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Principles of Real Estate Accounting and Taxation

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Real Estate Industry

What do we mean by real estate?

Asset classes - investment

Rental (Commercial, Residential, Storage, Retail, Industrial)

Hotels & Lodging, Nursing Homes, Health Care

Developers

Homebuilders, Commercial buildings, Condos, Land

Operators

Management Companies, Advisors, Brokers, Agents

Debt

Mortgages, Mezzanine loans, CMBS

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA

Charles W. Caldwell, D.B.A., CMA

Jon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPA

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Real Estate Industry

Who are the investors

Equity - Foreign, Tax-exempt, Private Equity, Individuals, REITs, Governments

Lenders – Insurance companies, Mezzanine lenders, CMBS, Banks, Mortgage REITs, Government sponsored, Non-bank financial

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA

Charles W. Caldwell, D.B.A., CMA

Jon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPA

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Real Estate Industry

Recurring real estate themes

Use of leverage

Borrowing costs can boost returns, but can cause problems

Write off of investment cost

Depreciation

Use of transparent tax vehicles

Partnership - Flexibility, promote, legal protection

REIT – Trading, income conversion

Ability to defer gain recognition

Like-kind exchange, installment sales, personal residence

Lower capital gains tax rate

Potential for as low as 20% rate

Business or investment classification

Partially based on asset; partially based on intent. Impacts taxes paid

Management fees and carried interest

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA

Charles W. Caldwell, D.B.A., CMA

Jon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPA

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Real Estate Industry

Private equity partnership structure

Promote/carried interest/incentive fee

Real estate waterfall example:

Distributable proceeds from operating cash flow and a capital events are to be distributed as follows:

1- To limited partners, pro-rata until the 8.0% annual compounded preferred return has been paid (any unpaid preferred return will compound and accrue);

2- Cash flow above the 8.0% annual compounded preferred return hurdle will paid to limited partners to return n their capital contributions

3- Excess proceeds above a 8% annual compounded preferred return will be split 80% to limited partners and 20% to the Sponsor, until such limited partner investors have earned a 15% annualized internal rate of return (IRR);

4- Excess proceeds above a 15% IRR are to be split 70% to limited partners and 30% to the Sponsor.

Alternatively,

3- provides 60% to Sponsor and 40% to limited partners until 20% to GP cumulatively is achieved

Variations on preferred return (including rate, compounding, timing), or GP promote (amount, timing, return of capital before GP or after GP is paid.

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA

Charles W. Caldwell, D.B.A., CMA

Jon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPA

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Accounting Overview

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Accounting for Real Estate

What is accounting?

“the art of recording, classifying and summarizing in terms of money, transaction and events.

The process of communicating financial information

Shareholders, partners, managers, government agencies and investors

How is Accounting Communicated?

Financial Statements in terms of money

Relevant and Reliable are key aspects

What are the Principles of Accountancy?

Applies to Business Entities:

Accounting

Bookkeeping

Auditing

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA

Charles W. Caldwell, D.B.A., CMA

Jon A. Booker, Ph.D., CPA, CIA

Cynthia J. Rooney, Ph.D., CPA

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Ways to measure of income

Gross vs. net income

Gross income includes all revenues or receipts

In rental real estate, certain amounts are charged back amounts to tenants (common area maintenance, utilities, property taxes)

Net income is determined by subtracting all expenses from all revenues. Subcategories like cost of goods sold, operating expenses, interest, and taxes are often used in reporting.

Computation varies for different purposes (GAAP, Tax, other)

Net operating income (“NOI”) is the annual income generated by an income-producing property after taking into account all income collected from operations, and deducting all expenses incurred from operations

Funds from operations (“FFO”) is an alternative measure of reporting commonly used by capital intensive businesses including publicly traded REITs

GAAP net income – gains or (losses) from sale of property + depreciation and amortization +- unconsolidated joint venture

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Balance sheet

Income Statement

Statement of Cash Flows

Statement of Owners Equity

Components of Financial Statements

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Users of Accounting Information

Managerial Accounting vs. Financial Accounting

Internal Users External Users

Standardization Standardization

Part of Business Operations Not Part of Business Operations Information Varies Information Relied Upon

Internal Process/Policy Financial Statements

Internal users focus on internal controls and procedures that monitor and provide protection to property and plant, and ensure that the financial information that is being provided is reliable and trustworthy.

