Tax Reform and Investment in U.S. Real Estate · provisions affecting real estate were drafted with...

TAX NOTES, APRIL 16, 2018 285

tax notes®

SPECIAL REPORT

Tax Reform and Investment in U.S. Real Estate

by James B. Sowell and Jon G. Finkelstein

Table of Contents

I. Background . . . . . . . . . . . . . . . . . . . . . . . . .286

II. Lower Rates and Broader Base . . . . . . . .286

A. Individuals . . . . . . . . . . . . . . . . . . . . . . .286

B. Corporations . . . . . . . . . . . . . . . . . . . . .287

III. Deduction for Qualified Business Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . .287

A. Separate Trades or Businesses. . . . . . .287

B. Qualified Business Income . . . . . . . . .288

C. Limitations on the Deduction . . . . . . 290

D. Example . . . . . . . . . . . . . . . . . . . . . . . . 291

E. Other Considerations . . . . . . . . . . . . . 292

IV. Applicable Partnership Interests . . . . . 293

A. Overview . . . . . . . . . . . . . . . . . . . . . . . 293

B. Definition of Applicable Partnership Interests . . . . . . . . . . . . . . 295

C. Related-Party Rules. . . . . . . . . . . . . . . 298

D. Other Considerations . . . . . . . . . . . . . 298

V. Net Operating Losses . . . . . . . . . . . . . . . 300

VI. Deductibility of Business Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

A. Overview . . . . . . . . . . . . . . . . . . . . . . . 301

B. Real Property Trade or Business Exception . . . . . . . . . . . . . . . . . . . . . . . 301

C. Section 163(j) and Partnerships . . . . . 305

D. Pre-2018 Section 163(j) Carryovers . . . . . . . . . . . . . . . . . . . . . . 307

E. ‘Interest-Like’ Items Not Subject to 163(j) . . . . . . . . . . . . . . . . . . . . . . . . . . . 308

VII. Recovery Period and Expensing . . . 308

VIII. Beneficial Treatment of Small Businesses . . . . . . . . . . . . . . . . . . . . . . 310

IX. Deduction of Investment Management Fees . . . . . . . . . . . . . . . 311

X. Excess Business Loss Limitation. . . 311

XI. Financial Accounting Timing Rule. . . . . . . . . . . . . . . . . . . . . . . . . . . . 312

XII. Like-Kind Exchanges . . . . . . . . . . . . 313

XIII. Non-Shareholder Contributions to Capital . . . . . . . . . . . . . . . . . . . . . . . . . 313

XIV. Tax-Exempt Entities. . . . . . . . . . . . . . 313

XV. FIRPTA. . . . . . . . . . . . . . . . . . . . . . . . . 314

XVI. Anti-Base-Erosion Rules . . . . . . . . . 314

XVII. Tax Credits . . . . . . . . . . . . . . . . . . . . . 316

XVIII. Technical Changes to the Partnership Rules. . . . . . . . . . . . . . . . 316

A. Partnership Technical Terminations. . . . . . . . . . . . . . . . . . . . . 316

James B. Sowell and Jon G. Finkelstein are principals in the passthroughs group of KPMG LLP’s Washington National Tax. Sowell is a former associate tax legislative counsel and attorney-adviser in the Treasury Office of Tax Legislative Counsel. The authors thank Washington National Tax’s Lynn Afeman and Josh Kaplan for their helpful comments.

In this report, Sowell and Finkelstein describe various issues under the Tax Cuts and Jobs Act that are relevant to taxpayers in the real estate industry. They warn those taxpayers to pay close attention to changes in tax treatment that could affect their investments.

This report represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG.

For more Tax Notes content, please visit www.taxnotes.com.

© 2018 Tax Analysts. All rights reserved. Tax Analysts does not claim

copyright in any public domain or third party content.

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286 TAX NOTES, APRIL 16, 2018

B. ECI on Sale of a Partnership Interest . . . . . . . . . . . . . . . . . . . . . . . . . .316

C. Mandatory Partnership Basis Adjustments. . . . . . . . . . . . . . . . . . . . . .316

XIX. Qualified Opportunity Zones . . . . . . . . .317

XX. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . .317

I. Background

Tax reform is now a reality. On December 22, 2017, the president signed into law the Tax Cuts and Jobs Act of 2017 (P.L. 115-97).

Many tax reform proposals have been discussed and considered in recent years, and the new law reflects some of the ideas advocated in those proposals. Nonetheless, the TCJA is the culmination of a very compressed legislative process, with the first chair’s mark being introduced in the House of Representatives on November 2 and the first chair’s mark being introduced in the Senate on November 9. The House passed its bill November 16, and the Senate passed its bill December 2. Although the House and Senate bills were conceptually similar, the technical provisions were in many instances quite different. Representatives from the two bodies reconciled those differences in conference and voted to approve the compromise legislation December 19 (Senate) and December 20 (House).

The real estate industry, to its credit, was focused on the significant implications that tax reform could have for the industry well before the start of this legislative process. By educating legislators, taxwriters, and stakeholders, many provisions affecting real estate were drafted with knowledge of, and sensitivity to, those implications. As a result, on balance the real estate industry seems to have come out of the process in a relatively favorable position compared with many other industries.

Although the real estate industry fared well under the legislation, the TCJA contains several provisions that will force reconsideration of historical decision-making processes and structuring assumptions. That reconsideration will be necessary in some situations to obtain new benefits; in others to preserve prior treatment; and in still others to mitigate, to the extent possible, detriments that flow from the new law.

Due at least in part to the rapid process and negotiations that led to enactment of the TCJA,

the legislation contains ambiguities and mistakes, many of which go to the core of the operative provisions. Accordingly, until technical corrections are enacted1 or Treasury provides guidance, decision-making with reference to the new law could in many situations be quite difficult.

II. Lower Rates and Broader Base

A. Individuals

Broadly speaking, for individuals, the new law reduces rates and broadens the base of income to which those rates are applied. The TCJA provides for seven rate brackets applicable to ordinary income (37 percent, 35 percent, 32 percent, 24 percent, 22 percent, 12 percent, and 10 percent), with the highest bracket applying to income exceeding $600,000 for married taxpayers filing jointly.2 The standard deduction is doubled to $24,000 for married taxpayers filing jointly,3 and most itemized deductions have been eliminated. The new law does, however, permit charitable deductions (with a more generous limitation amount);4 allow for the deduction of interest on home mortgage debt up to $750,000 (for married taxpayers filing jointly) for debt incurred after December 15, 2017,5 while grandfathering the $1 million amount for debt incurred before that time;6 and permit a $10,000 deduction for the aggregate of state and local income and property taxes (for married taxpayers filing jointly).7 Capital gains and qualified dividends continue to be taxed at a maximum rate of 20 percent.8

1Given the current political atmosphere, the fate of any broad-based

technical corrections bill is uncertain. See Stephen K. Cooper, “Democrats Unlikely to Support Tax Technical Corrections in 2018” (Dec. 19, 2017); and Asha Glover and Dylan F. Moroses, “Lawmakers Divided on Approach for TCJA Technical Corrections,” Tax Notes, Feb. 19, 2018, p. 1091.

2Section 1(j)(2).

3Section 63(c)(7).

4Section 170(b)(1)(G).

5Section 163(h)(3)(F)(i)(II).

6Section 163(h)(3)(F)(i)(III). The TCJA eliminates the ability to deduct

interest for up to $100,000 of home equity indebtedness. Section 163(h)(3)(F)(i)(I).

7Section 164(b)(6).

8Section 1(h). The rate applicable to unrecaptured section 1250 gain

remains at 25 percent. Section 1(h)(1)(E).




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The new law retains the alternative minimum tax for individuals but increases the exemption amount (from $86,200 to $109,400, with the phaseout threshold increasing from $164,100 to $1 million for married taxpayers filing jointly).9 Also, because of the reduction or elimination of most of the itemized deductions, many of the preference items that historically caused taxpayers to become subject to the AMT no longer exist, meaning fewer taxpayers will likely be subject to it.

The estate and gift taxes are retained, but the exemption amounts applicable to those taxes have been doubled from $5 million to $10 million.10

Because of budgetary rules, most of the individual tax provisions (including the rate reductions, elimination of most itemized deductions, the 20 percent deduction for qualified business income (QBI), and the increased AMT exemption amounts) are set to expire for tax years beginning after 2025.

B. Corporations

A key part of the legislation for businesses is the reduction of the corporate tax rate to 21 percent.11 Also, the new law eliminates the AMT for corporations.12 Unlike the individual provisions, which are scheduled to expire, these provisions have no sunset date.

III. Deduction for Qualified Business Income

A hallmark provision in the TCJA — new section 199A — provides for a 20 percent deduction for QBI and some other types of income. The deduction may be taken by individuals, estates, and trusts.13 As with other provisions applicable to individuals, the deduction for QBI is set to expire for tax years beginning after 2025.14

Unlike most deductions in the code, which provide for the recovery of costs incurred, this

deduction is generated by the earning of income. While unusual, the concept of providing for a deduction by reference to a percentage of income has some precedent. The deduction attributable to domestic production activities under now-repealed section 199 used the same approach, and it appears that former section 199 provided something of a model for what is now section 199A.15

In effect, the deduction provides an indirect means of reducing the marginal tax rate that applies to QBI. The amount of the effective reduction of a taxpayer’s rate will depend on the rate that would have been charged on the income against which the deduction would be applied. For instance, a taxpayer who would have paid tax at a rate of 37 percent would receive an effective rate reduction of 7.4 percent from a 20 percent deduction (20 percent x 37 percent), bringing the effective rate on this income down to 29.6 percent.

Determining qualification for, and the amount of, the deduction is by no means straightforward. It is necessary to methodically follow a step-by-step process to compute the available deduction.

A. Separate Trades or Businesses

The first step in determining the amount of the deduction available to a taxpayer involves identifying its separate trades or businesses. The measurement of a taxpayer’s QBI and application of the limitations described below must be undertaken separately for each trade or business.16 The statute and legislative history provide no guidance on the boundaries of a trade or business. As a result, there are many unanswered questions — for example, can a trade or business undertaken by multiple regarded entities be treated as a single trade or business? And how are separate operations within a single entity distinguished?

9Section 55(d)(4).

10Section 2010(c)(3) (estate tax); section 2001(g)(1) (gift tax).

11Section 11(b).

12P.L. 115-97, section 12001.

13Section 199A(a). See generally NYSBA Tax Section, “NYSBA Tax

Section Submits Report on Qualified Business Income,” Rpt. No. 1392 (Mar. 23, 2018).

14Section 199A(i).

15Matthew R. Madara, “Passthrough Deduction Intended to Benefit

Middle Class,” Tax Notes, Jan. 29, 2018, p. 588 (reporting that Christopher Hanna, majority senior tax policy adviser on the Senate Finance Committee, indicated that section 199A borrows elements from section 199, including that it applies to domestic income and has a 50 percent wage limitation).

16Section 199A(b)(2)(B) and (c)(1).




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B. Qualified Business Income

After identifying the relevant trades or businesses, the QBI of each one must be determined. QBI is defined as “qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.”17 Qualified items of income, gain, deduction, and loss means items of income, gain, deduction, and loss to the extent that they are effectively connected with the conduct of a U.S. trade or business (using the same concepts as those applicable to determining effectively connected income under section 864(c)) and are included or allowed in determining taxable income for the tax year.18 As this definition highlights, QBI includes only domestic income. A qualified trade or business includes any trade or business, excepting a “specified service trade or business” and the trade or business of performing services as an employee.19

Although the House proposal provided detailed rules attempting to capture and exclude service-related income from the tax rate reduction provided for QBI,20 section 199A, as enacted, seems to be less restrictive. Rather than stating objective rules that identify the qualifying income attributable to capital (and not services), section 199A simply provides that QBI does not include reasonable compensation, guaranteed payments for services under section 707(c),21 and (to the extent provided in regulations) non-partner-capacity payments under section 707(a) paid to the taxpayer for services rendered with respect to the qualified trade or business.22 It would appear

that the concept of reasonable compensation should not apply in the context of a partnership but instead should apply only to amounts paid by an S corporation.23 Initial signals from Treasury indicate that it will not attempt to expand the concept of reasonable compensation beyond S corporations for purposes of applying section 199A,24 although it may consider implementing other antiabuse principles, including addressing situations in which employees are converted to partners to take advantage of the 20 percent deduction under section 199A.25

Like the House proposal, section 199A denies the deduction for income related to some businesses that are particularly service-intensive26 — that is, specified service trades or businesses.27 A portion of the specified service trade or business definition is derived from section 1202(e)(3)(A) (but excluding engineering and architecture). This cross-referenced portion of the rule describes “any trade or business activity involving the performance of services in the fields of health,28 law, accounting, actuarial science, performing arts, consulting, athletics, financial services,29 brokerage services, [or] any trade or

17Section 199A(c)(1).

18Section 199A(c)(3)(A).

19Section 199A(d).

20Rules Committee Print 115-39, “Text of H.R. 1,” section 199A(d)

through (g) (qualification based upon active versus passive participation and capital percentage).

21Regarding guaranteed payments for the use of capital, see Laura

Davison, “Architects, Engineers Will Get Pass-Through Break: Official,” DTR RealTime (Feb. 2, 2018) (quoting Dana Trier, former Treasury deputy assistant secretary for tax policy, as stating that he “believes that guaranteed payments for the use of capital qualify as qualifying business income for purposes of the deduction”). But cf. reg. section 1.199-5(b)(1) (guaranteed payments under section 707(c) are not considered an allocable share of partnership income for purposes of section 199).


23See Rev. Rul. 69-184, 1969-1 C.B. 256 (a partnership cannot pay

compensation in the form of wages to a partner); and H.R. Rep. No. 115-466, “Conference Report to Accompany H.R. 1,” at 30 (Dec. 15, 2017) (“Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer.”).

24See Madara, “No Plans to Apply Reasonable Compensation Beyond

S Corps,” Tax Notes, Feb. 19, 2018, p. 1123 (quoting Trier as stating, “From where I sit . . . that reference to reasonable compensation is not an indication to redo the law of reasonable compensation. . . . From Treasury’s perspective, I don’t intend to spend time developing regulations that go into that question. We’ve got bigger fish to fry.”).

25Id. (referencing Trier as providing that “one situation those

[antiabuse] rules may address is when employees are made into partners to take advantage of the 20 percent deduction”).

26See Davison, supra note 21 (quoting Mark Prater, deputy staff

director and chief tax counsel for the Senate Finance Committee, as stating, “You find that you have to draw something of a line between the compensation-heavy businesses and the conventional businesses that have a mix of mark-up on inventories, related services, or asset-based income, etc.”).

27Section 199A(d)(1)(A).

28See LTR 201717010 (provision of laboratory reports to healthcare

professionals is not a trade or business (1) involving the performance of services in the field of health or (2) in which the principal asset of the trade or business is the reputation or skill of one or more of its employees); and LTR 201436001 (pharmaceutical business).

