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Latest Tax Strategies for Real Estate Funds & Operators

Learn about potential tax planning strategies and incentives that real estate funds and operators should consider in light of legislative changes.
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A divided Congress where Republicans hold the majority in the House and the Senate, with 48 Democrats and 49 Republicans (also 3 Independents), means that passing legislation, especially tax policies, is a difficult task this year. However, there is some appetite on both sides of the aisle to potentially include tax policies in a legislative package this year. Here are some potential tax planning strategies and incentives that real estate funds and operators should consider in light of potential legislative changes and recently enacted legislation:

What Is Coming Down The Pike In Terms Of New Legislation That May Impact Real Estate?

Carried interest changes. The "carried interest" rule of Section 1061 recharacterizes certain net long-term capital gains with respect to applicable partnership interests (API) as short-term capital gains. So, to take advantage of the current preferential long-term capital gain rate, a partnership must hold the asset giving rise to the gain for more than three years (in contrast to the one-year holding period requirement under Section 1222).

The holding period is calculated based on how long the asset is held by the partnership, not by the taxpayer’s holding period in the API. So, for example, if a partnership is funded in April 2023 and does not acquire capital assets until June 2023, then the three-year holding period does not expire until June 2026. As such, since a holding period determines the potential tax rate of any assets the fund sells, Section 1061 is an important consideration for real estate funds to keep in mind.

Note, in the past, there have been unsuccessful efforts in Congress and by the Biden Administration to extend this holding period to five years, although some proposals would limit this change to taxpayers making more than $400,000 annually. President Biden’s fiscal year 2024 budget also proposes to tax capital gains at the same rate as wages for those making more than $1 million in income, as well as closing the carried interest loophole.

Pass-through entity (PTE) tax elections. The Tax Cuts and Jobs Act (TCJA) created a cap on the State and Local Tax (SALT) itemized deduction of $10,000 (married filing jointly) and $5,000 (married filing separately) for tax years beginning after beginning after December 31, 2017, and before January 1, 2026. Members of Congress have unsuccessfully attempted to pass legislation to eliminate or increase the SALT cap, so in the absence of federal legislative change, state legislatures have been passing workarounds to provide income tax relief for individuals.

The current trending workaround is PTE elections, with over 30 states enacting PTE legislation. For the state PTE, pass-through entity taxpayers, such as partnerships and S corporations, can elect to pay state income taxes at the entity-level return rather than on the personal income tax returns of the individual partners and owners. As a result, this election can alleviate the SALT cap from an individual income tax perspective. There are many considerations in making a PTE election, and each state has its own specific requirements, so partners in real estate funds should contact a tax advisor to determine if a PTE election would be beneficial.

Sunsetting TCJA provisions. The TCJA included multiple tax provisions that either have already begun to phase out or, absent legislative changes, will sunset within the next few years. As real estate funds and operators make investment decisions, these are the potential changes coming down the line that may impact how real estate investors do business:

  • Bonus depreciation changes. For property acquired and placed in service after September 27, 2017, and before January 1, 2023, taxpayer could deduct 100% of the cost of bonus-eligible property in the first year. But this bonus rate decreases to 80% for qualifying assets placed in service in 2023 and will continue to decrease by 20% each year until it fully phases out to 0% for assets placed in service in 2027. There are also state tax implications to consider.
  • Section 163(j) changes. For tax years starting in 2022, the add-back for depreciation, depletion, and amortization is now excluded when computing adjusted taxable income. This is especially relevant to capital-intensive businesses as it may create negative tax consequences by limiting the amount of business interest expense deducted.

House Republicans are currently working on a tax bill to include a variety of tax provisions, including addressing sunsetting TCJA provisions to reinstate full bonus depreciation and rollback changes to how interest expense is computed under §163(j). Although Republicans are likely to pass this tax package through the House, it is unlikely that a tax bill will get any real traction until this fall when Congress goes through its annual appropriations negotiations for government funding. A standalone Republican tax bill would also be dead on arrival in the Senate.

Qualified opportunity zone funds (QOF). A QOF generally allows taxpayers to defer and potentially reduce the recognition of gains that are reinvested into certain new trades or businesses. QOFs continue to provide tax benefits to investors, including:

  • Deferral of Taxes – Investing capital gains within 180 days of the capital gain and not paying any tax on the reinvested gain right now. Instead, eligible gains may be deferred until there is an inclusion event or by December 31, 2026, whichever is earlier.
  • Tax-Free Appreciation (if a taxpayer holds the QOF investment for more than 10 years)

QOF requirements can be complex to navigate, so consult a tax advisor to see how this tax savings opportunity may benefit you.

Note, in the last session of Congress, a bipartisan group of senators introduced legislation proposing to reform opportunity zones, including extending the deferral period from December 31, 2026 to December 31, 2028, reinstating and expanding reporting requirements, and creating pathways for smaller-dollar impact investments. Although this legislation has not yet been re-introduced in the current session of Congress, legislators often re-introduce bills every few years, so as the deferral sunset date approaches, this proposed legislation may resurface again in this session of Congress.

