest expenses could still offset interest income). Exceptions may apply for financial services companies. We expect that gain from the sale of expensed business property would be treated as business income and may not qualify for capital gains rates.[7] Unlike the Trump Plan, the Blueprint would not allow businesses to elect out of these provisions.

  • The Trump Plan - The Trump Plan would allow businesses (possibly limited to companies engaged in manufacturing in the United States) to choose between the current system of depreciation/amortization and deductible interest, and a new system similar to the House GOP Blueprint wherein expenditures could be deducted currently but interest could not.   


Impact on REITs and Real Estate - Expensing of real estate investments would have a dramatic impact on REITs and the real estate industry. Presumably, such upfront expensing will generate large (and, as noted above, “inflation adjusted”) NOLs that would be carried forward in future years. Entrepreneurs investing through partnerships  may be able to use those NOLs to offset other income, presumably subject to “passive loss,” “at-risk” and other current law limitations. NOLs could be less useful for REITs, however. For example, absent changes in the current dividend tax rules, NOL carryovers would not reduce the taxable portion of a REIT’s dividend, and thus for some REITs the tax benefit of an NOL to their shareholders may be limited. On the other hand, the NOL carryover could allow the REIT to retain additional earnings without running afoul of the REIT distribution requirements. The elimination of deductions for interest expense could make preferred equity financing more attractive as compared to debt financing, provided that the dividends paid deduction is retained for such preferred shares. We suspect that the impact of this proposal on REITs in particular will depend greatly on a REIT’s specific circumstances.

Neither plan discusses the treatment of existing investments in real estate. It is worth noting, however, that the ABC Act (see above), contains a provision that would provide for continued amortization of the basis of property held and used in a trade or business immediately prior to the effective date of the new legislation, using the same schedule and method as in effect prior to the new legislation. Such significant disparities between new and existing investments likely will create planning opportunities (and pitfalls), as well as a need for anti-churning rules (not addressed in any of the proposals). Also, such changes would have a material impact on REIT M&A transactions, including going private transactions and contributions to an UPREIT.

4. Other Proposals

  • Carried Interest Taxed as Ordinary Income

    The House GOP Blueprint does not mention carried interest or indicate any plans to amend the partnership tax rules that give rise to carried interest, and some reports have indicated that was intentional. The Trump Plan does express an intent to tax carried interest as ordinary income. A change in the tax treatment of carried interest could impact real estate entrepreneurs, fund sponsors, and also management of public UPREITs who receive compensatory “LTIP” units, but given the lack of any details it is too soon to have a good sense as to how any such forms of carried interest would fare under the Trump Plan. The carried interest changes in the Camp Bill would not apply to a partnership engaged in a real property trade or business, but we do not know if the Trump Plan envisions a similar exclusion. Moreover,  given the proposed rate reductions for business income, the proper treatment of carried interest may be somewhat moot.[8] 

  • Like-Kind Exchanges

    Neither the House GOP Blueprint nor the Trump Plan addresses, or even mentions, like-kind exchanges. However, some commentators believe that a repeal of like-kind exchanges is likely to be a component of any comprehensive tax reform bill. The repeal of, or imposition of significant limitations on, Section 1031 has been proposed in the past, most notably in Camp Bill and the Obama administration’s FY2016 budget proposal.
      
    If like-kind exchange treatment becomes unavailable, capital expensing, if adopted, could be a partial mitigant.

  • Corporate Integration (Deduction for Dividends Paid)

    As noted above, Senate Finance Chairman Orrin Hatch recently expressed interest in reforming the corporate tax code to allow all corporations a dividends paid deduction similar to that allowed for REITs and mutual funds. Senator Hatch held two hearings on the subject and has discussed it in public appearances. However, he has not yet proposed any language or introduced a bill in Congress, and has acknowledged that it would have to be considered in conjunction with future tax reform efforts. Thus, while neither the House GOP Blueprint nor the Trump Plan includes full corporate integration as such, they are both clearly influenced by this proposal given the evident intent to create parity between the taxation of corporate and non-corporate business income. As any tax reform proposal moves through the legislative process, Hatch’s corporate integration proposal should be expected to significantly impact the discussion.
     
    Particularly in light of the proposals to eliminate the deduction for net interest expense , such a proposal could make preferred equity financing very attractive for all corporations (not just REITs). At the same time, however, any move in the direction of corporate integration could reduce the relative advantages of REITs for real estate investments.

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The House GOP Blueprint and Trump Plan contain proposals that would have significant impacts, directly and indirectly, on REITs and real estate investments, and it will be important to closely watch developments as Congress considers these proposals in the coming months.  

 


[1] https://abetterway.speaker.gov/?page=tax-reform

[2] www.donaldjtrump.com/policies/tax-plan.

[3] Attached here is a December 13, 2016 letter regarding tax reforms that was sent to Speaker Ryan and Chairman Brady from several of the real estate industry trade organizations, including the Real Estate Roundtable, NAREIT, the National Multifamily Housing Council and NAIOP.

[4] Other tax reform proposals that may come into play include the Tax Reform Act of 2014 (the “Camp Bill”), a draft bill that former Ways and Means Chairman David Camp put forward that represents the Republicans’ most recent comprehensive tax reform proposal in legislative form, and S.3529, the Progressive Consumption Tax Act of 2016, a bill sponsored by Senator Benjamin Cardin, a member of the Senate Finance Committee, that would provide for a lowering of corporate and individual rates and institution of a 10% VAT. Parts of these bills could be included in any tax reform legislation.

[5] The use of the budget reconciliation process will insulate the legislation from the need for 60 votes to break a potential filibuster and will enable the GOP, if it is aligned, to expedite tax reform and other fiscally-based legislation, including deficit-reduction legislation, with a simple majority vote in the Senate. However, under the so-called Byrd rule, a reconciliation bill cannot increase the deficit in any fiscal year after the window of the reconciliation bill unless (i) the costs outside the budget window (generally, 10 years) are offset by other savings in the bill, (ii) the Byrd rule is waived by 60 votes or (iii) revenue reducing provisions sunset at the end of the window period.

[6] See Nunns, et al., “An Analysis Of Donald Trump's Revised Tax Plan,” 2016 TNT 202-31 (Oct. 18, 2016).

[7] Under the ABC Act, on which this provision is modelled, business purchases eligible for expensing include purchases of property for use in a business activity, and business income includes sales of such property; in both cases, financial instruments (defined to include shares of stock and equity interests in widely held or publicly traded partnerships) are excluded from treatment as business property. In addition, the ABC Act applies a 25% rate to business income and does not include any conforming provision to Section 1231 of the Internal Revenue Code (which under current law permits net long term gain from the sale of depreciable business property to be taxed at capital gain rates). 

[8] For additional information on the 2009 carried interest legislative proposal by Representative Sander Levin,  the 2010 Obama budget proposal addressing carried interest and the Camp Bill, see prior Goodwin alerts dated March 3, and May 21, 2009 and March 6, 2014.