29There is some implication that services described in section

1202(e)(3)(B) (banking, insurance, financing, leasing, investing, or similar businesses) are not what is described within the term “financial services” under section 1202(e)(3)(A). Otherwise, the provisions would be duplicative.




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business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”30 For purposes of section 199A, the additional activities of investing and investment management; trading; and dealing in securities, partnership interests, or commodities are added to the specified service trade or business definition.31 Further, for purposes of section 199A, owners are considered together with employees in looking to whether someone’s reputation or skill is a principal asset of the trade or business.32

The carveout of specified trades or businesses would seem to be significant for sponsors in the real estate fund industry in particular. Investment management and investing in partnership interests could describe a significant portion of the services provided by many real estate fund managers, as might a trade or business in which the principal asset is the reputation or skill of one or more of a company’s employees or owners.

Although the specified service trade or business activities appear to be designed to exclude service-intensive businesses, the designated activities are fairly specific, aside from the “reputation or skill” provision. Depending on guidance issued defining the scope of that provision, it may be possible to isolate specific activities attributable to, for example, a property management or real estate development business,33 that could qualify for the 20 percent deduction. A question could arise about whether providing those services in an entity that also conducts other specified service trade or business

activities would taint all the income from that entity. That question presumably will also be the subject of guidance.34 It may be advisable for taxpayers to isolate the services other than the specified service trade or business activities in a separate entity and contract to provide them to the entity that is performing the broader real estate services.35

There is some question regarding the breadth of the income that is captured by a specified service business. Clearly, the fee income earned by that business would be excepted and treated as not earned with respect to a qualified trade or business. One may question, however, whether QBI for one trade or business (for example, real estate rental) allocated to an entity that conducts a specified service trade or business as a result of services provided by that entity will be tainted by virtue of the connection to the specified service trade or business. That situation is particularly relevant to ordinary carried interest income (for example, rental income) earned by a general partner of a real estate fund or joint venture.36 For that matter, the issue is also relevant to income from capital invested through a general partner entity.37

Textually, QBI includes qualified items “with respect to any qualified trade or business of the taxpayer.”38 A specified service trade or business is excluded from the definition of a qualified trade or business. So the question seems to be whether the income is earned with respect to the trade or

30Section 199A(c)(2)(A). See Owen v. Commissioner, T.C. Memo. 2012-

21 (for the business of selling prepaid legal services, the reputation or skill of employees was not a principal asset); see generally Daniel L. Mellor, “Gauging the Height of the Specified Service Business Guardrail,” Tax Notes, Feb. 5, 2018, p. 809; and Martin A. Sullivan, “Do Skills and Reputation Nix the Passthrough Deduction?” Tax Notes, Mar. 5, 2018, p. 1320.

31Section 199A(d)(2)(B).

32Section 199A(d)(2)(A).

33Regarding real estate development, construction management

services might qualify for the 20 percent deduction, and it seems that architecture and engineering should qualify, given that those fields were specifically carved out of the definition of specified service trades or businesses.

34Emily L. Foster, “Tax Bill Triage Not Complete, but Guidance

Priorities Emerging,” Tax Notes, Jan. 29, 2018, p. 590 (reporting that Bryan Rimmke, attorney-adviser in the Treasury Office of Tax Policy, said the tainting of qualifying trade or business income by reference to prohibited activities is one of the highest-priority items Treasury and the IRS must examine).

35Cf. Davison, “Top Treasury Official Doubts Congress Will Make

Tax Law Fixes,” 30 DTR 6 (Feb. 13, 2018) (quoting Trier as stating that “he wouldn’t necessarily look down on partnerships, such as law firms, that aren’t eligible for a 20 percent deduction under Tax Code section 199A, separating their office building and putting it in a separate entity to lease back to the business. In that scenario, the entity with the real estate could take the tax deduction.”).

36The general partner of a real estate fund or joint venture often will

play a role in investment management and investing in partnership interests, so there would seem to be a material risk that many general partner entities could be treated as engaged in a specified service trade or business.

37Unlike the House provision addressing QBI (see supra note 20), the

new law makes no general distinction between profits allocated to capital or to services.





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business at the lower-tier investment level, or whether the services that arguably result in the allocation of the income to the specified service trade or business cause the income to be treated as earned with respect to that specified trade or business.

Given the structure of section 199A, the better answer would seem to be that the allocation of QBI through a specified service business should not change the qualified nature of the income. As discussed above, although compensation income and non-partner-capacity payments under section 707(a) (to the extent provided in regulations) and section 707(c) payments for services are excluded from QBI, an allocation of QBI to a service partner apparently is not excluded.39 Instead, that income continues to be characterized by the underlying income of the partnership that generates the income. By analogy, it seems that an allocation of QBI through a specified service trade or business should not change the qualifying nature of that income, even though the income might be viewed as earned by reference to services.40

C. Limitations on the Deduction

Once the taxpayer determines its QBI for each qualified business, it is necessary for it to apply two separate limitations to determine the amount of the deduction allowable for the QBI related to that business. The allowable deduction for QBI of a trade or business cannot exceed the greater of:

• 50 percent of an applicable taxpayer’s allocable share of the Form W-2 wages for the qualified business; or

• 25 percent of an applicable taxpayer’s allocable share of the Form W-2 wages paid for a qualified business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property.41

Businesses use many wage payment arrangements (for example, a payroll company, a common paymaster, or employee leasing) that can create uncertainty regarding who is to be treated as the payer of wages for purposes of section 199A. Although no guidance exists under section 199A on the payer of wages, regulations under former section 199 may be instructive. Reg. section 1.199-2(a)(2) allows a taxpayer to “take into account any wages paid by another entity and reported by the other entity on Forms W-2 . . . provided that the wages were paid to employees of the taxpayer for employment by the taxpayer.” In effect, under this regulation, the Form W-2 wages generally should be treated as paid by the business that is the common law employer of the workers. Because the statute is specific in providing credit only for Form W-2 wages, it appears that payments to independent contractors and section 707(c) guaranteed payments to partners for services should not be taken into account in applying the wage limitations under section 199A(b)(2)(B).

The alternative limitation that allows the unadjusted basis of qualified property to be taken into account provides some benefit to capital-intensive businesses, including real estate businesses, that generally do not pay significant Form W-2 wages to directly employed individuals. Qualified property is tangible property (1) of a character that is subject to depreciation;42 (2) that is held by, and available for use in, the qualified trade or business at the close of the tax year; (3) that is used in the production of QBI; and (4) for which the depreciable period has not ended before the end of the tax year.43 The depreciable period is the period beginning on the date the property is first placed in service and ending on the later of (1) the date that is 10 years after the property is placed in service, or (2) the last day of the last full year in the applicable recovery period that would apply to the property under section 168 (but not applying the

39See supra notes 23-24 and accompanying text.

40An argument can be made that income attributable to a carried

interest should not be treated as attributable to services. Instead, only the issuance of the partnership interest in exchange for services is the compensatory event. After that time, the allocation arguably should not be treated as made for services. The limited scope of section 1061 concerning the taxation of applicable partnership interests supports the argument that in most contexts the tax law does not treat an allocation of partnership income as related to services provided by a partner.

41Section 199A(b)(2)(B).

42The requirement that property be depreciable could put additional

pressure on the dealer-versus-investor determination for many real estate sales, particularly those developed or repurposed in the “opportunistic” context. See, e.g., Notice 2013-13, 2013-1 C.B. 659; and Rev. Rul. 89-25, 1989-1 C.B. 79; but cf. LTR 8621003 (lender holding foreclosure property for sale was permitted to depreciate property during period of rental).

43Section 199A(d)(6).




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alternative depreciation system (ADS) recovery periods under section 168(g)).44 If property is sold during the tax year, it is no longer available for use in connection with the qualified trade or business at the end of the tax year and thus would be excluded in applying the limitation for that tax year.45 Moreover, the third requirement for qualified property states that the property must actually be used in the production of QBI, so if property is still owned but is not used, it appears that the unadjusted basis may not be included.46 The unadjusted basis of property generally is determined without regard to depreciation deducted for the property. Regulatory authority is provided to determine the unadjusted basis of property acquired in a section 1031 like-kind exchange.47

There is a question whether a basis adjustment under section 743(b) for qualified property can give rise to unadjusted basis for purposes of the 20 percent deduction. As a technical matter, the answer seems unclear. The correct policy answer is not altogether clear, either. The following example highlights the problem: Assume a partnership has two 50-50 partners, A and B. The partnership acquires a parcel of depreciable property for $1 million. After five years, that property has been depreciated to $500,000. At that time, Partner A sells its partnership interest for $500,000 to C, thus giving rise to a $250,000 positive section 743(b) basis adjustment for the property in the hands of C. Although the property has a depreciated basis of $500,000 in the hands of the partnership, its unadjusted basis remains $1 million. Thus, if C is given credit for the $250,000 section 743(b) basis as part of C’s unadjusted basis, C will have an unadjusted basis of $750,000 for the property.

Obviously, there is a double counting of $250,000 in the unadjusted basis attributable to C, since the section 743(b) basis adjustment represents a recapture of depreciation, but the depreciation has been ignored in calculating unadjusted basis. With that said, if C had

purchased the interest for $1 million, it seems that from a policy perspective C could rightfully claim $500,000 of the section 743(b) basis adjustment as unadjusted basis, since there is no double counting of that amount. Even for the $250,000 that is subject to double counting, the depreciable life of the section 743(b) basis adjustment generally will be longer than the common basis of the property, and arguably C should continue to report a share of unadjusted basis for that portion as long as the section 743(b) basis adjustment qualifies. These are difficult issues, and it is hoped that clarity will be provided through the guidance process.

For taxpayers that are allocated QBI by a partnership, the deduction is taken and the limitations described above apply at the partner level rather than the partnership level.48 In applying the limitations to a partner, a partner’s share of Form W-2 wages will be determined in the same manner as the partner’s allocable share of wage expenses, and unadjusted basis will be determined consistent with the partner’s share of depreciation expense attributable to the qualified property.49

Section 199A provides relief from the wage and qualified property unadjusted basis limitations and the exclusion for specified service trade or business income for taxpayers who earn income below a threshold amount. Neither the limitations nor the exclusion applies to taxpayers whose taxable income is $315,000 or less (for married taxpayers filing jointly), with the benefit phased out over the next $100,000.50

D. Example

An example is helpful in illustrating the importance of analyzing the limitation amounts for separate trades or businesses. Assume that an individual conducts two businesses: a rental office building and condominium development. Neither business pays wages. The two businesses

44Section 199A(d)(6)(B).

45H.R. Rep. No. 115-466, at 38 (Conf. Rep.).

46Section 199A(b)(6)(A)(i).


48Section 199A(f)(1)(A). Because the deduction is taken at the partner

level, there should be no requirement to adjust the basis of the partnership interest by reference to the QBI deduction. Cf. reg. section 1.199-5(b)(1).

49Section 199A(f)(1)(A) (flush language at end).

50Section 199A(b)(3) (wage-unadjusted basis limitations) and (d)(3)

(specified service business).




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are operated using different personnel in management and operations, and it is determined that the activities constitute two separate businesses.

The unadjusted basis of qualifying business property related to the office building is $500 million; 2.5 percent of that amount is $12.5 million. The office building generates $50 million of income, for a 20 percent deduction amount of $10 million. The condominium business has no depreciable property, so there is no unadjusted basis in qualifying property for that business. The condominium business also generates $50 million of business income, but it has no limitation amount, and thus no deduction may be claimed. The fact that the office building business has $2.5 million of unused limitation has no impact on the deduction amount allowed for business income generated by the condominium business. As this example highlights, the permissible grouping of trade or business activities can significantly change the amount of the 20 percent deduction.

E. Other Considerations

The presence of positive net QBI and limitation capacity in a tax year does not ensure that a taxpayer will be able to claim the 20 percent deduction for QBI earned in that year. If a taxpayer has a net loss from qualified trade or business activities for a tax year, that loss carries over to the following year for purposes of determining the QBI that can generate the 20 percent deduction.51 This rule does not limit the use of the loss during the year incurred for purposes of determining the taxpayer’s taxable income, but instead affects the amount of income in future years that can qualify for the 20 percent deduction. Essentially, taxpayers may take the 20 percent deduction only to the extent of their positive net QBI for all tax years beginning after 2017.

Some types of income qualify for the 20 percent deduction for all taxpayers simply because of the source of the income and regardless of any limitations (that is, a specified services trade or business, the wage-unadjusted basis limitation, domestic versus foreign income,

investment income (including interest),52 and the reduction for qualified business losses).

Of particular relevance to the real estate industry is real estate investment trust dividend income.53 That income is not treated as QBI, but instead is eligible for the 20 percent deduction by virtue of its status as “qualified REIT dividends.”54 A qualified REIT dividend includes all REIT dividends except to the extent that the dividends are eligible for taxation at capital gain rates for capital gain or qualified dividend income.55 That REIT dividend income can qualify for the 20 percent deduction without regard to any of the limitations discussed above should make the use of REITs more attractive in real estate fund structures when individuals, estates, and trusts have a material stake in the fund.56 One downside in the public REIT context, however, is that it appears that a shareholder in a mutual fund cannot take advantage of the 20 percent deduction for dividends attributable to REIT dividends earned by the mutual funds, at least without further guidance.

The 20 percent deduction cannot exceed the taxable income (reduced by net capital gain) of a taxpayer for the tax year.57 Accordingly, taxpayers with combined QBI (which includes both QBI and qualified REIT dividends)58 but significant investment losses may be limited in their ability to claim the deduction.


52Note that although interest income earned other than in connection

with a trade or business is specifically excluded from QBI (section 199A(c)(3)(B)(iii)), holding debt instruments producing this interest in a REIT can effectively convert the income into QBI because the REIT dividends attributable to the interest paid will qualify for the 20 percent deduction.

53Qualifying publicly traded partnership income is treated the same

as REIT dividends, so that income also qualifies for the 20 percent deduction without regard to the various limitations. Section 199A(b)(1)(B).

54Section 199A(b)(1)(B).

55Section 199A(e)(3).

56Consideration may be given to having the sponsors hold their

interest through a REIT, but the “five or fewer” rule in section 856(h) often will make qualification of a sponsor-owned entity as a REIT impossible.

57Section 199A(a) (flush language at end).

58Section 199A(b)(1).




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The 20 percent deduction is not allowed in calculating adjusted gross income, but instead is allowed as a deduction, reducing taxable income.59 As a result, the deduction does not affect limitations that are based on AGI. The deduction is available both to taxpayers who itemize deductions and those who do not.60

On February 7, Treasury and the IRS issued their updated guidance plan, which includes many items “that have become near term priorities as a result of the Tax Cuts and Jobs Act.”61 Among the new items listed is “computational, definitional, and anti-avoidance guidance under new section 199A.”62 Accordingly, it appears that guidance on several of the issues described above will rank as a priority for guidance in the near term.