External Users have little or no access to the operations of an organization so they rely on the financial data provided expecting it to be accurate and reliable to be able to make their financial decisions.

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Generally Accepted Accounting Principles (GAAP)

What is GAAP? The standard framework of guidelines for financial accounting used in any jurisdiction, generally known as Accounting Standards.

Beneficial because it attempts to standardize and regulate definitions, assumptions, and methods.

GAAP Based on four basic principles:

Consistency

Relevance

Reliability

Comparability

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Generally Accepted Accounting Principles (GAAP)

Historic Cost GAAP

Used by most companies and real estate holding companies

Balance Sheet value differs from “true” current value.

Criticized for inaccuracy but still widely used

Standard, reliable and reasonable measure

Depreciation and Improvements directly impact cost basis

Alternative methods of “true” value include market-to-market and industry accepted guidelines

Fair Value GAAP

Under US GAAP, an investment company generally accounts for an investment at fair value and is generally prohibited from consolidating its controlled investments.

Nature of the investment activities — The investment company’s only substantive activities are investing in multiple investments for returns from capital appreciation, investment income (such as dividends or interest) or both.

Express business purpose — The express business purpose of an investment company is investing to provide returns from capital appreciation, investment income (such as dividends or interest) or both.

Unit ownership — Ownership in the investment company is represented by units of investments, in the form of equity or partnership interests, to which a portion of the net assets are attributed.

Pooling of funds — The funds of the investment company’s investors are pooled to avail the investors of professional investment management. The entity has investors who are not related to the parent (if there is a parent) and those investors, in aggregate, hold a significant ownership interest in the entity.

Fair value management — Substantially all of the investment company’s investments are managed, and their performance is evaluated, on a fair value basis.

Reporting entity — The investment company provides financial results about its investment activities to its investors. The investment company can be, but does not need to be, a legal entity.

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The General Accounting Process

“Language of Business”

Information & System of Measurement - 3 Components:

Identification

Recording

Communication

Identification: Business activity must know the transaction before recording or communicating. Process must be specific and relevant to the particular trade or profession. (i.e. PSA, Option agreement, property condemnation, casualties or exchanges.

Recording: Keeping a chronological record of transactions and events measured in dollars, classified, and summarized into accounting format. Consulting, financial planning, and other services are now an integral part of accounting in large part due to the advancement through technology.

Communication: Achieved through the preparation of financial statements (the end product of the accounting process). Summarizes the transaction into a form that will require analyzing and interpreting of the financial information for users.

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The General Accounting Process

Accounting Cycle – methodical set of rules to ensure the accuracy and conformity of the financial statements with great reliance on technology for efficiency and accuracy.

Nine Steps to the Accounting Cycle:

Collecting and analyzing data from transactions and events

Journalizing the transaction into the books of original entry

Post summarizing entries from the books of original entry to G/L

Prepare an unadjusted trial balance

Prepare and post adjusting journal entries

Prepare an adjusted trial balance

Organize the accounts into financial statements

Close books

Prepare a post-closing trial balance

History – Lucas Pacioli, an Italian Franciscan friar in 1544, founded the double entry system of bookkeeping. All modern systems are an adoption of the system that date to 1544.

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The General Accounting Process

Double Entry System of Bookkeeping – is a system that involves recording of transactions having two basic aspects, one involving the receiving of a financial benefit and the other giving a financial obligation, and recorded on the same set of books and records. Every Debit must have a corresponding Credit: Total Debits = Total Credits.

