By Jason Kleinman,
Partner, Herrick, Feinstein LLP
Three ingredients are needed to make a tax shelter: debt, depreciation and a safe investment. Real estate deals can bring these three together.
As many of you may know, however, the “passive activity loss” rules, which were enacted in 1986, limit most of the tax-sheltering benefits of real estate deals to “real estate professionals.”
Such professionals have been incentivized to continue investing in real estate in part because their paper losses have been permitted to offset income from unrelated activities, hence the “shelter” label.
This article describes little-known aspects the Tax Cut and Jobs Act of 2017 that chip away at this advantage.
Real estate professionals who find their deductions limited may need to structure around these new limits or, if that’s not feasible, price their forgone tax benefits into a deal before investing.
Let’s begin by reviewing the tax benefits that real estate professionals (i.e. people who spend 1000-plus hours a year working in real estate) have had relative to the general population.
Suppose such a professional has an apartment building that he bought for $10 million, with $8 million of debt accruing interest at a six percent rate.
Each year, he’s been permitted to deduct $480,000 of interest plus $363,000 of depreciation expense (i.e. 3.63 percent of $10 million), for a total deduction of $843,000.
Now, to make this more realistic, let’s multiply this deduction by five (because our investor, if he is a real estate professional, is likely to have many similar properties), for a total deduction of $4.215 million per year.
So, if our investor has annual rental income of $3.215 million, his excess $1 million deduction has been permitted to offset his income from unrelated activities.
While the investor described above has been permitted to make use of his $1 million deduction each year, the passive activity loss rules have made it difficult for the rest of us to do the same.
Because of the Tax Act, however, even real estate professionals are going to have a hard time making full use of such deductions for 2018 and subsequent years.
Three new limits may hit real estate professionals especially hard:(1) a new cap of $500,000 ($250,000 for single filers) for losses incurred in any year by non-corporate investors, with the balance rolling over as net operating losses (“NOLs”), (2) a new ceiling on NOLs, limiting their usefulness to 80 percent of the investor’s taxable income in any year and (3) caps on interest deductions.
Let’s look at how the Tax Act changes the treatment of current year losses for our investor, who would have otherwise had a $1 million net deduction.
Our investor will find that his $1 million net deduction will get knocked down to a $500,000 deduction ($250,000, if our investor is single).
His remaining $500,000 of deduction will not disappear. It will simply get added as a NOL for future years.
However, even NOLs will not be as valuable to our investor as they had been, since instead of offsetting income on a dollar-for-dollar basis each year, the new ceiling rule will limit the NOL’s usefulness to 80 percent of the investor’s income in any year.
So, our investor, who started with a $1 million loss, is now taking a $500,000 loss in the current year, with the other $500,000 loss postponed and possibly worth less than it had been in future years.
The limitations on interest expense may have an even greater impact on deductions available to real estate investors.
However, as these limits begin to apply only when the borrower, or borrowing entity, has gross receipts exceeding $25 million, rank and file investors will not be subject to these limits. For the larger investors, what the new limits on interest deductions will do is require them to choose between capping their interest deductions at 30 percent of their adjusted taxable income each year or conceding to a less favorable depreciation schedule.
The extent to which depreciation deductions will need to be forfeited, to preserve the full deductibility of interest expense, will depend on the type of real estate the investor owns.
Though we suspect that most investors will find it worthwhile to sacrifice some depreciation deductions as the tradeoff for preserving their interest deduction, the details will vary from investor to investor.
Adding the above together, real estate professionals may continue making better use of their deductions from real estate investments than do the rest of us. It is the extent of their advantage that is diminishing.
What remains to be seen is whether investors will concede to these new limits or engage in more complex structuring to preserve the deductions to which they have become accustomed.