Finally, a taxpayer who claims the 20 percent deduction under section 199A will be subject to the substantial understatement penalty by reference to a lower threshold of misreporting. A substantial understatement of income tax under section 6662(d)(1) exists when the understatement for the tax year exceeds the greater of (1) 5 percent, rather than 10 percent, of the tax required to be shown on the return for the tax year, or (2) $5,000.63

IV. Applicable Partnership Interests

Following more than 10 years of debate over the taxation of carried interest in the investment fund context, a provision now has been enacted addressing its taxation. The scope of the new provision is significantly narrower than others in bills considered in previous years. As discussed below, the new provision, as drafted, leads to many surprising results, and it is not clear that all those results were intended.

A. Overview

The new rules are in section 1061, which requires an asset holding period of greater than

three years for an “applicable partnership interest” to obtain long-term capital gain treatment.64 That three-year holding period is required for sales of assets held (directly or indirectly) by the applicable partnership. Although not entirely clear, it appears that this three-year holding period also applies to the sale of the applicable partnership interest itself.65 Except in a narrow context involving related-party transfers,66 it appears that the three-year holding period is relevant only to the asset being sold.67 Accordingly, if a partnership sells an asset held for more than three years, gain allocated to a partner that has held a partnership interest for less than three years still could be allocated as long-term capital gain. Similarly, putting aside related-party transfers, if a partner sells its interest, as long as that partner has a holding period for its entire partnership interest of more than three years, it appears irrelevant that the partnership has held some of its assets for less than three years.

In determining the holding period of an asset, a taxpayer should apply the same rules that govern application of the one-year standard under section 1222. The holding period of a real estate development property essentially is determined “brick by brick,” meaning that the holding period is established progressively as the building is completed.68 For investments in a partnership, the holding period can be bifurcated with a new holding period being created for each separate contribution to, or acquisition of, an interest in a partnership.69 Importantly, the regulations allow for netting of contributions and

59Section 62(a) (last sentence).

60Section 63(b)(3) and (d)(3).

61Treasury and IRS, “2017-2018 Priority Guidance Plan” (Feb. 7,

2018).62

Id.63

Section 6662(d)(1)(C).

64Section 1061(a). See generally Blake D. Rubin, Andrea Macintosh

Whiteway, and Maximilian Pakaluk, “Real Estate Owners: Don’t Get Carried Away by New Carried Interest Rate,” Tax Notes, Apr. 2, 2018, p. 45.

65Section 1061(a)(1) recharacterizes a taxpayer’s net long-term capital

gain “with respect to” an applicable partnership interest.66

See infra text accompanying note 109.67

Section 1061(a)(2) recharacterizes a taxpayer’s net long-term capital gain “with respect to” that interest. The net long-term capital gain is recognized “with respect to” the asset sold, so it seems that only the holding period of the asset being sold should be relevant.

68Rev. Rul. 75-524, 1975-2 C.B. 342.

69Reg. section 1.1223-2(a) and (b)(1). Contributions to a joint venture

to fund upgrades to a property in anticipation of a sale can create a new holding period for the partnership interest. Further, for REIT executives, each issuance of long-term incentive plan units will create a new holding period for a portion of the units held.




SPECIAL REPORT


distributions within a one-year period when determining the holding period of a partnership interest.70 Accordingly, if a partner has made contributions to the partnership within one year of disposing of the interest, a part-redemption/part-sale transaction (with the distribution in redemption occurring first) may provide a better result than an outright sale. It is important to recognize that except in limited circumstances involving publicly traded partnerships, it is impossible to identify the holding period for specific units. Instead, each unit will represent a proportionate blend of the separate holding periods for all the units held by a partner.71

Rather than treating amounts failing the three-year test as ordinary income, as had been the typical recharacterization under prior versions of carried interest legislation, section 1061 treats this gain as short-term capital gain.72 Although the gain is still taxable at ordinary income rates, short-term capital gain treatment can be more beneficial than ordinary income treatment. Short-term capital gain is not subject to self-employment tax,73 and for real estate professionals who do not classify this income as passive under section 469, the income also will not be subject to the 3.8 percent tax on net investment income under section 1411.74 Likewise, by characterizing the income as short-term capital gain, the new law avoids treating the income as unrelated business taxable income,75 which was of concern under previous versions of carried interest legislation.

Section 1061 provides for short-term capital gain treatment under the three-year holding period rule “notwithstanding section 83 or any election in effect under section 83(b).”76 In an effort to clarify this rather confusing statement regarding section 83, the legislative history indicates that even if a taxpayer has included an

amount in income under section 83 upon the acquisition of an applicable partnership interest or has made an election under section 83(b) for that interest, the three-year holding period requirement for obtaining long-term capital gain treatment for the applicable partnership interest does not change.77 Presumably, a section 83(b) election will start the running of the three-year period for a partner holding an applicable partnership interest, although the “clarification” creates some confusion on this point.

As drafted, section 1061 leads to some surprising outcomes regarding gain that seemingly is, and is not, subject to recharacterization under the three-year holding period rule. Section 1061 operates by applying section 1222(3) and (4) (defining long-term capital gain and loss treatment for the sale of capital assets held for more than one year) and substituting “3 years” for “1 year.”78 Under a strict reading of the statute, it appears that section 1061 does not operate to recharacterize section 1231 gain, given that the one-year holding period in section 1231 is in section 1231(b)(1) (defining property used in a trade or business), not section 1222.79 It is unclear that this result was intended, and it might be changed by a technical correction or regulation.80

On the other hand, the code also contains provisions, like the REIT capital gain dividend rule in section 857(b)(3)(B), that provide for long-term capital gain treatment by characterizing the relevant income as gain from the sale or exchange of a capital asset “held for more than 1 year.” By virtue of those provisions, long-term capital gain treatment generally would result under section 1222(3). Under a strict reading of section 1061, there is concern that REIT capital gain dividend

70Reg. section 1.1223-2(b)(2).

71Reg. section 1.1223-2(c).

72Section 1061(a) (flush language).

73Section 1402(a)(3)(A).

74Section 1411(c)(1)(ii) and (2) (real estate professional income

excluded because of its being trade or business income that is not passive or attributable to trading).

75Section 512(b)(5).

76Section 1061(a) (flush language).


78Section 1061(a)(2).

79Cf. CRI-Leslie LLC v. Commissioner, 882 F.3d 1026 (11th Cir. 2018)

(holding that section 1234A does not apply to section 1231 assets because those are not “capital assets”). Although section 1061 may not recharacterize section 1231 gain generally, gain attributable to section 1231 assets may be subject to recharacterization in a related-party transfer, as discussed below (see infra note 109), when gain is recharacterized without reference to section 1222. Section 1061(d).

80Although the new law provides regulatory authority to the extent

necessary to carry out the purposes of section 1061 (section 1061(f)), it seems questionable whether correction of a definitional problem like this could be accomplished under that authority.




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income allocated to an applicable partnership interest could never satisfy the three-year holding period threshold even if the REIT held the asset generating the relevant gain for significantly longer than three years, because section 857(b)(3)(B) deems the gain to result from the sale or exchange of an asset held only for more than one year. Note, however, that for a period between 1997 and 2003, a lower capital gain rate was available for property held for more than five years.81 During that period, REITs were allowed to designate a portion of their capital gain dividends by reference to the gain on assets sold with a longer-than-five-year holding period.82 Without further guidance, this previous treatment of capital gain dividends should provide some assurance that a REIT capital gain dividend could be treated as gain from the sale of an asset held for more than three years to the extent that the assets generating the gain were held for that period.

B. Definition of Applicable Partnership Interests

Section 1061 operates for “applicable partnership interests.” To qualify as an applicable partnership interest, the partnership interest must be directly or indirectly transferred to (or held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or a related person,83 in any “applicable trade or business.”84 An applicable trade or business is defined as an activity that is conducted on a regular, continuous, and substantial basis and that consists, in whole or in part, of (1) raising or returning capital, and (2) either (a) investing in or disposing of “specified assets” (or identifying

specified assets for investment or disposition), or (b) developing specified assets.85 For these purposes, specified assets include securities, commodities, real estate held for rental or investment, cash or cash equivalents, options or derivative contracts for the foregoing assets, or an interest in a partnership to the extent of the partnership’s interest in the foregoing assets.86 The legislative history states that the activity may be conducted in one or more entities.87 The legislative history also states that “developing specified assets takes place, for example, if it is represented to investors, lenders, regulators, or others that the value, price, or yield of a portfolio business may be enhanced or increased in connection with choices or actions of a service provider or of others acting in concert with or at the direction of a service provider.”88

The definition of an applicable partnership interest raises several difficult issues regarding the provision’s scope. First, section 1061 applies to an applicable partnership interest held by a “taxpayer.”89 Prior versions of carried interest legislation offered by Rep. Sander M. Levin, D-Mich., would have applied by reference to investment service partnership interests held by a “person.”90 By contrast, and like section 1061, the carried interest provision proposed by former House Ways and Means Chair Dave Camp applied by reference to an interest held by a “taxpayer.”91 The use of “taxpayer” in section 1061 raises questions about whether the applicable partnership interest determination is to be undertaken only for partners that are subject to federal income tax, possibly excluding flow-through entities like partnerships.

81Section 1(h)(2) and (9) (effective for tax years ending after May 6,

1997, and before May 6, 2003, with a transition rule for tax years that included May 6, 2003).

82See Publication 550, “Investment Income and Expenses (Including

Capital Gains and Losses),” at 24 (2003); and Notice 2004-39, 2004-1 C.B. 982 (describing the designation under prior law of a portion of a capital gain dividend as “5-year gain”).

83Although section 1061(d)(2) defines related person for purposes of

the related-party transfer rule in section 1061(d), the statute contains no definition of related person for purposes of the applicable partnership interest definition in section 1061(c)(1).

84Section 1061(c)(1).

85Section 1061(c)(2). While not entirely clear, under a strict reading of

the statute, it appears that the “activity” that must be conducted on a regular, continuous, and substantial basis is the combined activity described under (1) and (2)(a) or (2)(b), and it is not necessary that the separate activities described in (1) and (2)(a) or (2)(b) each be conducted on a regular, continuous, and substantial basis. Clearly, however, there must be some amount of activity conducted under each of (1) and (2)(a) or (2)(b), and the combined level of overall activity must be regular, continuous, and substantial.

86Section 1061(c)(3) (emphasis added).


88Id.

89Section 1061(a).

90H.R. 2889, the Carried Interest Fairness Act of 2015, section

710(c)(1) (the Levin bill).91

H.R. 1, the Tax Reform Act of 2014, section 1061(a) (the Camp bill).




SPECIAL REPORT


An example in the technical explanation of the Camp bill illustrates a situation in which two individuals own an interest in a management company that holds an interest in, and provide services to, an investment fund. The technical explanation describes the interests in the management company as applicable partnership interests, but it does not address the fund interest held by the management company. The example is quoted below:

For example, assume that X and Y are partners in XY partnership which is the managing partner of a private equity fund. In year one, XY partnership receives a 30-percent profits interest in the fund in connection with future performance of investment-related services for the fund. X and Y contact wealthy individuals and institutional investors to raise capital for the fund. These investors become limited partners in the fund and agree under the terms of the fund’s partnership agreement to make capital contributions as the fund invests in portfolio businesses. X, Y, and the employees of XY identify portfolio businesses in which the private equity fund invests. The terms of the fund’s investment permit the fund and its service providers to have management input in the portfolio businesses which is designed to develop the value of the portfolio companies over the period of the fund’s investment. After several years, the fund’s interests in the portfolio companies are sold. In this example, from year one, X and Y each hold an interest in a partnership (XY) in connection with the performance of services in an applicable trade or business, so the proposal applies.92

Existing authority recognizes that a partnership may be treated as a taxpayer under section 7701(a)(14), although the authority is not entirely consistent, and some cases look to the purposes of the provision under analysis in determining whether a partnership should be

treated as a taxpayer.93 Significantly, all the cited case law94 was decided before the enactment of section 6225 — the new partnership audit rules — which provides that a partnership may be subject to liability for federal income tax.95

Section 1061(c)(1) says that the general rule defining an applicable partnership interest “shall not apply to an interest held by a person who is employed by another entity that is conducting a trade or business (other than an applicable trade or business) and only provides services to such other entity.” This rule seems designed to provide relief to employees of private equity portfolio companies who receive an interest based on their services to the company. If those people are providing services only to an operating business of a portfolio company, the services would not seem to relate to an “applicable trade or business” since the business does not involve specified assets. Because real estate held for rental or investment is treated as a specified asset, the application of this exception in the real estate context seems very limited.

Two exceptions apply to exclude treatment of some partnership interests as applicable partnership interests. First, an applicable partnership interest does not include a partnership interest directly or indirectly held by a corporation.96 Significant controversy arose in connection with earlier versions of carried interest legislation because corporations, which were not rate-sensitive, would have been subjected to the complexities and other onerous provisions of carried interest legislation.97 Accordingly, this

92Joint Committee on Taxation, “Technical Explanation of the Tax

Reform Act of 2014: A Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title III — Business Tax Reform,” JCX-14-14 (Feb. 27, 2014).

93See Southern v. Commissioner, 87 T.C. 49 (1986); Hayden v.

Commissioner, 112 T.C. 115 (1999), aff’d, 204 F.3d 772 (7th Cir. 2000); Siller Brothers Inc. v. Commissioner, 89 T.C. 256 (1987); Elliston v. Commissioner, 82 T.C. 747 (1984), aff’d without written opinion, 765 F.2d 1119 (5th Cir. 1985); and Clearmeadow Investments LLC v. United States, No. 05-1223 T (Fed. Cl. 2010).

94Id.

95If it is intended that a partnership could not be the holder of an

applicable partnership interest, so that the typical general partner entity in a fund structure would not be subject to these rules, then passive investors in those entities seemingly could avoid application of the three-year holding period rule.

96Section 1061(c)(4)(A).

97See Carol Kulish Harvey, James B. Sowell, and Deborah Fields, “I

Spy an ISPI: Expansive Breadth of Carried Interest Proposals,” Tax Notes, Aug. 2, 2010, p. 526; and James M. Peaslee, “Carried Interests and Loss Limits for C Corporations,” Tax Notes, June 21, 2010, p. 1397 (letter to the editor).




SPECIAL REPORT


version simply excludes corporations that hold partnership interests from these rules.

Questions have arisen about whether the reference to a “corporation” for these purposes might include an S corporation. There is conflicting authority on the treatment of an S corporation as a corporation more generally.98 Arguably, the authorities refusing to treat an S corporation as a corporation are focused on the entity’s calculation of taxable income and not on the character of income recognized by the S corporation, thereby supporting treatment of an S corporation as a corporation for purposes of section 1061.99 On March 1, however, Treasury and the IRS issued Notice 2018-18, 2018-12 IRB 443, indicating an intent to issue regulations clarifying that the term “corporation” does not include an S corporation for purposes of section 1061 and to make the regulations effective for tax years beginning after December 31, 2017 (the effective date of section 1061).

