The recent tax reform act, P.L. 115-97, represents the largest change to the U.S. Internal Revenue Code since 1986. Non-U.S. investors in U.S. real estate (often called "inbound" real estate investors) will be affected by changes enacted in the act.
Although some uncertainty exists about the application of the interest-stripping provisions in particular, the portions of the act discussed here are likely to affect the typical inbound real estate investment structure, particularly those from countries that do not have an income tax treaty with the United States (including many countries in the Middle East, North Africa, Asia, and Latin America).
The portfolio interest exception
Investors who reside in countries that do not have an income tax treaty with the United States in effect have made extensive use of the "portfolio interest" exception from U.S. withholding taxes on outbound payments of interest. The typical inbound investment structure makes use of U.S. corporations, known as "blockers," to "block" the flowthrough of income from a foreign investor's real estate investments so that the foreign investor does not have a U.S. return filing obligation.
The blockers typically are held by companies established in tax haven jurisdictions such as the British Virgin Islands or the Cayman Islands. The blocker is funded using equity investments, as well as debt that qualifies for the portfolio interest exception. The blocker corporation then typically invests in U.S. real estate, either directly or via partnerships with U.S. real estate companies, managers, or promoters.
Qualifying for the portfolio interest exception means that the interest payments made on the foreign debt funding the blocker will be exempt from the 30% federal withholding tax (in the case of a lender from a nontreaty country, or a lower rate if a treaty applies). At the same time, the interest expense serves to reduce the taxable income of the U.S. real estate investment business and thus provides a partial tax "shield." Notably, the act made no changes to the portfolio interest exception, so this manner of inbound funding remains viable for 2018 and beyond.
Earnings stripping rules
For tax years ending on or before Dec. 31, 2017, interest expense incurred by a U.S. blocker corporation was potentially subject to deduction limitations under the "earnings stripping" provisions of Sec. 163(j) (prior to amendment by the act) when the offshore funding companies were closely held by a small number of owners. The tax overhaul replaced the former Sec. 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 income, gain, deduction, or loss which is not properly allocable to a trade or business, business interest or business interest income, net operating losses, the new passthrough deduction (see below) and, before 2022, depreciation and amortization).
Under these new rules, interest is disallowed whether it is paid to a related party or a third party, and whether it is paid to a U.S. or foreign party. Any disallowed interest can be carried forward indefinitely. Although the act provides that if the investor elects, this interest deduction limitation does not apply to blockers investing in real estate, directly or through a limited liability company (LLC), it is unclear whether this exception will apply when a blocker invests in U.S. real estate through a partnership that carries on a real estate business. Investors are looking to the IRS for clarification.
Assuming there are no interest deductibility restrictions on investing in U.S. 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 (discussed above). Note that the election of the real estate business to opt out of the new Sec. 163(j) provisions comes at the cost of adopting the alternative depreciation system (ADS) instead of the more taxpayer-favorable modified accelerated cost recovery system (MACRS) of depreciation.
Reduction in the federal corporate income tax rate
The blocker is subject to U.S. corporate income tax on its annual taxable income and on any net gain realized on the sale of the U.S. 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 U.S. 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 limit). However, the blocker's NOL that is deductible in any one tax year is limited to 80% 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 U.S. 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 Sec. 1031 for all but real property, so that like-kind exchanges of personal property no longer are available. However, the act does permit tax-deferred like-kind exchanges of real property assets that are not "held primarily for sale."
Passthrough tax rate for investors in passthrough entities
Since it is common for a corporate blocker to invest in U.S. real estate through a partnership, or an LLC taxed as a partnership, investors should note that investors in the partnership — but not the blocker corporation — will be allowed to deduct 20% of domestic qualified business income (i.e., the net of the taxpayer's items of income, gain, deduction, and loss related to the taxpayer's business). Ordinary dividends from a real estate investment trust (REIT) or a 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 (1) 50% of the business's W-2 wages, or (2) 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 available to taxpayers in certain specified service businesses (including health, law, accounting, and financial services) only if their income does not exceed $415,000 for married filing jointly, $207,500 for other individuals, and the deduction phases out for taxpayers in specified service businesses if their income is over the threshold of $315,000 for married filing jointly and $157,500 for other individuals. Notably, specified service businesses do not include engineering or architectural firms. Additionally, the act suggests that many real estate management companies are not considered specified service businesses either.
Partnership interests received in connection with the performance of services in managing assets, including real estate, are subject to a three-year holding period before they are treated as long-term capital gains, instead of the current one-year holding period. Carried interests from an investment in a portfolio company that does not satisfy the three-year holding period are treated as short-term capital gain taxed at the higher ordinary income rates. Carried interests resulting from "qualified dividend income" remain eligible for the lower applicable tax rate (maximum 20%).
Base erosion and anti-abuse tax
The act limits deductions for payments by domestic corporations (including blockers) to foreign related parties by imposing a 10% minimum tax (5% in 2018 and 12.5% after 2025) on the blocker's "modified taxable income" less its regular tax liability (reduced by certain credits). Modified taxable income is computed without regard to deductible payments made to foreign related parties. A 25% 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 Sec. 59A base erosion and anti-abuse tax (BEAT) 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 3% 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 care should be exercised before assuming that the BEAT will not apply.
Inbound investment in U.S. real estate will probably not be affected
With the potential exception of the NOL 80% annual limitation, most of the changes brought by P.L. 115-97 should be beneficial to inbound investors in U.S. real estate from nontreaty countries. Therefore, the amount of those investments into the United States will probably not diminish now that the act is in effect.
Fuad S. Saba (firstname.lastname@example.org) has over 25 years of international tax and transfer-pricing experience and is currently a partner at FGMK LLC in Chicago, where he leads its Specialty Tax Practice.
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