Housing legislation. There is also bipartisan support in Congress for housing legislation. Sponsors of these bills are waiting for a legislative vehicle that could include these housing policies. Two options are either a technical corrections bill for recent legislation, or the government funding package that will be negotiated this fall. Here are some of the potential housing policies that could become law in this session of Congress:

  • In March, Senate Finance Committee Chair Ron Wyden (D-OR) introduced the Decent, Affordable, Safe Housing for All (DASH) Act, which would also provide new tax credits to encourage investment in homeownership in low-income communities and to incentivize environmentally-friendly development strategies.
  • Also in March, Sens. Todd Young (R-IN) and Ben Cardin (D-MD) introduced the Neighborhood Homes Investment Act (NHIA), which would create a federal tax credit that covers the cost between building or renovating a home in distressed neighborhoods and the price at which they can be sold. Biden’s fiscal year 2024 budget also includes funding for similar policies as what is included in the NHIA.
  • Young is also expected to reintroduce the Affordable Housing Credit Improvement Act, which was previously introduced with bipartisan support in 2021. This bill would increase the amount of the Low-Income Housing Tax Credits (LIHTC) allocated to each state and make changes to the LIHTC program to better serve at-risk and underserved communities.

Other popular transactions in the real estate industry. Whether Section 1031 like-kind exchanges tenant-in-common arrangements (TICs), or entity reorganizations, the current landscape of real estate taxation provides a variety of other tax strategies to explore when considering transactions and potential legislative changes in the pipeline. For more information on trending transactions for real estate investors, click here.

What Is The Latest On Tax Credits For Real Estate Funds & Operators?

Recently enacted legislation also offers tax incentives for real estate funds and operators, especially those who are interested in investing in energy efficiency and distressed communities.

Clean energy tax credits. The Inflation Reduction Act of 2022 (IRA) is the largest climate legislation in U.S. history, providing a variety of clean energy incentives for taxpayers. Some of the tax incentives relevant to real estate funds and operators include:

  • New Energy Efficient Homes Credit. This credit is available to eligible contractors building qualified new energy-efficient homes that are acquired by a person for use as a residence. Based on which Energy Star and zero-energy program requirements are met, and whether the home is single-family or multi family, the credit amount ranges from $500 to $5,000 per unit. This credit has been extended through December 31, 2032. Prevailing wage requirements apply. Note, this credit is not transferrable and only applies to residential properties.
  • Section 179D Deduction. The IRA made significant changes to the Section 179D deduction, so starting in 2023, the maximum deduction amount increased to $5 per square foot (adjusted for inflation), depending on the square footage of the building that is energy efficient, and if prevailing wage and apprenticeship requirements are met. The IRA also eliminated the lifetime cap of this incentive, and deduction limits will now reset every three or four years, depending on the building. 
  • Investment Tax Credit for Energy Property (ITC). For projects beginning construction prior to January 1, 2025, the IRA provides a credit of 6% (base amount) of qualified investment costs of a renewable energy project. Fuel cell, solar, geothermal, small wind, energy storage, biogas, microgrid, controllers, and combined heat and power properties are eligible for this tax credit. Note, for geothermal heat property, the base investment tax credit is 6% for the first 10 years, and then phases out to 5.2% in 2033 and 4.4% in 2034. The credit amount can increase if the project meets prevailing wage and apprenticeship requirements, certain domestic content requirements for steel, iron, and manufactured products, or if the property is located in an energy community. This means the maximum ITC can be as high as 50%, but it is expected that for many taxpayers the credit amount may be 30% (base amount x 5 if labor requirements are met). This credit can be used towards the cost of installing solar panels on roofs, updating heating and power systems, or installing dynamic glass.

Here are some of the ways real estate funds and operators can monetize the IRA clean energy tax credits and incentives:

  • Transferability of credits: Taxpayers other than nonprofit organizations, state and political subdivisions, the Tennessee Valley Authority, Indian tribal governments, any Alaska Native corporation, and rural electric cooperatives may sell IRA tax credits to unrelated taxpayers for cash. The payment is tax-exempt income for the transferor and is a non-deductible expense to the transferee. Additionally, the basis of the property is reduced by the amount of the credit. Given that many Real Estate Investment Trusts (REITs) have the infrastructure to implement clean energy efficiencies, e.g., installing solar panels on roofs, this could be a good source of income for REITs. Note, the IRS and Treasury recently issued guidance on the transferability and monetization features of the IRA credits. For more information on this guidance, click here.
  • Partnership flips. One of the most common structures in use today for monetizing clean energy tax credits is partnership flips, which provide flexibility in allocating income and loss (and credit). For an example of how partnership flips work and using other common structures like sale-leasebacks and inverted leases to monetize IRA tax credits, click here.

New markets tax credit (NMTC). The NMTC Program is both a financing tool for qualified projects and a tax incentive for investors. The NMTC Program attracts private capital into low-income communities by permitting individual and corporate investors to receive a tax credit against their federal income tax in exchange for making equity investments in specialized financial intermediaries called Community Development Entities (CDEs). The credit totals 39% of the original investment amount and is claimed over a period of seven years.

The NMTC is set to expire on December 31, 2025, however, in April 2023, a bipartisan coalition in the House of Representatives introduced the NMTC Extension Act of 2023 to permanently extend the NMTC at $5 billion in annual credit authority, adjust this amount annually for inflation, and provide an exception from the Alternative Minimum Tax for New Markets investments. Companion legislation was introduced in the Senate in February. Investors should monitor the progress of this legislation in this session of Congress and contact a tax advisor to evaluate taking advantage of this opportunity before it expires in two years if Congress does not act to extend this program.

To keep up with this proposed legislation, subscribe to our Tax FORsights to receive our weekly edition of From the Hill with a weekly summary on tax policy developments & regulatory updates.

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