Second, an applicable partnership interest does not include a capital interest that gives the partner a right to share in partnership capital commensurate with (1) the amount of capital contributed (determined at the time of receipt of the partnership interest) or (2) the value of the interest included in income under section 83 upon receipt or vesting.100 In an attempt to illustrate the application of the “commensurate” standard, the legislative history states:

In the case of a partner who holds a capital interest in the partnership with respect to capital he or she contributed to the partnership, if the partnership agreement provides that the partner’s share of partnership capital is commensurate with the amount of capital he or she contributed (as of the time the partnership interest was received) compared to total

partnership capital, the partnership interest is not an applicable partnership interest to that extent.101

Read literally, this language implies that a capital interest will be excluded to the extent that there is no “capital shift” in connection with the contribution. The language, however, does not define the scope of the partnership interest that is related to contributed capital, and thus does not clarify what portion of the profits are excluded from section 1061. According to the legislative history, it is not intended that a partnership interest can fail to be treated as transferred in connection with the performance of services merely because a partner contributes capital; also, Treasury is directed to provide guidance implementing that intent.102 Reading the two statements together, it is difficult to determine what amount of income associated with contributed capital will be exempt from reclassification under section 1061. Presumably, we will have to wait for regulations to deliver an answer to this important question.

In the meantime, comparison with prior versions of carried interest legislation may provide some support for a defensible approach under the TCJA. The Levin bill contained detailed rules describing qualified capital interests, and it would have allowed allocations for that capital only if the allocations could be benchmarked to allocations made to another significant partner that was not a service provider.103 The Levin bill would actually have allowed the service partner to receive allocations exceeding the benchmarked return if the excess was related to carried interest and management fees that were allocated with reference to other partners and were not required to be self-charged to a service partner.104 Without guidance indicating the proper profit allocation to excuse as related to contributed capital, that benchmarking approach would seem to be defensible in applying the new law.105

98Compare Rev. Rul. 93-36, 1993-1 C.B. 287 (denying an S corporation

automatic qualification for a business bad debt deduction under section 166, even though that qualification is available to a “corporation”) and ILM 201552026 with Rath v. Commissioner, 101 T.C. 196 (1993).

99Cf. TAM 9130003.

100Section 1061(c)(4)(B).


102Id. at 266.

103Levin Bill, supra note 90, at section 710(d)(1).

104Id. at section 710(d)(5).

105Cf. prop. reg. section 1.1402-2(h)(3) and (4) (benchmarking

standard used in proposed self-employment tax regulations defining exempt income allocated to a limited partner).




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C. Related-Party Rules

Transfers of applicable partnership interests to related parties are subject to special rules under section 1061.106 Section 1061 provides that upon the transfer of an applicable partnership interest to a related person, the transferor must include in short-term capital gain the excess of:

(A) so much of the taxpayer’s long-term capital gains with respect to such interest for such taxable year attributable to the sale or exchange of any asset held for not more than 3 years as is allocable to such interest, over (B) any amount treated as short term capital gain under [section 1061(a)] with respect to the transfer of such interest.107

For purposes of this provision, a related person includes only persons with a family relationship under section 318(a)(1) and persons who performed services during the current calendar year or the prior three calendar years in any applicable trade or business in which or for which the taxpayer performed a service.108

The related-party provision appears to impose at least one, and possibly two, changes to the general application of section 1061. First, it appears that a transfer of an applicable partnership interest to a related person would result in the recognition of short-term capital gain to the extent of capital gain attributable to assets held by the partnership for three years or less, even if the transferring partner has held the transferred interest for more than three years.109 Second, the provision may override nonrecognition treatment on the transfer of an applicable partnership interest to the extent of capital gain attributable to assets held for between one and three years, although this result is not

entirely clear. Earlier versions of carried interest legislation did override nonrecognition treatment upon the disposition of a relevant interest.110 The language in this provision, however, is very difficult to interpret.

The flush language at the beginning of the provision simply refers to a “transfer” and inclusion of “short-term capital gain,” arguably implying that the gain is always recognized upon a related-party transfer. The limitation, however, by reference to the “long-term capital gains with respect to such interest for such taxable year attributable to the sale or exchange of any asset held for not more than 3 years as is allocable to such interest” is very hard to decipher. Arguably, the reference to “long-term capital gains with respect to such interest” requires that long-term capital gain actually has been recognized. But that statement is confusing, given the later reference to amounts “attributable to the sale or exchange of any asset held for not more than three years.” The reference seems to require that underlying assets of the partnership be sold, but the second portion of the limitation accounts for assets sold, which seems to cast significant doubt over what could be meant by the first portion of the limitation. All that really can be said for this provision is that guidance might be issued to provide some clarity.

D. Other Considerations

Section 1061 provides regulatory authority to address an issue that has proved cumbersome in prior versions of carried interest legislation: the enterprise value issue. This issue refers to the argument that an interest in the sponsor entity (the general partner/management company) technically could be an applicable partnership interest, and that the intangible value related to the sponsor’s business (as opposed to the value

106Section 1061(d)(1).

107Id.

108Section 1061(d)(2).

109The lack of references to the term “capital asset” or section 1222 in

the related-party transfer rule may cause gain attributable to section 1231 assets to be characterized as short-term capital gain when that gain may not be subject to recharacterization generally.

110Levin bill, supra note 90, at section 710(b)(1) (nonrecognition

unavailable for transfer of investment services partnership interest); Camp bill, supra note 91, at section 1061(b)(3) (nonrecognition unavailable for transfer of applicable partnership interest). The Camp bill would also have triggered recognition of the recharacterization account balance upon a transfer to a related person, using the same related-person definition as is contained in the TCJA. See Camp bill, supra note 91, at section 1061(e). This latter provision from the Camp bill appears to have been the model for the provision in the TCJA.




SPECIAL REPORT


related to the sponsor’s carried interest in underlying funds) should not be recharacterized as short-term capital gain.111 Accordingly, section 1061 provides that to the extent provided in regulations, the three-year holding period in section 1061 would not apply to income or gain attributable to any asset not held for portfolio investment on behalf of “third-party investors.”112 For purposes of this provision, a third-party investor is defined as a person who (1) holds an interest in the partnership that is not held in connection with an applicable trade or business and (2) is not (and has not been) actively engaged, and is (and was) not related to a person so engaged, in (directly or indirectly) providing substantial services related to an applicable trade or business to the partnership or any applicable trade or business.113

Section 1061 lacks many of the provisions included in earlier versions of the legislation that were intended to discourage work-arounds of the section. For example, earlier versions of carried interest legislation gave no credit for exempt capital when the amounts were borrowed from another partner,114 offered treatment similar to that under the carried interest rules for “disqualified interests” (other investment interests designed to replicate the economics of a carried interest),115 and triggered gain upon distribution of partnership assets for the designated interest.116 Because those rules are absent, planning that attempts to use these gaps in the statute can be expected.

One such transaction that might be considered is a distribution of an undivided interest in real estate with less than a three-year holding period to the carried interest partner before a sale of the asset. Several issues must be considered regarding that transaction. Obviously,

the substance of the distribution is of paramount importance. Terms that continue to tie the carried interest partner’s share of sale proceeds to what would have been received if the asset was still held by the partnership create significant concern. Also, assuming the carry partner is not completely redeemed and the remainder of the asset continues to be held by the partnership, a revaluation and reverse section 704(c) layer for the remainder of the asset could continue to result in an allocation of gain to the carry partner.117

For example, consider a partnership in which A and B are partners. A is the capital partner, and B is the service partner, having contributed no capital. Asset 1 will be sold for $100 million of gain (assume $0 basis), and that gain would be allocated 50-50 between A and B, since B is in a 50-50 catch-up layer of the allocation waterfall for all the gain. The partnership distributes a $50 million undivided interest in the asset to B before the sale. As a result of the disproportionate distribution, the partnership revalues the partnership assets, including Asset 1, and allocates that gain under reverse section 704(c) principles — $50 million to A and $50 million to B. When the $50 million interest in Asset 1 is distributed to B, it appears that the remaining $50 million of reverse section 704(c) gain continues to be allocated 50-50 to both A and B, now $25 million to each. The fact that B took a share of the asset with gain equal to B’s reverse section 704(c) gain inside the partnership does not appear to result in an elimination of that reverse section 704(c) gain.

It may be possible to achieve some assurance of avoiding those results by creating tracking interests in the asset before the distribution, so that A does not have a share of gain in the tracked interest that remains in the partnership. Given the fungible nature of the asset, however, there are obvious concerns about the substance of the tracking interests and whether the isolation of gain on that portion of the asset can satisfy the rules for substantial economic effect.

Also, some may consider incorporating into fund agreements allocation provisions that allow only allocations for carried interest from gain attributable to property held for more than three

111Sowell, “Carried Interest: Line Drawing and Fairness (or Lack

Thereof), Part 3,” Tax Notes, Nov. 25, 2013, p. 857; Jack S. Levin, Donald E. Rocap, and William R. Welke, “Carried Interest Legislative Proposals and Enterprise Value Tax,” Tax Notes, Nov. 1, 2010, p. 565.

112Section 1061(b).

113Section 1061(c)(5).

114Levin bill, supra note 90, at section 710(d)(8); Camp bill, supra note

91, at section 1061(c)(2)(E)(iii).115

Levin bill, supra note 90, at section 710(e).116

Id. at section 710(b)(4); Camp bill, supra note 91, at section 1061(b)(4).

117Reg. section 1.704-1(b)(2)(iv)(f) and (g); and reg. section 1.704-

3(a)(6)(i).




SPECIAL REPORT


years. That exercise is not as simple as including an allocation provision stating the limitation on available income, however. The partners must actually take risks regarding their economic return if adequate three-plus-year gains do not materialize to equate to the return they would have received without the limitation. But the “value-equals-basis” rule118 in the section 704(b) regulations provides assurance that the effective swapping of three-plus-year gains for less-than-three-year gains will not lack “substantiality.”119 Before incorporating those allocation provisions, however, partners should be mindful of language in the legislative history indicating that guidance “is to address prevention of the abuse of the purposes of the [applicable partnership interest] provision, including through the allocation of income to tax-indifferent parties.”120

Section 1061 provides authority for the issuance of regulations or other guidance as necessary to carry out the purposes of the provision.121 Initial signals from Treasury, however, indicate that general guidance on section 1061 will not be an immediate priority.122

Section 1061 is effective for tax years beginning after 2017.123 The new law does not include rules grandfathering applicable partnership interests or assets held as of the effective date of the legislation. Accordingly, gain

that has accrued before the effective date without recognition will be subject to recharacterization if recognized after the effective date for an asset that does not satisfy the three-year holding period requirement.

V. Net Operating Losses

The TCJA significantly limits the availability of net operating loss carryforwards. NOLs arising in a tax year beginning after 2017 that are carried forward are limited to 80 percent of the taxable income for the carryforward tax year, calculated without regard to the deduction for NOLs.124 For REITs, the 80 percent limitation is applied without regard to the dividends paid deduction.125 NOLs are no longer eligible for carryback,126 but they now can be carried forward indefinitely.127

This limitation on the use of NOLs may alter the dynamics in the decision-making process to accelerate deductions because a delayed deduction that will reduce future-year positive taxable income may be more valuable than a deduction that will produce a current-year loss, the carryforward of which will be limited to 80 percent of taxable income.

Further, the limitation on NOLs could affect the analysis of blocker corporations when leverage is used to limit the tax leakage associated with the use of a C corporation. When an investor uses a leveraged blocker C corporation as its investment vehicle, a combination of investment-level operating losses and blocker-level interest deductions often will generate significant NOL carryovers for the C corporation. Previously, those losses would have been completely available to offset gain from the disposition of the underlying investment. Under the new law, if the gain from the investment is large enough — exceeding 125

118Reg. section 1.704-1(b)(2)(iii)(c) (last two sentences of flush

language at the end).119

To rely on the “value-equals-basis” rule, allocations seemingly must be evaluated under the rules for substantial economic effect (rather than the partner’s interest in the partnership), which generally would require that the partnership liquidate based on positive capital accounts. Reg. section 1.704-1(b)(2)(ii)(b)(2); William S. McKee, William F. Nelson, and Robert L. Whitmire, Federal Taxation of Partnerships and Partners, para. 11.02[3] (2009) (“Unfortunately, the helpful mechanics of the safe harbor, such as the value-equals-basis and five-year rules, are not applicable to the determination of a partner’s interest in the partnership.”).

120H.R. Rep. No. 115-466, at 268 (Conf. Rep.). The meaning of “tax-

indifferent parties” here is uncertain, but given the context, one can imagine that this could be intended to reference parties that are not sensitive to the character of income or possibly to whether capital assets are held for more than three years.

121Section 1061(f).

122Section 1061 was not included as one of the “near-term priorities”

on the guidance plan, supra note 61. See also Foster, “Tax Bill Triage,” supra note 34 (reporting that Rimmke and Clifford Warren, special counsel to the IRS associate chief counsel (passthroughs and special industries), indicated that section 1061 was not a top priority for guidance — that is, not as significant a concern as sections 199A, 163(j), or 168(k)).

123P.L. 115-97, section 13309(c).

124Section 172(a).

125Section 172(d)(6)(C). The following example highlights the need

for the special rule for REITs. Assume that a REIT has $1 million of REIT taxable income and $1 million of NOL carryforwards. Under the new law, the REIT may use $800,000 of the NOL carryforward, reducing its REIT taxable income to $200,000, and then may pay a $200,000 dividend to bring its REIT taxable income to $0. Without the special rule, if the REIT paid a $200,000 dividend to reduce its REIT taxable income to $800,000, it would be allowed to use only $640,000 of the NOL carryforward ($800,000 x 80 percent), leaving it with $160,000 of REIT taxable income.

126Section 172(b)(1)(A)(i).

127Section 172(b)(1)(A)(ii).




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percent of the total NOLs (that is, 100 percent/80 percent) — the NOLs still can be fully used. But for lesser gain amounts, there could be some portion of the NOLs that goes unused.

VI. Deductibility of Business Interest

A. Overview

The TCJA amended section 163(j) to create a broad deferral-disallowance regime for business interest. Section 163(j) now provides that a taxpayer generally will be prohibited from deducting business interest expenses (interest that is properly allocable to a trade or business)128 exceeding the sum of business interest income and 30 percent of adjusted taxable income.129 For tax years beginning after 2017 and before 2022, adjusted taxable income is defined as taxable income other than (1) items not allocable to a trade or business; (2) business interest income and deductions; (3) depreciation, amortization, and depletion; (4) the 20 percent deduction for QBI; and (5) NOLs.130 For tax years beginning after 2021, depreciation, amortization, and depletion must be deducted in determining adjusted taxable income.131 Any disallowed interest may be carried forward indefinitely.132

Section 163(j) applies after the rules for capitalizing interest under section 263A and after rules that otherwise disallow deductibility of interest, like sections 265 and 279.133 The limitation on deductibility of interest applies to tax years beginning after 2017,134 so interest on existing debt instruments is not grandfathered.

B. Real Property Trade or Business Exception

A person may elect to be excluded from the new interest limitation provision if that person is

engaged in a real property trade or business under section 469(c)(7)(C).135 This election, once made, is irrevocable.136 As discussed further below, if a taxpayer makes this election, it must depreciate nonresidential real property, residential rental property, and qualified improvement property using the ADS recovery period.137 Accordingly, there is some trade-off in the form of slower depreciation for the benefit of being free from the business interest deduction limitations.