All Transaction are recorded in the “books of original entry”:

Cash receipts journal

Cash disbursements journal

Purchase journal

Sales journal

General journal

General ledger

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Cash, Receivables, Prepaid Expenses, Building, Land, Intangibles

Assets = Liabilities + Equity

Owners Capital–Withdrawals +Revenue-Expenses

Payables, Unearned Revenue, Accruals, Loans

The Accounting Equation

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Tax Overview

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Types of Tax on Real Estate Transactions

Many types of taxes that influence real estate returns

Transfer Tax – local/state tax on transfer of real property

Controlling interest transfer tax

Sales Tax – local/state tax on sales of goods and services

Tax is on personal property; capital improvements generally excluded

Tax is imposed on purchaser if not charged at sale

Property Tax – annual tax on value of property

Reassessment of value occurs under local rules (may be periodic or only upon sale)

Federal Income Tax – tax on net income of individual or business

Gross receipts less allowable deductions multiplied by tax rate

State and Local Income Tax – tax on income imposed by state/local governments

Estate, Gift Tax – tax on transfers of property during lifetime and upon death

Payroll Tax – taxes withheld on employees based on wages. Also unemployment funds unemployment assistance programs

Other – includes mortgage transfer tax, fees, commercial rent tax,

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History of Income Tax System

Pre-1861: tariffs, excise and property taxes

First income tax enacted to pay for Civil War in 1861, expired in 1871

First permanent income tax passed in 1894, but struck down by Supreme Court as unconstitutional

Sixteenth Amendment ratified in 1913 made the income tax constitutional

Internal Revenue Code was enacted in 1939 and subsequently revised in 1954, and 1986

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Under the federal law of the United States of America, tax evasion or tax fraud, is the purposeful illegal attempt of a taxpayer to evade payment of a tax imposed by the federal government. Conviction of tax evasion may result in fines and imprisonment.

Tax evasion is separate from "tax avoidance", which is the legal utilization of the tax regime to one's own advantage in order to reduce the amount of tax that is payable by means that are within the law. Tax evasion is illegal while tax avoidance is both legal and moral. Judge Learned Hand had this to say about tax avoidance:

Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes

Tax Evasion vs. Tax Avoidance

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In a worldwide tax system, all income of domestic companies is subject to tax, including if earned from foreign sources.

Provides credits for taxes paid to foreign governments

In a territorial tax system, a country collects tax only on income earned within its borders.

Exempts from the domestic tax base the dividends received from foreign subsidiaries

The U.S. system was considered a worldwide system. It historically allowed its companies to defer tax liability on foreign “active” income until it is repatriated (i.e., returned) to the United States.

Beginning in 2018, the US system is effectively changing to a territorial system.

Worldwide vs. Territorial Tax System

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Real Estate can be valued using the after-tax internal rate of return (“IRR”) to an investor

Real estate investments increase IRR by (1) deferring taxable income recognition, (2) accelerating taxable deductions, (3) providing preferential tax treatment to certain investors, (4) minimizing effective tax rate

If cash inflow is taxable, after-tax cash inflow = before-tax cash inflow × (1- t)

If cash outflow is deductible, after-tax cash outflow = before-tax cash outflow × (1- t)

t = marginal tax rate

IRR Example

* Not all cash flow items correlate to a taxable income or deduction (debt)

Why Tax is Important to Real Estate Investment

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Three primary drivers of the tax result:

Type of asset

Type of investor

Type of vehicle

Real Estate Investment – Tax Considerations

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Income Reporting

and Measurement

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GAAP Reporting Period – can be annual, quarterly, monthly or other period of time

Taxable Year – revenue recognition principle and matching principle

Revenue recognized when earned, expenses recorded in the same period as related revenue is recorded

Generally calendar year end is used for individuals

Tax year of a partnership must be the same as the majority of partners

Most corporations can adopt a fiscal year end

Time Periods

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Cash method – expenses recorded when paid; revenue recognized when earned

Constructive receipt – income included under the cash method of accounting in the year when a person has unrestricted access to and control over the income

Accrual method – revenue recognition principle and matching principle

Revenue recognized when earned, expenses recorded in the same period as related revenue is recorded

Cash method is used by individuals and certain small businesses; accrual by other businesses

Under either method, capitalization of prepaid amounts is required – if an expense results in a benefit with a duration of 12 months or less and that benefit does not extend beyond the taxable year, it can be deducted. Otherwise amounts must be capitalized

Overall Method of Accounting

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General rule is for GAAP is that revenue recognition must occur when the revenue is “earned”

Revenue generally is realized or realizable and earned when all of the following criteria are met:

Persuasive evidence of an arrangement exists,

Delivery has occurred or services have been rendered,

The seller's price to the buyer is fixed or determinable,

Collectability is reasonably assured.