For purposes of this exclusion, a real property trade or business is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”138 The legislative history makes clear that the exception is not limited to rental businesses139 and indicates that it is “intended that a real property operation or a real property management trade or business includes the operation or management of a lodging facility.”140 Also, a colloquy between Sen. James Lankford, R-Okla., and Senate Finance Committee Chair Orrin G. Hatch, R-Utah, entered in the Congressional Record on December 19, 2017, implies an intention for the operation and management of residential rental property housing the elderly — including assisted living residential living facilities, memory care residences, or continuing care retirement communities — to qualify as a real property trade or business.141 The exclusion for a real property trade or business, however, would not appear to apply to interest on debt that funds mortgage businesses, because mortgage debt

128Section 163(j)(5). See generally NYSBA Tax Section, “NYSBA

Recommends Guidance on Section 163(j),” Rpt. No. 1393 (Mar. 28, 2018).129

Section 163(j)(1). Section 163(j)(1)(C) also adds “floor plan financing interest” to the limitation amount. Those amounts are relevant only to the automotive industry and hence are ignored for purposes of this discussion.

130Sections 163(j)(8)(i) through (iv).

131Section 163(j)(8)(v).

132Section 163(j)(2).


134P.L. 115-97, section 13301(c).

135Sections 163(j)(7)(A)(ii) and (B).

136Section 163(j)(7)(B).

137See infra notes 191-193 and accompanying text.

138Sections 163(j)(7)(B) and 469(c)(7)(C). For an excellent discussion

on the existing authority applying the “real property trade or business” standard under section 469(c)(7)(C), see Patrick Barackman, “Real Estate Professionals — Passing the Test,” 43 J. Real Est. Tax’n 173 (2016).

139H.R. Rep. No. 115-466, at 233 n. 697 (Conf. Rep.). The legislative

history indicates that because the “description of a real property trade or business refers only to the section 469(c)(7)(C) description, and not the other rules of section 469 (such as the rule of section 469(c)(2) that passive activities include rental activities or the rule of section 469(a) that a passive activity loss is limited under section 469), the other rules of section 469 are not made applicable by this reference.” Id.

140Id.

141Congressional Record — Senate, at S8109-S8110 (Dec. 19, 2017).




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does not qualify as real property for purposes of this provision.142

The exclusion also would not appear to apply to investments of cash in C corporations or REITs (as opposed to investments made by them), even if those entities operate qualifying real estate businesses. That is, without further guidance143 it does not appear that the real property trade or business of a C corporation or REIT could be attributed to the shareholders of that entity or that the debt and interest otherwise could be treated as “allocable to” the trade or business of the C corporation or REIT. One generally would consider interest on debt incurred to invest in stock to be subject to section 163(d) as investment interest, so that section 163(j) governing business interest would be irrelevant in any event. Note, however, that section 163(d) does not apply to corporations, possibly leaving a hole through which debt incurred by a corporation would be subject to no limitations. While not addressed in the statute, the legislative history contains a statement indicating that no such hole exists and that interest on all debt incurred by a corporation will be considered business interest for the corporation, thus subjecting interest on all corporate debt to analysis under section 163(j). The conference report states:

Section 163(d) applies in the case of a taxpayer other than a corporation. Thus, a corporation has neither investment interest nor investment income within the meaning of section 163(d). Thus, interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision.144

On April 2, Treasury and the IRS issued Notice 2018-28, 2018-16 IRB 1, which, consistent with the legislative history, indicates that all

interest paid or accrued by a C corporation on indebtedness of a C corporation will be business interest expense subject to section 163(j) (and all business interest earned by a C corporation will be business interest income). This treatment would not apply to an S corporation. The notice does not address REITs, although it seems likely that a REIT would be treated as a C corporation for these purposes. Notice 2018-28 also provides that regulations will address the treatment of interest incurred by a partnership with C corporation partners.145

By contrast to shareholders of corporations and REITs, it seems logical that partners who debt-finance their contribution to, or purchase an interest in, a partnership conducting a real property trade or business should be able to deduct interest without regard to section 163(j) if an election has been made. The proper coordination of the investment interest limitation under section 163(d) and business interest limitation under section 163(j) seemingly should influence the determination of whether the trade or business of a partnership dictates the treatment of debt incurred by the partners under the circumstances described. That is, if interest incurred in a for-profit venture is not subject to the investment interest limitation rules under section 163(d), presumably that interest should be analyzed under section 163(j).

Accepting the premise that proper coordination is desirable, it becomes important to recognize that section 163(d)(3)(B)(ii) excludes from the term “investment interest” interest that is taken into account under section 469 in computing income or loss from a passive activity

142See H.R. Rep. No. 115-466, at 205 n.569 (Conf. Rep.); Hickman v.

Commissioner, T.C. Summ. Op. 2017-66; Guarino v. Commissioner, T.C. Summ. Op. 2016-12; and ILM 201504010.

143See Real Estate Roundtable letter to Treasury (Feb. 23, 2018)

(advocating application of real property trade or business exception for interest on debt incurred by a corporation and invested in a REIT or C corporation that conducts a real property trade or business).

144H.R. Rep. No. 115-466, at 228 n.688 (Conf. Rep.).

145In addition, regulations will address the application of section

163(j) to consolidated groups and, at a high level, the notice indicated that section 163(j) would be applied at a group level. The regulations are to also clarify that the disallowance and carryforward of a C corporation’s deduction for business interest expense under section 163(j) will not affect whether or when such business interest expense reduces the earnings and profits of the C corporation paying interest. Although not discussed in the Notice, presumably such disallowed interest expense would be ignored for purposes of calculating the current (but not accumulated) earnings and profits of a REIT by virtue of section 857(d)(1).




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of a taxpayer. A passive activity under section 469 necessarily involves the conduct of a trade or business, except that rental activities also are subject to section 469 even if they do not rise to the level of a trade or business.146 Interest on debt incurred to acquire an interest in a partnership that conducts a passive activity is treated as a passive activity deduction under section 469.147 Accordingly, interest incurred on debt that funds an investment in a partnership conducting a trade or business generally will not be analyzed under section 163(d).148 Instead, with the exception of corporations not subject to section 469,149 that interest generally will be analyzed as a trade or business expense potentially subject to limitation under section 469.150 Presumably, Congress does not intend that interest subject to section 469 be otherwise completely exempt from the limitations under section 163(j). Instead, if interest incurred to acquire an interest in a partnership (whether by purchase or contribution) is not subject to the investment interest limitations under section 163(d), presumably Congress would intend that the interest be taken into account for purposes of the limitation under section 163(j).

Recognizing that Congress likely would intend that debt incurred by a partner to fund a contribution to, or acquisition of an interest in, a partnership conducting a trade or business be subject to section 163(j), it seems equally rational that if the partnership is conducting a real property trade or business, debt incurred by a partner under the described circumstances should have the option of being excluded from section 163(j).

There seems to be two ways to make the exception for an electing real property trade or business available to those partners. First, the debt might be treated as “properly allocable to”151 the real property trade or business of the partnership that has made an election to be excluded from section 163(j) — that is, the partner’s treatment would be determined by reference to the activities and election of the partnership. Alternatively, the partner might be treated as being engaged in a real property trade or business “with respect to” the debt by attribution from the partnership, thus requiring the partner to make an independent election.

On the first option, there would appear to be some precedent for treating debt incurred at the partner level as being allocable to the activities of the partnership. Notice 89-35 provides rules for allocating interest expense for purposes of applying the passive activity loss limitation in section 469, the investment interest limitation in section 163(d), and the personal interest limitation in section 163(h). For debt proceeds allocated under reg. section 1.163-8T to the purchase of an interest in a partnership, Notice 89-35 allows the debt proceeds and the associated interest expense to be allocated among all the assets of the entity using any reasonable method.152 For debt that funds a contribution to a partnership, Notice 89-35 also provides that interest expense on debt proceeds allocated under reg. section 1.163-8T to the contribution should be allocated using any reasonable method.153

While the rules set forth in Notice 89-35 would provide a readily available and rational model for Treasury and the IRS to follow, there may be some

146Section 469(c)(1)(A).

147See Notice 89-35, 1989-1 C.B. 675; reg. section 1.469-2T(d)(3); and

reg. section 1.163-8T(b)(4); see also JCT, “General Explanation of the Tax Reform Act of 1986,” at 265 n.57 (May 4, 1987); and McKee, Nelson, and Whitmire, supra note 119, at para. 9.02[3][b] n.363.

148Section 163(d)(5)(A)(ii) describes a limited exception for interest

incurred in a trade or business that is not subject to section 469, which generally relates to trader income. See Rev. Rul. 2008-12, 2008-1 C.B. 520; and Rev. Rul. 2008-38, 2008-2 C.B. 249.

149See supra note 144 and accompanying text referencing legislative

history providing that interest incurred by a corporation is business interest subject to section 163(j) in any event.

150Although C corporations, other than closely held C corporations,

are not subject to the passive loss rules under section 469, those entities also are not subject to the limitations on investment interest under section 163(d). See section 163(d)(1) (excluding corporations).

151Under section 163(j)(5), business interest means “any interest paid

or accrued on indebtedness properly allocable to a trade or business.” A real property trade or business is a type of business that by election can avoid application of section 163(j) for debt that otherwise would be subject to the provision. It must be the case that debt is connected to the real property trade or business by virtue of the same “properly allocable” standard as any other trade or business.

152Reasonable methods of allocating debt among the assets of a

passthrough entity ordinarily include a pro rata allocation based on the fair market value, book value, or adjusted basis of the assets, reduced by any debt of the passthrough entity or the owner allocated to the assets. Notice 89-35.

153Reasonable methods for this purpose ordinarily include allocating

the debt among all the assets of the entity or tracing the debt proceeds to the expenditures of the entity under the rules of reg. section 1.163-8T as if the contributed debt proceeds were the proceeds of a debt incurred by the entity. Notice 89-35.




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concern about characterizing the debt and interest as properly allocable to the activity of a partnership that must calculate its own limitation amount. Sections 469, 163(d), and 163(h) — all subjects of Notice 89-35 — each apply at the level of the taxpayer for whom the tax liability will be affected by deductibility of the relevant interest — that is, the partner. For purposes of those provisions, there is a fluidity in the activity as between the partnership and partners.

Because 163(j) actually applies at the partnership level, there may be some belief that debt incurred at another level in the tiers of ownership cannot be treated as allocable to the partnership’s trade or business since the interest on that debt is not subject to limitation at the partnership level. Nonetheless, for the reasons stated above regarding the coordination of section 163(d) and (j), it still seems that the trade or business of the partnership should be attributed to the partners for purposes of characterizing debt that funds a contribution to, or purchase of an interest in, the partnership conducting the business. Although the authority is not entirely consistent in attributing a partnership’s trade or business to partners, there are several examples in which that approach has been followed.154

Coordination with the election and required use of ADS recovery periods must be considered. Section 168(g)(1)(F) and (8) now requires the use of ADS recovery periods for nonresidential real property, residential rental property, and qualified improvement property held by an electing real property trade or business (as defined in section 163(j)(7)(B)). Clearly, to avoid the limitations of section 163(j), the partnership must make the applicable election and depreciate all described property using the ADS recovery periods. The question becomes, however, whether the partners also must make that election and whether making it will subject all nonresidential property, residential rental property, and

qualified improvement property held directly by the partner to ADS recovery periods.

Applying a Notice 89-35 approach, it would seem possible to look only to the partnership for the real property trade or business and to automatically exclude debt of a partner that is allocable to the trade or business from the application of section 163(j) without any further election by the partners. This approach seemingly would bind the partners to the election status of the partnership for interest incurred and property held by the partnership, but it would leave them free to separately determine whether to elect exclusion from section 163(j) and application of ADS recovery periods to directly held real property.

In applying an “attribution of real property trade or business” approach, it seems more likely that an election would be required at each level, and it is possible that an election made by the partner would affect all properties held by that partner. It also seems that, at a minimum, the partnership must make the election for a partner’s election to apply to debt incurred for the partnership property. It seems unlikely that Treasury and the IRS would embrace a system that allows for the separate determination of depreciation for property for each partner.

All things considered, if the desire is to coordinate subsections 163(d) and (j), it seems most logical to use the same method of tracing the debt and interest for both subsections as well as for section 469. An approach like Notice 89-35 could thus wind up as the adopted method.155 The guidance plan lists as a near-term priority “computational, definitional, and other guidance under new section 163(j),”156 and hopefully this issue will be addressed in that guidance.

In addition to the real property trade or business exception, section 163(j) also contains a de minimis exemption that may be available in some contexts relevant to the real estate industry. That exemption is discussed later in this report.157

154In some contexts, the attribution of a partnership’s trade or

business by reference to the participation of the partner in the partnership’s business or the magnitude of the partner’s interest in the partnership has been analyzed. See, e.g., Rev. Rul. 92-17, 1992-1 C.B. 142 (section 355 active trade or business); and reg. section 1.368-1(d)(4)(ii) (continuity of business enterprise). In other contexts, the trade or business of a partnership is attributed to the partners without limitation. See, e.g., section 512(c)(1); section 875(a); and reg. section 1.856-3(g).

155Cf. Real Estate Roundtable, supra note 143 (advocating approach

following Notice 89-35).156

Guidance plan, supra note 61.157

See infra notes 209-217 and accompanying text.




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C. Section 163(j) and Partnerships

For real estate partnerships that do not or cannot elect exclusion from the section 163(j) limitation rules, it will be necessary to understand how the limitation rules operate for debt incurred by a partnership. At a high level, the limitation first applies at the partnership level by reference to the partnership’s business interest income and 30 percent of the partnership’s adjusted taxable income, then business interest deductions that are allowed are taken into account in determining the non-separately stated taxable income or loss of the partnership that flows through to the partners.158 Disallowed excess business interest is allocated to the partners, thus reducing their adjusted basis in their partnership interests, and those amounts may be deducted in later years only to the extent of excess taxable income allocated by that partnership to those partners.159 Excess taxable income allocated by a partnership that is not used to deduct previously disallowed excess business interest allocated by that partnership may be used to deduct other business interest incurred directly by the partner.

While this high-level description may suffice for an understanding in most instances, some scenarios will require a more detailed understanding of the rules. The rules applicable to partnerships are very complicated, and operation of the rules, as written, may not be altogether rational in several instances.160 It is important to focus on the defined terms and their use in the statute in understanding how the rules operate in more complicated situations.

The first term to focus on is “excess business interest.” Excess business interest is the amount of business interest that is not allowed as a deduction to a partnership for any tax year.161 As described above, excess business interest is allocated to the partner and carried forward to future years.