GAAP generally requires “straight line rent” for income recognition

based on the idea that the usage of a lease is on a consistent basis over time or the leased asset is used at about the same rate from month to month.

To calculate straight-line rent income, aggregate the total cost of all lease payments, and divide by the total lease term

GAAP Gross Income

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For sales of property in the real estate industry, the basic accrual method is expanded, requiring that:

Sales are consummated (sales price is definite and assured of collection)

Initial and continuing investments by the buyer in the property are sufficient

All the risks and rewards of ownership reside with buyer

There is no continuing duty or involvement by the seller post-sale (after closing) and

There is no future subordination of any buyer receivable (seller financing cases).

Also, for retail land sales, accrual is only required if:

The refund period expires for buyer’s deposit or payments

Cumulative principal and interest payments equal at least ten percent of selling price

A down payment of at least 20%. If not, then at least 90% of current raw land sales contracts must be collected in full if such contracts are not cancelled within six months of their recordation in public records. This latter point ensures that the raw land contracts satisfy the full accrual method

No subordination of buyer’s receivable unless a home construction loan is superior, &

The seller met its obligation by completing any land developments.

GAAP Gross Income

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Income is accrued when realized unless a special provision applies. Realization occurs when the earnings process with respect to the provision of goods or services is complete, regardless of when payment is made.

Special tax provisions for income recognition, include:

Prepaid rent – rent is includible in income the earlier of the date it is received or when it is earned

Long term construction contracts

Section 467 lease - when significant deferral or prepayment exists under the terms of a lease

Income inclusion no later than when included for financial reporting

Taxable Income excludes the following items:

Unrealized appreciation in assets (not recognized until sold)

Cash received from amounts borrowed (also repayments are not expenses)

Construction allowances and leasehold improvements received as a tenant

Taxable Gross Income

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Matching Principle

Generally, a company must record its expenses incurred to generate the revenue reported.

Depreciation expense determined using the “useful life” of the asset

Impairment charges are recorded when the GAAP carrying amount of an asset is not recoverable

An asset is not recoverable if the carrying amount exceeds the expected future cash flows to be derived from the asset on an undiscounted basis

Carrying amount is its original historical/original cost and may have been reduced by depreciation

Reversal of impairment in subsequent years is generally prohibited.

Allowable Deductions Against GAAP Income

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Business deductions generally allowed for costs to operate

Must be both ordinary (common in the business and industry) and necessary (not the same as required)

Must meet the “all events test”

Three requirements:

Must be fixed because all events establishing the liability have occurred

Must be determinable with reasonable accuracy

No deduction for general reserves

Economic performance must occur

Occurs when the party provides survives, property or use of property

Certain limitations apply for deductions

Benefit extends beyond a year

Meals (50%), Entertainment (not deductible)

Start-up and organizational expenses

Interest expense if more than 30% of EBITA/EBIT

Allowable Deductions Against Taxable Income

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Depreciation and amortization expense relate to write off of capitalized costs

Methods and life are established by tax based on asset type

Begins on the date that asset is “placed in service”

Individual ability to deduct generally is more stringent

Requires bucketing of income

Non-deductible individual amounts include:

Personal expenses

Investment expenses,

Taxes (including state and local taxes from business and property tax)

Charitable and medical deductions are limited

Standard deduction

Allowable Deductions Against Taxable Income

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Limits deduction for business interest expense to sum of business interest income plus 30% of the ‘adjusted taxable income’ (ATI) of a taxpayer for the tax year

Adjusted taxable income is defined similar to EBITDA for tax years beginning after 2017 and before 2022, and similar to EBIT (computed without regard to any deduction for depreciation, amortization, or depletion, and without regard to Section 199) for tax years beginning after 2021

Allows disallowed interest deductions to be carried forward indefinitely

Exempts taxpayers with average gross receipts for the three-year period ending with the prior taxable year that do not exceed $25 million

Provides that limitation applies to both related-party and unrelated-party debt -- does not apply to investment interest income

Excludes certain trades and businesses

Taxable Interest Expense Limitation

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Interest Limitation Amount: A taxpayer’s interest deduction may not exceed 30% of Adjusted Taxable Income (ATI) plus business interest income plus floor plan financing interest

ATI is roughly equivalent to EBITDA for tax years beginning before January 1, 2022

ATI is roughly equivalent to EBIT (i.e., the add back for depreciation, amortization, and depletion is removed) for tax years beginning after January 1, 2022

Exemptions from new section 163(j): (1) interest paid or accrued on floor plan financing interest (i.e., interest paid/accrued on purchase of certain motor vehicles held for sale/lease); (2) certain small businesses with average gross receipts less than $25 million; (3) investment interest; (4) employee services businesses; (5) certain regulated utilities; and (6) electing real property and farming businesses

Under the partnership provisions, the limitation applies at the partnership level. When computing ATI of the partner, K-1 information from the partnership is ignored, but if the partnership has unused limitation, new Section 163(j) provides for a mechanic for it to be used by the partner

New Section 163(j) does not indicate whether the limitation applies to the consolidated group as a single taxpayer

However, the Conference report describes the House bill as providing that the limitation applies at the consolidated tax return filing level. The Conference report also indicates that the Senate bill followed the House bill, with modifications (not described as including consolidated return provision)

Taxable Interest Expense Limitation

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Example

Taxable Interest Expense Limitation

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Noncorporate taxpayers generally may deduct 20% of combined qualified business income from a partnership, S corporation, or sole proprietorship

In the case of a taxpayer who has qualified business income from a partnership or S corporation, the amount of the deduction is capped at the greater of

50% of the W-2 wages paid with respect to the qualified trade or business, or

The sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property

Qualified business income

Effectively connected with a trade or business within the US and does not include:

Income from ‘specified services trades or businesses’ (for taxpayers with income above the income thresholds)

Individuals’ share of S corp reasonable compensation and partnership guaranteed payment income

Investment-type income (e.g., capital gains and dividends)

REIT dividends, cooperative dividends, and qualified publicly traded partnership income are qualified income (and not subject to the wage limitations)

20% deduction for domestic qualified business income

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If total deductible expenses of a business exceed income, a net operating loss (NOL) results

A deduction of only 80% of taxable income for NOLs arising in taxable years beginning after December 31, 2017

New law repeals carryback of all NOLs arising in a tax year ending after 2017

Carryforward for NOLs to be carried forward indefinitely starting in 2018

Tax Net Operating Losses

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Common operating differences:

Impairment (lower of cost or market)

Rent – Free rent, escalated rent, prepaid rent

Allocation of purchase price to intangibles (lease intangibles: in place leases and above or below market rent)

Depreciation and amortization – assets, organization costs

Capitalization differences –repairs definition, cost segregation

Consolidation differences

Income Tax Basis (accrual) vs. US GAAP (accrual)

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Tax Rates

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Tax rates – what causes differences

Character of income

Lower rate on capital gain and dividends

Three primary variables:

Entity used

Classification of investor

Type of asset

Differences in Tax Liability

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Individual tax rates

Capital gain (loss) from investments

Short or long term

Section 1231

No offset of capital loss with other income

Ordinary income rate on business income

Rental properties

Operating income

Passthrough deduction effectively reduces rate on business income

Preferential dividend rate

Net investment income, self-employment & medicare tax rates

Tax rates

For real estate investment

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Individual tax rates - 2017

For real estate investment

2017 Individual Tax Rates
Tax Rate	Single	Married Filing Joint	Married Filing Separate	Head of Household
10%	Up to $9,325	Up to $18,650	Up to $9,325	Up to $13,350
15%	$9,326 – $37,950	$18,651– $75,900	$9,326 – $37,950	$13,351 – $50,800
25%	$37,951 – $91,900	$75,901 – $153,100	$37,951 – $76,550	$50,801 – $131,200
28%	$91,901 – $191,650	$153,101 – $233,350	$76,551 – $116,675	$130,201– $212,500
33%	$190,651 – $416,700	$233,351 – $416,700	$116,676 – $208,350	$212,501 – $416,700
35%	$416,701 – $418,400	$416,701 – $470,700	$208,351 – $235,350	$416,701 – $444,550
39.60%	Over $418,401	Over $470,701	Over $235,351	Over $444,551