The next term to focus on is “excess taxable income.” At first blush, excess taxable income seems to represent the partnership’s excess capacity to deduct interest that is passed through to the partners, thus allowing them to deduct directly incurred business interest (or disallowed excess business interest deductions allocated from the partnership). This amount, however, reflects only adjusted taxable income, 30 percent of which should be allowed to offset business interest deductions. Adjusted taxable income excludes some items of income, business interest income notable among them.162

More specifically, excess taxable income is equal to an amount that bears the same ratio to the partnership’s adjusted taxable income as the excess of (1)(a) 30 percent of the partnership’s adjusted taxable income over (b) the amount (if any) by which business interest deductions of the partnership exceed the business interest income of the partnership, bears to (2) 30 percent of the partnership’s adjusted taxable income.163 In effect, this calculation treats business interest deductions as being offset, to the extent possible, by business interest income, and then treats unneeded adjusted taxable income as passing through to the partners as excess taxable income. Business interest income exceeding business interest deductions is not accounted for in determining excess taxable income. Also, business interest income that matches business interest deductions is accounted for only in determining the adjusted taxable income treated as excess taxable income.164 But the business interest income seemingly is not an item that is treated as part of excess taxable income.165

Excess taxable income is first used by a partner to allow for the deduction of disallowed excess business interest previously allocated by the partnership; only after the excess business interest has been fully offset may excess taxable income be used to offset other business interest deductions directly incurred by the partner.166 The

158Section 163(j)(4)(A)(i).

159Section 163(j)(4)(B)(i).

160See Lisa Starczewski and Bruce Booken, “A Deep Dive Into the

New Business Interest Limitation Reveals Need for Correction,” 29 DTR 17 (Feb. 12, 2018).

161Section 163(j)(4)(B)(ii).

162Section 163(j)(8)(A)(ii).

163Section 163(j)(4)(C).

164Section 163(j)(4)(C)(i)(II).

165Section 163(j)(4)(C) (calculating excess taxable income as a

percentage of the partnership’s adjusted taxable income).166

Section 163(j)(4)(B)(ii).




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provision allowing for the use of future-year excess taxable income to offset prior-year excess business interest states that “excess business interest shall be treated as business interest paid or accrued by the partner in the next succeeding tax year in which the partner is allocated excess taxable income from the partnership, but only to the extent of such excess taxable income.”167 This provision, read literally, seems to treat the excess business interest as currently paid by the partner to the extent matched on a dollar-for-dollar basis with the excess taxable income allocated to the partner, even though the partner appears to be permitted to deduct the excess business interest only to the extent of 30 percent of the allocated excess taxable income.168 By treating excess business interest as incurred to the extent of excess taxable income, a question arises whether the interest in excess of the 30 percent limitation amount ceases to be siloed by reference to the partnership and instead may be deductible by reference to other business interest income or adjusted taxable income directly earned by the partner. As discussed below, treatment of the excess business interest above the 30 percent limitation amount could affect the basis adjustment to the partnership interest under section 163(j) upon disposition.169

Other than the allocation of excess taxable income, for purposes of applying the section 163(j) business interest deductibility limitation at the partner level, the partner’s share of income, gain, loss, and deduction from the partnership is ignored in calculating the partner’s adjusted taxable income.170 That reduction in the partner’s adjusted taxable income is intended to prevent partners from double dipping regarding the partnership’s income or loss that determined deductibility of interest at the partnership level.

But as mentioned above, business interest income apparently is not included in the calculation of adjusted taxable income.171 Thus, the provision addressing double counting technically does not appear to prevent a partner from taking business interest income into account in applying the section 163(j) limitation at both the partner and partnership levels.

Business interest income is allowed to offset business interest deductions on a dollar-for-dollar basis, so there is some rationale for ignoring business interest income exceeding business interest deductions in calculating excess taxable income. Excess taxable income is included in the adjusted taxable income of the partner, only 30 percent of which can offset business interest deductions incurred at the partner level. Likewise, it seems rational that the partnership is allowed to allocate to the partners business interest income exceeding business interest deductions in applying section 163(j) at the partner level, since those amounts were not needed at the partnership level to allow for the deduction of business interest and thus should be permitted for use in deducting business interest at the partner level.172 It is surprising, however, that under the statute business interest income that was used to offset business interest deductions at the partnership level appears to be available again to offset business interest deductions at the partner level. Notice 2018-28 indicates that such a result was not intended and that regulations will be issued to prevent this double counting so that a partner may only use business interest income of the partnership that exceeds business interest expense of the partnership.

The separate treatment of adjusted taxable income and excess taxable income on the one hand, and business interest income on the other, can lead to some strange and possibly unintended results. For instance, a partner who has carried forward excess business interest allocated by a partnership in a prior year can deduct the excess

167Section 163(j)(4)(B)(ii)(I).

168The flush language at the end of this subparagraph seems

intended to create the 30 percent of excess taxable income limitation, although the language references “paragraph (1)(A)” when it presumably should reference “paragraph (1)(B).” A technical correction is needed. Section 163(j)(4)(B)(ii).

169See infra notes 177-178.

170Section 163(j)(4)(A)(ii)(I).

171See section 163(j)(8)(A)(ii).

172Without a rule like section 163(j)(4)(A)(ii)(I) (preventing double

counting of adjusted taxable income), business interest income should flow through to the partners under the general rules of subchapter K. See reg. section 1.702-1(a)(8)(ii) (general rule for allocation of separately stated items that could result in a different tax liability for a partner than if the item was not separately stated).




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business interest in carryover years only by reference to the partnership’s excess taxable income.173 Accordingly, a partnership’s business interest income that flows out to a partner in a current year, although available to offset business interest deductions incurred directly by a partner in that year, apparently is unavailable to offset excess business interest allocated by a partnership and carried over by a partner from a prior year.

The following example illustrates this strange and seemingly improper result: Assume that a partnership has business interest deductions of $100 exceeding business interest income in 2018 (and no adjusted taxable income). The partnership would allocate $100 of excess business interest to the partners, which could be offset only by excess taxable income of the partnership in future years. In 2019 the partnership has business interest income of $100 exceeding business interest deductions (and no adjusted taxable income). Because the $100 of business interest income exceeding business interest deductions is not included in the partnership’s excess taxable income, that amount technically is unavailable to offset the $100 of excess business interest carried over from 2018.

As described above, a partner generally is required to reduce the basis in its partnership interest by the amount of any allocated disallowed excess business interest.174 That basis reduction, however, will be reversed to the extent of excess business interest that remains disallowed at the time of a disposition of the partnership interest.175 The reversal of the basis adjustment apparently is intended to allow the partner to recognize a capital loss upon the sale or liquidation of its partnership interest for the remaining disallowed excess business interest. Excess business interest resulting in that kind of basis increase will not carry over to the transferee.176

Under a strict reading of the statute, a basis increase is triggered upon a disposition of the partnership interest only to the extent that excess

interest has not been deemed paid or accrued (that is, there has not been an allocation of excess taxable income from a partnership equal to the partner’s excess business interest expense attributable to the partnership).177 For example, if a partner’s excess business interest expense from a partnership for a prior year is $100, and the partner’s allocable share of excess taxable income in the current year is $100, the statute literally provides that all $100 of excess business interest expense will be deemed to have been paid or accrued by the partner.178 Only $30 of the interest will be deductible, however. If the partner then disposes of the partnership interest, the $70 of remaining previously disallowed interest expense seemingly will not be converted into an increase in the partner’s basis because it will be deemed to have been paid or accrued by the partner. If the partner has other sources of taxable income, the $70 of previously disallowed interest expense perhaps could be used to offset income unrelated to the partnership generating the expense. If the partner is a blocker corporation owning only a single partnership interest and has no other source of taxable income, however, this $70 of interest expense appears to be lost with no corresponding basis increase. Both results appear to be inconsistent with the “silo” regime for partnership interest expense set forth in the statute and the legislative history. It is possible that this seemingly inappropriate result will be addressed in future guidance.

D. Pre-2018 Section 163(j) Carryovers

Prior to the TCJA, section 163(j) disallowed interest deductions under a completely different set of rules, and those rules provided for the carryover of disallowed interest to future tax years. The TCJA did not indicate how interest that was disallowed under pre-2018 section 163(j) would be treated. Notice 2018-28 indicates that guidance will be issued clarifying that taxpayers “may carry such interest forward as business interest” to the taxpayer’s first tax year beginning after December 31, 2017. According to the Notice, the regulations will also clarify that business

173Section 163(j)(4)(B)(ii)(I).

174Section 163(j)(4)(B)(iii)(I).

175Section 163(j)(4)(B)(iii)(II).

176Section 163(j)(4)(B)(ii)(II) (last sentence).

177Section 163(j)(4)(B)(iii)(II).

178Section 163(j)(4)(B)(ii)(I).




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interest carried forward will be subject to potential disallowance under section 163(j) “in the same manner as any other business interest otherwise paid or accrued” in a tax year beginning after December 31, 2017.

As described above, if a taxpayer elects in 2018 to be excluded from section 163(j) as an electing real property trade or business, that taxpayer will not be treated as engaged in a trade or business for purposes of section 163(j).179 As a result, the taxpayer will not have business interest income or incur business interest expense. It is not clear under Notice 2018-28 whether pre-2018 interest carried over as business interest may be deducted without limitation by virtue of being treated as being paid or accrued by an electing real property trade or business (that is, if the interest expense is treated as “business interest” and the electing taxpayer has no business income due to the election, no amount would be deductible). To the extent that regulations provide that business interest carried forward will be treated in the same manner as any other business interest otherwise paid or accrued in 2018, as implied by Notice 2018-28, it seems that such carried forward interest of an electing real property trade or business should not be subject to disallowance under section 163(j). Hopefully the regulations will make this clear.180

E. ‘Interest-Like’ Items Not Subject to 163(j)

Finally, apart from the partnership issues, it is important to recognize what is not covered by section 163(j). First, guaranteed payments for the use of capital under section 707(c) are not covered. Further, a preferred partnership interest that requires allocations of income to satisfy the preferred return has the effect of providing a deduction for partners holding common interests, since income is allocated away from the common partners to match the preferred return. These points could lead taxpayers to focus on the use of

preferred partnership interests in place of debt in some contexts.181 Leases in a sale-leaseback arrangement also are not addressed. Obviously, there often is a significant interest component in the lease payments, but absent application of section 467,182 the entire lease payment remains deductible under current law so long as the form of the arrangement is respected for U.S. tax purposes.183

VII. Recovery Period and Expensing

Under the TCJA, the modified accelerated cost recovery system recovery period for depreciation deductions for nonresidential real property and residential rental property remains at 39 years and 27.5 years, respectively.184 Notably, however, the ADS recovery period for residential rental property has been reduced from 40 years to 30 years, effective for property placed in service after 2017.185

The new law defines a new class of depreciable property as “qualified improvement property.”186 This property includes everything that previously was qualified leasehold improvement property, qualified retail improvement property, and much of what was qualified restaurant property, along with interior building improvements (other than elevators, escalators, internal structural framework, and building expansions) placed in service after a building’s initial placed-in-service date.187 According to the legislative history, the intent was that the MACRS recovery period for qualified improvement property be 15 years and that the

179Section 163(j)(7)(A)(ii).

180Note that a similar issue exists when a real property trade or

business does not elect exemption from section 163(j) in 2018 and has disallowed interest that carries over to 2019. Query if Treasury and the IRS will view the carryover issue similarly when the taxpayer has consciously chosen to defer business interest deductions under section 163(j) presumably in favor of obtaining more favorable expensing and depreciation results for that year.

181Obviously, debt-equity issues must be considered in structuring

the terms of the interests. See generally J. William Dantzler Jr., “The Distinction Between Partnership Debt and Partnership Equity,” Tax Notes, July 10, 2017, p. 197. Cf. also Notice 2004-31, 2004-1 C.B. 830 (addressing some guaranteed payment arrangements in the context of former section 163(j)).

182Reg. section 1.467-2.

183See generally Langdon T. Owen Jr., “Typical Tax Aspects of Real

Property Leases,” 37 Real Est. Tax’n 166 (2010); and Paul D. Carmen, “Benefits and Burdens of Ownership Still Govern True Lease Characterization,” 41 Real Est. Tax’n 14 (4th Qtr. 2013).

184Section 168(c).

185Section 168(g)(2)(iii).

186Qualified improvement property formerly was a defined term for

purposes of the bonus depreciation rules, but it did not define a class of property for purposes of MACRS or ADS depreciation. Section 168(k)(3) (as effective before January 1, 2018).

187Section 168(e)(6).




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ADS recovery period for that property be 20 years.188 The statute, however, was not drafted properly regarding qualified improvement property, and a technical correction is needed to give effect to the intended result.189 Without the technical correction, it appears that qualified improvement property is depreciable over 39 years under MACRS and 40 years under ADS.190

For real property trades or businesses that elect to be exempt from the limitation on interest deductions under section 163(j), all nonresidential real property, residential rental property, and qualified improvement property must be depreciated using the applicable ADS recovery periods (that is, longer lives).191 So there would be a trade-off for electing the interest limitation exemption. Importantly, the switch to ADS recovery periods applies to all nonresidential rental property, residential rental property, and qualified improvement property — not just to property placed in service beginning in 2018.192 The change-in-use rules under reg. section 1.168(i)-4 should be used to compute depreciation for assets placed in service in prior years that would change from MACRS to ADS because of this election. Note that those rules require use of the ADS recovery period as in effect when the property was placed in service, so it would appear that unless regulations are modified, residential rental property placed in service before 2018 would convert to an ADS life of 40 years.193

The new law permits 100 percent bonus depreciation (that is, 100 percent expensing) for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023.194 Qualified property includes assets with recovery periods of 20 years or less and most other categories of property that historically have been bonus-eligible.195 The 100 percent expensing provision applies to both property of which the taxpayer is the original user and used property purchased by the taxpayer, so long as the used property was not previously used by the acquiring taxpayer and was not acquired from a related party.196 Although it is clear that qualified improvement property was intended to be eligible for expensing, it appears that a technical correction also is needed to clarify that qualified improvement property placed in service after 2017 is eligible for expensing in the absence of the interest deductibility election.197 The guidance plan designates the expensing provision under section 168(k) as a near-term priority for guidance,198 although it is not clear that expensing of qualified improvement property will be included in that guidance.199

It appears that 100 percent expensing should be available for property placed in service after September 27, 2017, and before January 1, 2018.200 Accordingly, there is a window of time before 2018 when qualified leasehold improvement property and qualified retail improvement property (formerly defined as 15-year property under section 168(e)(3)(E)(iv) and (ix)) could qualify for expensing by virtue of the property having a recovery period of 20 years or less.201

188H.R. Rep. No. 115-466, at 204-205 (Conf. Rep.) (indicating that

qualified improvement property will have a 15-year MACRS recovery period and 20-year ADS recovery period).

189Although a description of qualified improvement property was

added to section 168(e)(6), qualified improvement property was not added to section 168(e)(3), the operative provision describing the MACRS and ADS (by cross-reference in section 168(g)(3)) lives for property. P.L. 115-97, section 13204(a)(1)(A)(i) (eliminating qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property from section 168(e)).

190See Foster, “Tax Law Fixes,” supra note 34 (reporting that Trier, in

referencing the mistake regarding qualified improvement property, stated, “My reaction is that there’s not much we can do. I’m not sure how Treasury can bail that one out.”).