Ordinary income rate on business income

Rental properties

Operating income

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Individual tax rates - 2018

For real estate investment

2018 Individual Tax Rates
Tax Rate	Single	Married Filing Joint	Married Filing Separate	Head of Household
10%	Up to $9,525	Up to $19,050	Up to $9,525	Up to $13,600
12%	$9,526 – $38,700	$19,051– $77,400	$9,526 – $38,700	$13,601 – $51,800
22%	$38,701 – $82,500	$77,401 – $165,000	$38,701 – $82,500	$51,801 – $82,500
24%	$82,501 – $157,500	$165,001 – $315,000	$82,501 – $157,500	$82,501– $157,500
32%	$157,501 – $200,000	$315,001 – $400,000	$157,501 – $200,000	$157,501 – $200,000
35%	$200,001 – $500,000	$400,001 – $600,000	$200,001 – $300,000	$200,001 – $500,000
37%	Over $500,001	Over $600,001	Over $300,001	Over $500,001

Ordinary income rate on business income

Rental properties

Operating income

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Individual capital gain tax rates

Capital gain (loss) from investments

Short or long term

Section 1231

No offset of capital loss with other income

Capital Gain and Qualified Dividends
Type	Taxpayers in 12% bracket or below	Taxpayers in 35% bracket or below	Taxpayers with income over 35% bracket
Short Term Capital Gains	Taxed at ordinary income rates	Taxed at ordinary income rates	Taxed at ordinary income rates
Long Term Capital Gains*	0	15%	20%
Qualified Dividends	0	15%	20%
Real Estate Unrealized Recapture Gain (Section 1250 Property)	15%	25%	25%

* Investments held for more than one year

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3.8% tax on all net investment income above $250,000/$200,000

Net investment income includes

Interest, dividends, royalties, rents, and other income not derived in an ordinary trade or business;

Income from a trade or business that is a passive activity;

Income from a trader fund;

Net gain on the disposition of property (except if used in a trade or business).

Self-employment taxes are on earned income

Include social security and medicare taxes

The medicare tax rate is 3.8%

Net investment income tax rates

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20% deduction for domestic qualified business income

Noncorporate taxpayers generally may deduct 20% of combined qualified business income from a partnership, S corporation, or sole proprietorship

In the case of a taxpayer who has qualified business income from a partnership or S corporation, the amount of the deduction is capped at the greater of

50% of the W-2 wages paid with respect to the qualified trade or business, or

The sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property

W-2 wage limit phases in for taxpayers with taxable income less than $157,500 (single)/$315,000 (married filing jointly)

Limit is fully phased in at $207,500/$415,000 respectively

Qualified business income is effectively connected with a trade or business within the US

Qualified income does not include:

Income from ‘specified services trades or businesses’ (for taxpayers with income above the income thresholds)

Individuals’ share of S corporation reasonable compensation and partnership guaranteed payment income

Investment-type income (e.g., capital gains and dividends)

REIT dividends, cooperative dividends, and qualified publicly traded partnership income are qualified income not subject to the wage limitations and are limited to 20% of such income

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20% deduction for domestic qualified business income

Example: 20% deduction

Partnership allocates $100 of qualified business income to Partner A

Partner A’s allocable share of Partnership’s W-2 wages is $50

A entitled to deduct $20 (50% of Partner A’s allocable share of Partnership’s W-2 wages is $25, which is greater than deduction)

Section 199A deduction reduces effective rate of taxpayer taxed at top marginal rate to 29.6% ((100-20) x 37%)

The deduction does not reduce net investment income (NII)

The deduction is a partner / shareholder level deduction and does not decrease basis

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20% deduction for domestic qualified business income

What are specified service activities?

Any activity involving the performance of services described in Section 1202(e)(3)(A), other than engineering and architecture, but including investing, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities

Section 1202(e)(3)(A): “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees”

It is unclear how much prohibited services activity taints a business activity

The provision may provide a benefit to certain labor income (e.g., specified services below the income thresholds)

Loss Carryover

Losses from a previous year are netted with current year income when determining qualified business income

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Owners of corporations are said to be double taxed

Entity level corporate tax as well as shareholder level tax on dividend distributions (both shareholder and corporation pay tax on the same income

No preference on capital gain rate / capital loss limited carryover

Losses carry forward as “net operating loss” and can offset future income

In 2018, corporate tax rates are a flat 21% on all income

Corporate tax rates

2017 Corporate Income Tax Rates
Taxable income over	Not over	Rate
0	50,000	15%
50,000	75,000	25%
100,000	335,000	39%
335,000	10,000,000	34%
10,000,000	15,000,000	35%
15,000,000	18,333,333	38%
18,333,333	………	35%

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See excel

Example of real estate investments

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Entity Type

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Taxes

Tax rate on allocation of tax items

Double taxation

Distribution of property to owners

Ability to use losses

Choice of tax year

State tax rates

Employment taxes

Liability protection

Potential for mergers and acquisitions

Need to distribute earnings to owners

Financing needs

Ease of joint ventures

Compensation of owners

Factors in choosing a business entity

For real estate investment

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Sole proprietorship

General partnership

Limited partnership

Limited liability company (“LLC”)

Single and multi-member LLC

C corporation

S corporation

Trust

Real estate investment trust (“REIT”)

Tenancy in Common (“TIC”)

Foreign entity

• Controlled foreign corporation (“CFC”)

• Passive foreign investment company (“PFIC”)

Form of ownership business entity type

For real estate investment

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No conversion for sole proprietor, partnerships, SMLLC, LLC

In some cases having a separate entity will be respected as making certain income determinations or elections

C corporation

Blocks income as to timing and character

S corporation

May block some items

Real estate investment trust (“REIT”) and foreign corps

Converts real estate and other character of income to dividend

Conversion of character of income

For real estate investment

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Legal classification is not the same as tax classification

Some entities are “per se” corporations (ineligible to elect)

US C corporations & certain foreign entities are not eligible

Default classification

Domestic entity – defaults to partnership if it has two or more members; disregarded if it has a single owner.

Foreign entity – defaults to partnership or disregarded if at least one member does not have limited liability; corporation if all members have limited liability.

A U.S. LLC or LLP defaults to partnership (or disregarded), whereas a foreign LLP is treated by default as a corporation (if, as is generally the case, all its members have limited liability).

Check the box rules

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Change in classification

Adding a second owner will change a disregarded entity into a partnership and vice versa

Change in the elected tax classification will lock the entity into that status for 60 months

Default classification is not an election, so the first change occur after formation as a different entity type

Check the box rules

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• Sole proprietorships

• Single member LLCs

• General and limited partnerships

• Limited Liability Companies (LLCs)

• C corporations

• S corporations

• Real Estate Investment Trusts ("REITs")

• UPREIT

• DownREIT

• Tenancy in Common ("TICs")

Conversion from/to entity types

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What is a REIT

A corporation or trust that elects to be subject to special provisions of the Internal Revenue Code which govern:

Its organizational structure

Nature of its assets

Sources of its income

Minimum distributions to its shareholders

Taxed as a corporation but for the dividends paid deduction

Dividends are determined under earnings and profits - a separate set of principles

Dividends paid deduction is taken before net operating loss deduction

100% tax on “prohibited transactions” (i.e. dealer property)

Tax on built-in-gains

Includes any unrealized appreciation in the corporation prior to REIT election

Subject to alternative minimum tax

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REIT Background

Real Estate Investment Trust - a company that owns or finances income-producing real estate.

Modeled after mutual funds, REITs provide investors of all types regular income streams, diversification and long-term capital appreciation.

Pay out all of their taxable income as dividends and shareholders pay the income taxes on those dividends.

Allow small investors access to portfolios of large-scale properties the same way they invest in other industries – through the purchase of stock.

REITs are traded on major stock exchanges but there are also public non-listed and private REITs. The two main types of REITs are Equity REITs and Mortgage REITs.

Equity REITs generate income through the collection of rent on, and from sales of, the properties they own for the long-term.

Mortgage REITs invest in mortgages or mortgage securities tied to commercial and/or residential properties.

Today, REITs are tied to almost all aspects of the economy, including apartments, hospitals, hotels, industrial facilities, infrastructure, nursing homes, offices, shopping malls, storage centers, student housing, and timberlands.