191Section 168(g)(1)(F) and (8).

192Given the exclusion of deductions for depreciation, amortization,

and depletion in calculating the interest limitation amount under section 163(j) through 2021, some may find that section 163(j) will not actually limit interest deductions for tax years before 2022. Accordingly, some taxpayers engaged in a real property trade or business may wait until 2022 to elect out of the interest limitation rules to take advantage of the more beneficial depreciable lives.

193Reg. section 1.168(i)-4(d)(5)(ii)(B).

194Section 168(k)(6)(A)(i).

195Qualified property also includes computer software; water utility

property; and qualified film, television, or live production property. Section 168(k)(2)(A)(i).

196Section 168(k)(2)(A)(ii) and (E)(ii).

197Qualified improvement property formerly was referenced in the

bonus depreciation rules, but that reference was removed, effective for property placed in service after December 31, 2017. P.L. 115-97, section 13204(a)(4)(A). It was intended that the property would qualify for expensing under the new law as a result of having a recovery period of 20 years or less. Section 168(k)(2)(A)(i). Accordingly, the failure of that property to qualify for expensing derives from the above-discussed mistake requiring a technical correction. See supra note 189.

198Guidance plan, supra note 61.

199See supra note 190.

200See id.

201See section 168(k)(2)(A)(i)(I).




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Property formerly defined as qualified improvement property under the bonus depreciation rules (which definition mirrors the definition in the TCJA) also should qualify for expensing during this period.202 Qualified restaurant property also could qualify during this period to the extent that the property meets the definition of qualified improvement property.203

As has historically been the case, property required to be depreciated using ADS is ineligible for 100 percent expensing.204 Also, taxpayers may elect out of bonus depreciation, including 100 percent expensing on a recovery class basis.205 For the first tax year ending after September 27, 2017, a taxpayer may elect to use 50 percent in lieu of 100 percent as the applicable expensing percentage.206

The availability of expensing technically is not limited in situations in which a taxpayer conducting a real property trade or business elects to be exempt from the limitation on deductibility of interest.207 However, as described above, the requirement that an electing real property trade or business use the ADS recovery period for qualified improvement property makes that property ineligible for expensing, even if a technical correction ultimately confirms that the property otherwise is eligible. However, personal property remains eligible for expensing even if the section 163(j) election is made, since the ADS recovery period is not required for that property.

Although the rules providing for 100 percent expensing expire after 2022, the new law provides for reduced expensing for property placed in service after 2022 as follows: (1) 80 percent in 2023; (2) 60 percent in 2024; (3) 40 percent in 2025; and (5) 20 percent in 2026.208

VIII. Beneficial Treatment of Small Businesses

The TCJA materially increases the availability of some favorable tax treatment for small businesses. Potentially relevant to the real estate industry, these provisions concern use of the cash method of accounting,209 an exemption from the uniform capitalization (UNICAP) rules for property acquired for resale,210 and an exemption from the percentage-of-completion method under section 460 (thereby allowing qualifying taxpayers to use the completed contract method).211

In addition to making these preexisting provisions more liberal, the TCJA provides an exemption from the interest limitation rules in section 163(j) for businesses that satisfy the same standard.212 This exception could be important in the real estate fund context in instances in which the election for real property trades or businesses are unavailable or undesirable because of the required use of ADS recovery periods for nonresidential property, residential rental property, and qualified improvement property.213

Qualification for all these provisions is determined by reference to the gross receipts test in section 448(c). Under the new law, a partnership214 or corporation will pass this test for a tax year if the entity’s average annual gross receipts for the three-tax-year period ending with the year before the tax year under analysis does not exceed $25 million. For purposes of applying the gross receipts test, all persons treated as a

202See section 168(k)(2)(A)(i)(IV) (as effective before January 1, 2018).

203See sections 168(e)(3)(E)(v) and (7)(B) (as effective before January 1,

2018).204

The elimination of qualified improvement property as a specific class of property eligible for bonus depreciation and changes to the rules concerning the depreciable life of qualified improvement property are effective for property placed in service after December 31, 2017 (P.L. 115-97, section 13204(a)(4)(A) and (b)(1)).

205Section 168(k)(7).

206Section 168(k)(10).

207A real property trade or business is not one of the businesses

excluded from the expensing provision by virtue of being excluded from the interest deduction limitations in section 163(j). Section 168(k)(9).

208Sections 168(k)(6)(A)(ii) through (v).

209Section 448(c)(1).

210Section 263A(i). Historically, the exception to the UNICAP rules

applied only to personal property (see former section 263A(b)(2)(B)), but the new law would expand the exception so that it also may apply to real property.

211Section 460(e)(1)(B) and (2).

212Section 163(j)(3).

213For example, a blocker C corporation that holds a direct or indirect

interest in a REIT would not appear to be engaged in a real property trade or business. If the blocker C corporation can satisfy the de minimis standard applicable to small businesses by reference to its percentage share of gross receipts from the underlying activity, that entity still may be able to avoid application of the section 163(j) interest limitations for interest incurred on debt it borrowed.

214Importantly, this exemption is unavailable for any “tax shelter

prohibited from using the cash receipts and disbursements method of accounting under section 448(a)(3).” Section 163(j)(3). Rules determining the treatment of a partnership as a tax shelter are quite broad. See generally Karen Lohnes et al., Limited Liability Companies, 725 BNA Tax Mgmt. Port., at section V.C.




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single employer under section 52(a) or (b) or section 414(m) or (o) will be treated as one person.

The rules in sections 52 and 414 are significantly broader than the more commonly referenced related-party rules under section 267 and 707, and careful attention must be paid to determine whether separate entities will be combined in applying the gross receipts test. At a high level, common ownership of blocker corporations by a single greater-than-50-percent corporate shareholder (by vote or value and taking into account attribution) would cause the blocker corporations to be considered on a combined basis.215 Also, at a high level, ownership by five or fewer shareholders who are individuals, estates, or trusts (possibly including some pension trusts)216 of more than 50 percent of the stock of multiple blocker corporations (again, by vote or value and taking into account attribution) would cause those corporations to be evaluated on a combined basis.217 These two scenarios certainly do not describe the universe of situations in which entities will be analyzed on a combined basis, and attribution rules can make analysis of even these seemingly straightforward scenarios very complicated. Reliance on the section 163(j) de minimis rule will require extensive analysis in many situations.

IX. Deduction of Investment Management Fees

Historically, when a partnership paid investment management fees in connection with an activity engaged in for the production of income within the meaning of section 212, those items were allocated as separately stated items,218 and an individual partner’s allocable share of those fees was characterized as a miscellaneous itemized deduction. As miscellaneous itemized deductions, the amounts could be deducted only to the extent that total miscellaneous itemized deductions exceeded 2 percent of AGI.219 The

allocation of items that were subject to the 2 percent floor certainly was not ideal, but in some instances it still could benefit some taxpayers.

Under the new law, no deduction is allowed for miscellaneous itemized deductions.220 Accordingly, an allocation of investment management and similar fees that now are incurred in connection with a section 212 activity will provide no benefit to individual taxpayers.

X. Excess Business Loss Limitation

Some taxpayers historically have been limited in their ability to deduct passive losses under section 469. Persons qualifying as real estate professionals typically have not been limited in deducting losses for rental real estate under those rules.221

The TCJA creates an additional loss limitation provision. Under the new law, for taxpayers other than C corporations, excess business losses will not be allowed as a deduction in the current year but instead will be carried over as part of a taxpayer’s NOL.222

For purposes of these rules, an excess business loss for married taxpayers filing jointly would equal (1) the aggregate deductions of the taxpayers attributable to all trades or businesses over (2) all business income and gain of the taxpayers plus $500,000 (adjusted for inflation).223 For partnerships and S corporations, this limitation will apply at the partner or shareholder level.224 In effect, the new loss limitation rule will limit the ability of taxpayers that are not C corporations to deduct business losses exceeding a threshold amount (for example, $500,000 for married taxpayers filing jointly) against other income, like wages and investment income.

This rule will apply after application of section 469,225 so losses deferred under section 469 will not enter into the calculation of excess

215Sections 52(a) and 1563(a)(1).

216LTR 200734018 (foreign pension trust classified as a trust under

reg. section 301.7701-4); LTR 200508004 (same).217

Sections 52(a) and 1563(a)(2). For purposes of this brother-sister controlled group rule, stock ownership by a person is taken into account only to the extent the stock ownership is identical for each corporation. Reg. section 1.1563-1(a)(3)(i).

218Rev. Rul. 2008-39, 2008-2 C.B. 252.

219Section 67(a).

220Section 67(f). As with other provisions applicable to individual

taxpayers, the provision disallowing the deduction for itemized miscellaneous deductions is set to expire for tax years beginning after 2025.

221Section 469(c)(7).

222Section 461(l).

223Section 461(l)(3).

224Section 461(l)(4).

225Section 461(l)(6).




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business losses. However, the deductibility of business losses for taxpayers who are not active participants in a business activity for purposes of section 469 may be limited by the new law. For instance, deferred losses that are taken into account upon disposition of a passive activity226 will factor into the calculation of excess business losses.

As stated above, losses that are deferred will become part of the taxpayer’s NOL carryforward.227 Strangely, it does not appear that the losses used under carryforward provisions remain subject to the excess business loss limitation in future years. Instead, by including the disallowed excess business losses in the taxpayer’s NOL carryforward, the losses become subject to the new “80 percent of taxable income” limitation applicable to NOL carryforwards.228

XI. Financial Accounting Timing Rule

The TCJA requires accrual-method taxpayers to treat the all-events test for all items of gross income as being met no later than when the income is taken into account as income on an applicable financial statement.229 The provision does not apply to income earned in connection with a mortgage servicing contract or to any item of gross income for which the taxpayer uses a special method of accounting under any other provision of the code (other than methods provided in sections 1271 through 1288).230 The legislative history provides as examples of these special methods of accounting long-term contracts under section 460 and the installment method under section 453.231 Presumably, the leasing provisions under section 467 also would be treated as a special method of accounting.

An applicable financial statement is a financial statement:

1. prepared in accordance with generally accepted accounting principles and (a)

filed with the SEC, (b) used for (i) credit purposes, (ii) reporting to shareholders, partners, other proprietors, or beneficiaries, or (iii) any other substantial nontax purpose, or (c) filed with any other federal agency other than for federal tax purposes;

2. prepared on the basis of international financial reporting standards and filed with a foreign equivalent of the SEC;

3. filed by the taxpayer with any other regulatory or governmental body specified by Treasury; or

4. otherwise designated under rules specified by Treasury.232

The definition of an applicable financial statement certainly includes public REIT financial statements and would seem to include most financial statements provided in the real estate fund context.

One issue of concern under earlier versions of the financial accounting timing rule was whether a real estate fund using mark-to-market accounting to reflect the current fair market value of property for financial accounting purposes would be required to report gain and loss for tax purposes on a mark-to-market basis. Under the final version of the legislation, it does not appear that the use of mark-to-market accounting should result in current recognition of gain for federal income tax purposes. In this regard, the legislative history contains a footnote stating:

The provision does not revise the rules associated with when an item is realized for Federal income tax purposes and, accordingly, does not require the recognition of income in situations where the Federal income tax realization event has not yet occurred . . . [T]he provision does not require the recognition of gain or loss from securities that are marked to market for financial accounting purposes if the gain from such investments is not realized for Federal income tax purposes until such time that the taxpayer sells or otherwise disposes of the investment.233

226Section 469(g).

227Section 461(l)(2).

228See supra notes 124-127 and accompanying text.

229Section 451(b)(1)(A).

230Section 451(b)(1)(B)(ii) and (2). See generally Lee A. Sheppard,

“Fahrenheit 451(b),” Tax Notes, Feb. 26, 2018, p. 1161 (discussing the implications of excepting sections 1271 through 1288).

231H.R. Rep. No. 115-466, at 276 n. 874 (Conf. Rep.).

232Section 451(b)(3).

233H.R. Rep. No. 115-466, at 276 n. 872 (Conf. Rep.).




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The incorporation of financial accounting concepts into tax reporting raises many issues, and it is likely that practitioners are just starting to scratch the surface. The guidance plan designates “definitional and other guidance under new section 451(b) and (c)” as a near-term priority,234 although it can be expected that many uncertainties will remain even after the guidance is issued.

XII. Like-Kind Exchanges

Under the TCJA, section 1031 will continue to apply to exchanges of real property (but not dealer property or domestic-foreign exchanges).235 Section 1031 will not apply to exchanges of any other property, so gain recognition will be required for personal property exchanged in connection with real property to the extent that gain exists.

The new law provides that a partnership that has made a valid election under section 761 to be excluded from the application of subchapter K will continue to be treated as an interest in the assets of the partnership and not as an interest in the partnership.236 This provision seems to be designed to preserve the real property tenants-in-common exchange transactions that became prominent during the early 2000s.237

The new provision applies to exchanges completed after 2017, although a transition rule will exempt exchanges when the first transaction in the exchange (sale for a forward exchange or acquisition for a reverse exchange) occurred on or before December 31, 2017.238

XIII. Non-Shareholder Contributions to Capital

The TCJA changes the federal tax treatment of state and local incentives and concessions granted to corporations to encourage them to locate operations or develop property within their jurisdictions. Those amounts historically have

been excluded from income as non-shareholder contributions to capital under section 118.239

Under the new law, the following transactions are excluded from the application of section 118: (1) contributions in aid of construction or any other contribution as a customer or potential customer, and (2) any contributions by a governmental entity or civic organization (other than a contribution made by a shareholder as such).240 It is important to note that under the IRS’s historical position, tax abatements generally do not give rise to gross income or result in a contribution to capital under section 118.241 The legislative history would seem to confirm that position.242 Accordingly, there may be some benefit to negotiating incentives in the form of abatements, as opposed to direct contributions.

The provision will be effective for contributions made after December 22, 2017.243 As an exception, the new law will not apply to contributions made by a governmental entity after December 22, 2017, if the contribution is made under a master development plan that was approved before that date by a governmental entity.244

XIV. Tax-Exempt Entities

Of significant concern to the real estate and investment community generally was a provision in the House bill “clarifying” that “super tax-exempt entities” would be subject to tax on UBTI. Thankfully, that provision was eliminated in the conference agreement and did not become part of the new law.245


235Section 1031(a)(1).

236Section 1031(a)(1); cf. Rev. Rul. 2004-86, 2004-2 C.B. 191.

237See generally Richard M. Lipton, Michael T. Donovan, and Michelle

A. Kassab, “The Promise (and Perils) of Using Delaware Statutory Trusts in Real Estate Offerings,” 108 J. Tax’n 348 (2008).

238P.L. 115-97, section 13303(c).

239See generally W. Eugene Seago and Edward J. Schnee, “Capital

Contributions to Corporations for Public Benefits,” Tax Notes, Nov. 22, 2010, p. 907.

240Section 118(b). See generally James Atkinson and John Geracimos,

“2017 Tax Reform’s Limitation on Favorable Non-Shareholder Contribution to Capital Treatment: Contribution to Uncertainty,” 59 No. 3 T.M. Memorandum (BNA) (2018).

241For a discussion on the historic treatment of tax abatements in the

context of section 118, see IRS, “Appeals Settlement Guidelines on State and Local Location Tax Incentives” (Mar. 7, 2011).

242H.R. Rep. No. 115-466, at 240 (Conf. Rep.) (“A municipal tax

abatement for locating a business in a particular municipality is not considered a contribution to capital.”).

243P.L. 115-97, section 13312(b)(1).

244Id. at section 13312(b)(2).

245H.R. Rep. No. 115-466, at 404-405 (Conf. Rep.).




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However, tax-exempt entities are the subject of other adverse provisions. The TCJA treats some private colleges and universities somewhat like private foundations — that is, those taxpayers will be subject to a 1.4 percent excise tax on NII.246 The rate is 2 percent for private foundations.247

Also of significance is that a tax-exempt organization is no longer allowed to use UBTI losses from one unrelated trade or business to offset UBTI from another unrelated trade or business.248 For tax years beginning after 2017, UBTI losses from an unrelated business will be carried over and will be available to offset future UBTI earned by that same unrelated business. UBTI losses that arose in tax years beginning before 2018 will not be subject to that limitation.249

The statute and legislative history provide no guidance on how to distinguish separate unrelated trades or businesses. The guidance plan has designated this issue a near-term priority, so hopefully confusion regarding this issue can be resolved soon.250

XV. FIRPTA

Despite the efforts of the real estate industry,251 the TCJA does not contain substantive changes to the 1980 Foreign Investment in Real Property Tax Act rules under section 897. Nonetheless, other changes made by the new law should benefit many non-U.S. taxpayers investing in U.S. real estate.

The reduction in the corporate rate to 21 percent will result in the taxation of FIRPTA gain for non-U.S. corporate investors at this reduced

rate so long as the branch profits tax is not applicable.252 Although the withholding rate on the direct sale of a FIRPTA asset by a non-U.S. taxpayer generally would result in withholding at a rate equal to 15 percent of the gross sale proceeds,253 because of the reduction in the corporate tax rate to 21 percent, the withholding rate applied to partnerships under sections 1445(e) and 1446(b) on FIRPTA gain allocated to a non-U.S. corporate partner is reduced from 35 percent to 21 percent.254 Partnerships still must withhold tax under section 1446 at the highest individual tax rate (37 percent) on FIRPTA gain allocated to a non-U.S. partners that are not corporations.255

XVI. Anti-Base-Erosion Rules

The TCJA adopts an international tax regime that is dramatically different from the regime that applied under prior law. The new regime makes some movement away from the historical regime that taxed U.S. taxpayers on a worldwide basis and toward a regime that taxes income on a territorial basis, although the move is significantly limited by new rules that require the immediate taxation of most foreign subsidiary earnings. Without the new regime’s limitations, taxpayers would have significant incentive to shift income offshore and thus avoid U.S. income tax on that income.

The new law adopts onerous anti-base-erosion rules intended to prevent erosion of the U.S. tax base through these type of actions. The provisions have the potential to affect structures and arrangements entered into by non-U.S. taxpayers investing in U.S. real estate — particularly the use of debt and interest

246Section 4968(a).

247Section 4940(a).

248Section 512(b)(6).

249P.L. 115-97, section 13702(b)(2).

250Guidance plan, supra note 61. There is some thought that the

enactment of this provision may have been driven by an IRS report finding that tax-exempt colleges and universities were improperly reporting losses that did not relate to “for-profit” activities. See IRS Exempt Organizations, “Colleges and Universities Compliance Project Final Report” (Apr. 2013); see also R. Lee, “New Business Income Guidelines Baffle Tax-Exempt Groups,” TM Weekly Report (Feb. 12, 2018). If this is the case, one would hope that the grouping rules for investment fund activities will be generous, given that they clearly represent for-profit activities.

251See generally Kenneth T. Rosen and Randall Sakamoto, “Unlocking

Foreign Investment in U.S. Commercial Real Estate,” Tax Notes, Oct. 16, 2017, p. 405 (article was prepared for the Invest in America Coalition, the Real Estate Roundtable, and the National Multifamily Housing Council).

252A foreign corporation generally is subject to the branch profits tax

under section 884 on FIRPTA gains from dispositions of U.S. real property interests other than stock of FIRPTA companies and the receipt of REIT distributions under section 897(h)(1), except to the extent that the branch tax is eliminated or reduced by an applicable tax treaty or the corporation satisfies the requirements of the branch termination exception for the year of the disposition or distribution. See reg. section 1.884-1(d)(2)(xi), Example 4.

253Section 1445(a).

254Sections 1445(e)(1) and 1446(b)(2)(B) (each referencing the highest

rate of tax specified for corporations). Despite the reduction in the corporate tax rate, the withholding rate applicable to foreign corporations under section 1442 on fixed or determinable annual or periodical income remains at 30 percent.

255Section 1446(b)(2)(A).




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deductions to reduce U.S. tax leakage related to those investments.

One provision — new section 267A — disallows interest deductions for disqualified related-party amounts paid under a hybrid transaction or by or to a hybrid entity. Section 267A is intended to deny a deduction in the United States when a related non-U.S. recipient of the item is not subject to tax on the item in the recipient’s local country. Luxembourg preferred equity certificate structures would appear to be one target of this provision.256

Under section 267A, a payment of interest or royalties represents a disqualified related-party amount to the extent that the payer and payee are related and (1) there is no corresponding income inclusion to the related party in its country of residence, or (2) the related party is allowed a deduction for the payment under its local-country tax law.257 A hybrid transaction involves a transaction or instrument under which payments are treated as interest or royalties for U.S. federal income tax purposes but are not so treated for purposes of the tax law of the country where the recipient is resident or otherwise subject to tax.258 A hybrid entity is an entity treated as fiscally transparent (flow-through) in one jurisdiction, but not in the other, when one of the jurisdictions is the United States.259 The statute gives Treasury and the IRS broad regulatory authority to expand the scope of transactions subject to section 267A.260

A separate provision — section 59A — provides for a base erosion and antiabuse tax (BEAT) that will require “applicable taxpayers” to pay a tax equal to the “base erosion minimum tax amount” for the tax year.261 The BEAT targets large corporations (both U.S. and non-U.S.) that reduce their regular U.S. tax liabilities below a specified

threshold by making deductible payments to related non-U.S. entities.

This provision seemingly will have limited applicability in the real estate context. First, an applicable taxpayer does not include a REIT, so payments made by a REIT are not subject to this tax.262 Also, “applicable taxpayers” are limited to corporations that have average annual gross domestic receipts of at least $500 million for the three-tax-year period ending with the preceding tax year and that have a base erosion percentage of 3 percent or higher.263 The base erosion percentage generally is calculated by dividing the amount of deductions claimed for payments to related foreign parties by the total amount of deductions the taxpayer is permitted to take. For this purpose, all persons treated as a single employer under section 52 (with some modifications) are treated as one person, so the gross receipts taken into account may be broader than those earned by a single entity.264 Still, it is hoped that the $500 million gross domestic receipts threshold will exclude many non-U.S. investors in U.S. real estate.265

When the BEAT is applicable, the base erosion minimum tax amount is equal to the excess of 10 percent (5 percent for a tax year beginning in calendar year 2018 and 12.5 percent in a tax year beginning after 2025) of the taxpayer’s modified taxable income over the regular tax liability, with some adjustments for credits.266 For these purposes, modified taxable income means the taxable income of the taxpayer determined without regard to any base erosion tax benefit (or the base erosion percentage of any allowed NOL for the tax year).267 A base erosion tax benefit

256See generally Jasper L. Cummings, Jr., “Using Luxembourg

Preferred Equity Certificates,” Tax Notes, Jan. 18, 2016, p. 323.257

Section 267A(b)(1).258

Section 267A(c).259

Section 267A(d).260

Section 267A(e).261

Section 59A.

262Section 59A(e)(1)(A).

263Sections 59A(e)(1)(B) and (C). The gross receipts of foreign

corporations are taken into account only to the extent that they are effectively connected with a U.S. trade or business. The base erosion percentage is lower for banks and securities dealers.

264Section 59A(e)(2).

265In the real estate fund context, it would appear that some

sovereign wealth funds that use single-owner blocker corporation structures for investment would have the greatest exposure to the BEAT.

266Section 59A(b).





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means any deduction allowed for a base erosion payment for the tax year;268 a base erosion payment is an amount paid to a related foreign person for which a deduction is allowable (including depreciation on property acquired from the related person).269

The new law also introduces additional reporting requirements under section 6038A related to those base erosion arrangements and will increase the penalty for violation from $10,000 to $25,000.270

XVII. Tax Credits

Although tax reform created great concern about the continued availability of tax credits applicable to real estate, the primary credits survived, albeit with one in a more limited context. The low-income housing tax credit and the new markets tax credit both have been retained in the new law without change.271 For the historic rehabilitation tax credit, however, the TCJA eliminates the 10 percent credit for pre-1936 buildings but provides a continuing 20 percent credit for certified historic structures.272 This credit may be claimed ratably over a five-year period beginning in the tax year in which a qualified rehabilitated structure is placed in service.273

XVIII. Technical Changes to the Partnership Rules

A. Partnership Technical Terminations

The TCJA eliminates section 708(b)(1)(B) so that the sale or exchange of 50 percent or more of the profits or capital interests in a partnership within a 12-month period will no longer technically terminate the partnership.274 As a result, the depreciable lives of tangible partnership property will no longer restart, elections will no longer terminate, and many other results that typically follow from a technical termination will no longer apply.

B. ECI on Sale of a Partnership Interest

Last year the Tax Court in Grecian Magnesite275 refused to follow a long-standing IRS position276 that a partner selling an interest in a partnership holding assets, gain on the sale of which would result in ECI, would itself recognize ECI by reference to the assets of the partnership. The TCJA essentially overrules that decision, effective as of November 27, 2017, by providing that gain from the sale or exchange of a partnership interest will be taxed as ECI to the extent that the non-U.S. seller would be allocated ECI if the partnership sold all its assets for FMV on the date of the sale or exchange.277

Given application of the FIRPTA regime in the real estate context,278 this new provision may have limited effect for the real estate industry, although guidance coordinating the provisions is needed. Some advisers had looked at Grecian Magnesite as giving qualified foreign pension funds (not subject to FIRPTA)279 the ability to hold real property through a partnership and avoid recognition of U.S. taxable income by selling interests in the partnership. The new law will not permit that result, thereby forcing qualified foreign pension funds to continue holding most U.S. real property through a REIT to avoid U.S. tax on gain related to the sale of the real estate.280

C. Mandatory Partnership Basis Adjustments

Since 2004, a partnership has been required to adjust the basis of partnership assets under section 743(b) if the adjusted basis of partnership


269Section 59A(d).

270Section 6038A(b).

271H.R. Rep. No. 115-466, at 290 and 403 (Conf. Rep.).

272Section 47(a)(2).

273Id.

274P.L. 115-97, section 13504(a).

275Grecian Magnesite Mining, Industrial & Shipping Co. SA v.

Commissioner, 149 T.C. No. 3 (2017).276

See Rev. Rul. 91-32, 1991-1 C.B. 107.277

Section 864(c)(8); see also section 1446(f) (regarding withholding); see generally NYSBA Tax Section, “Request for Immediate Guidance Under Sections 864(c)(8) and 1446(f)” (Feb. 2, 2018).

278Reg. section 1.897-7T.

279Section 897(l).

280On April 2, Treasury and the IRS issued Notice 2018-29, 2018-16

I.R.B. 1, indicating the intent to issue regulations to address withholding obligations under new section 1446(f) related to gain from the sale, exchange or other disposition of a partnership interest by a nonresident alien or foreign corporation that is treated as effectively connected with the conduct of a trade or business in the United States under new section 864(c)(8). Treasury and the IRS had previously issued Notice 2018-08, 2018-7 I.R.B. 352, on December 29, 2017, suspending the requirement to withhold on dispositions of certain interests in publicly traded partnerships due to practical problems with applying such a withholding regime without guidance.




SPECIAL REPORT


property exceeds its FMV by more than $250,000.281 The TCJA expands the scope of that provision, also applying the mandatory basis adjustment rules to a transferee partner who would be allocated a net loss exceeding $250,000 upon the sale of all partnership assets when the partnership interest is transferred.282

An example is helpful in illustrating the effect of this provision. Assume that Partners A and B form a partnership by A contributing Property A with $0 basis and $1 million value, and B contributing Property B with $1 million value and basis. Later on, Property B falls in value to $400,000, and Property A retains its $1 million value. B sells its interest for $700,000, recognizing a loss of $300,000. If the assets of the partnership were sold for their FMV, B would be allocated $0 gain or loss from Property A (because all gain would be allocated to A under section 704(c)) and loss of $300,000 on the sale of Property B. Accordingly, even though the partnership has net $400,000 gain for all its properties, B’s sale of its partnership interest will invoke the mandatory step-down rules. Note that a sale by A of its partnership interest would not invoke the mandatory basis adjustment rules.

XIX. Qualified Opportunity Zones

An additional provision in the TCJA may be of interest to some who are active in the real estate industry. This tax incentive is intended to encourage economic investment in targeted low-income areas.

The new law allows for the designation of some low-income communities as qualified opportunity zones (QOZs)283 and provides tax incentives for those who invest in them. New section 1400Z-2 provides for (1) the temporary deferral of capital gains reinvested in a qualified opportunity fund within 180 days of the sale that

generated the gain,284 and (2) a permanent exclusion of capital gains from the sale or exchange of an investment in a qualified opportunity fund held for at least 10 years.285

A qualified opportunity fund is defined as an investment vehicle organized as a corporation or partnership for the purpose of investing in QOZ property (other than alternative qualified opportunity funds) that holds at least 90 percent of its assets in QOZ property.286 QOZ property includes QOZ stock, QOZ partnership interests, and QOZ business property.287

The guidance plan lists “guidance regarding Opportunity Zones under sections 1400Z-1 and 1400Z-2” as a near-term priority.288 It can be expected that this guidance will be dedicated to procedures describing the application process for designation as an opportunity zone.

XX. Conclusion

In many ways, the TCJA creates a new paradigm through which one must view investment in real estate. Rate dynamics for investors have changed, calculation of taxable income is now different, and investor sensitivities to different kinds of income have been altered. To compound the difficulties in planning under the new rules, ambiguities and outright mistakes are present in many parts of the legislation. Treasury and the IRS seem committed to issuing guidance that will make the new rules workable to the extent possible, and they are prioritizing guidance projects to advise on some of the most important issues quickly.

In the meantime, taxpayers can act on what they know (or anticipate) and gather information in preparation for taking action when some of the answers become clearer. Hopefully, this report will be helpful in both of those exercises.

281Section 743(a) and (d).

282Section 743(d)(1)(B).

283Section 1400Z-1(b).

284Section 1400Z-2(a) and (b).

285Section 1400Z-2(c).

286Section 1400Z-2(d)(1).

287Section 1400Z-2(d)(2).





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