REIT model is used in more than 30 countries around the world

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To qualify as a REIT, an entity must:

Be structured as corporation, trust, or association

Be managed by a board of directors or trustees

Have the shares that are fully transferable

Be taxable as a domestic corporation

Not be a financial institution or an insurance company

Be jointly owned by 100 persons or more

Pay dividends of at least 90% of the REIT's taxable income

No more than 50% of the shares can be held by five or fewer individuals during the last half of each taxable year

At least 75% of total assets must be invested in real estate

Derive at least 75% of gross income from rents or mortgage interest

No more than 20% of its assets may consist of taxable REIT subsidiaries.

REIT Qualification

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Summary of REIT federal tax compliance requirements

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Summary of REIT federal tax compliance requirements

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Advantages of a REIT

The two factors that make a REIT particularly attractive planning tool are that it is:

Treated as a corporation from a tax perspective; and

Not subject to any corporate level tax assuming it distributes 100% of its taxable income.

These two facts make it a useful tool for investing in real estate assets when there is a desire to have a corporate blocker between the investor and the real estate.

Examples of where a REIT can be utilized include:

Blocks UBTI for tax exempt investors

Pension Held REIT Exception

Blocks ECI for non-U.S. investors

Exception for distributions attributable to USRPI disposition

Blocks state income tax obligations of investors in the REIT

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Disadvantages of a REIT

The various qualification requirements discussed below can place limitations on the activities of the REIT or force certain activities to be conducted in a taxable C corporation.

Risk of failure to meet the requirements.

Additional compliance costs

Cost of preferred shareholders

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REIT Investor Taxation - Individual

Dividend distributions for tax purposes are allocated to ordinary income, capital gains and return of capital, each of which may be taxed at a different rate.

Individual Taxation of REIT Dividends

Ordinary REIT dividends are taxed as ordinary income tax rate up to the maximum rate of 29.6 percent (37 percent less 20 percent passthrough deduction), plus a separate 3.8 percent surtax on investment income (no qualified dividend reduction).

REIT dividends will qualify for a lower tax rate in the following instances:

When the individual taxpayer is subject to a lower scheduled income tax rate;

When a REIT makes a capital gains distribution (20 percent maximum tax rate, plus the 3.8 percent surtax), Section 1250 recapture (pass through 25 percent rate) or a return of capital distribution (nontaxable);

When a REIT distributes dividends received from a taxable REIT subsidiary or other corporation (20 percent maximum tax rate, plus the 3.8 percent surtax); and

When permitted, a REIT pays corporate taxes and retains earnings (20 percent maximum tax rate, plus the 3.8 percent surtax).

In addition, the maximum 20 percent capital gains rate (plus the 3.8 percent surtax) applies generally to the sale of REIT stock.

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REIT Investor Taxation – Non-US

Tax Exempt Entity Taxation of REIT Dividends

No tax on any income

Dividends treated as UBTI if entity is a pension held REIT

Non-US Taxation of REIT Dividends

Ordinary REIT dividends are taxed as FDAP (subject to 30% gross rate) but may be reduced by a treaty.

Many treaties do not provide the same reduction for REITs as other corporations (e.g. 0% could apply to C corps but 15% for REIT dividends)

Pensions often have a better reduction under a treaty

Capital gain distributions are treated as effectively connected US income if attributable to the sale of US property in the REIT

Distributions are FIRPTA, subject to:

A 21% rate for corporations, or

A 20% rate for non-US individuals

Qualified Foreign Pensions have no tax on capital gain distributions

In addition, FIRPTA applies generally to the sale of REIT stock, but not if it is domestically controlled (more than 50% US ownership)

Return of capital distributions may be FIRPTA unless reduction is requested

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A REIT may still pay taxes (potential complex filing requirements)

Federal taxes

Excise taxes on dividends if not managed timely

“Prohibited transaction” tax (Discussed later in this section)

State taxes

State and local franchise tax and net worth tax (tax on capital)

Special states (Texas, DC, Washington B&O)

Corporate state income taxes on REIT (e.g., some states proposing to not allowing DPD others )

Minimum entity taxes

Unincorporated Business Taxes (especially relevant to NYC operations)

Other Receipts Taxes

Taxes paid by TRS

Activities put in TRS are double taxed

Debt can be used to minimize leakage

Stuffing loss activities is common practice

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REIT