Real Estate Tax Alert

Post-election tax reform implications for the real estate industry Overview Now that the election is behind us, it is a good time to consider how the results will affect the real estate industry and, in particular, whether new tax legislation may be on the horizon. While the potential for tax reform existed prior to the election, the election results increased the likelihood of reform significantly. With the Republican party controlling the White House and having majorities in both houses of Congress, the prospects for comprehensive individual and business tax reform being signed into law is much higher than would have been the case with a divided government. While other issues dominated the headlines during the elections, it is worth noting that President-elect Trump’s tax proposals moved toward proposals from the House Republican plans for tax reform unveiled last June (the House Republican Plan) during the course of his presidential campaign. As a result, the House and the President-elect may not be far apart on their vision for tax reform. This does not mean that there won’t be differences or hurdles, but the likelihood of reform is higher today than it was before the election. At least some parts of President-elect Trump’s and the House Republicans’ proposals are expected to face difficulties in the Senate, where 60 votes generally are needed to advance legislation. House Speaker Paul Ryan (R-WI), however, has said a Republican-controlled Congress could advance tax reform in 2017 by using budget reconciliation procedures that allow legislation to be approved in the Senate with a simple 51-vote majority. The new 115th Congress will be sworn into office on January 4, 2017 and President-elect Trump will be inaugurated on January 20, 2017. The real estate industry should pay close attention to tax legislation Congress proposes in 2017, as well as President-elect Trump’s fiscal year 2018 budget, which is expected to include more details on his proposals. In the meantime, the current Congress will return next week for a lame-duck session. It must act on legislation to fund the federal government beyond December 9, 2016, when a temporary spending bill expires. Congress could also act on proposals to extend certain tax provisions that are set to expire at the end of 2016. A summary of certain tax provisions that may be affected by tax reform and are of import to holders of real estate are below.

Background Tax rate reduction As many real estate investors invest in partnerships and other flow-through vehicles, individual income tax rates are of tantamount importance. President-elect Trump has proposed to consolidate the current seven individual tax brackets into three with ordinary income rates of 12%, 25%, and 33%. Under current rates, the highest marginal US individual federal income tax rate is 39.6%. The proposal also would eliminate the alternative minimum tax (AMT). If enacted, these changes would considerably reduce individual federal income tax rates. Investors and principals also should benefit from a repeal of the AMT. Real Estate Alert | November 2016

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Moreover, his proposal would repeal the Affordable Care Act (ACA) including the 3.8% net invest income tax (NIIT). Ultimately, this should benefit individual real estate fund investors and REIT shareholders who earn significant investment and passive income (e.g., rents, dividends, interest and capital gain income). President-elect Trump’s proposal for individual tax reform is very similar to the House Republican Plan. That plan also calls for three individual tax brackets at the same marginal rates, as well as repealing the AMT. President-elect Trump has proposed to reduce the corporate tax from 35% to 15%. He also would eliminate the corporate AMT. President-elect Trump’s corporate tax proposal is broadly similar to the House Republican Plan, although that plan proposes to reduce the corporate tax rate to 20%. There also are certain differences on interest deductibility and expensing versus capitalizing certain capital investments. One key difference between the various tax reform proposals has been the extent to which rate reductions will benefit corporate taxpayers vs. individual taxpayers. While each real estate owner would need to evaluate its own circumstances, most real estate owners would likely prefer that more of the rate reduction would be on the individual side. On the other hand, non-U.S. owners that invest in United States real estate through taxable corporations would prefer that the rate reduction be focused on a reduction of corporate tax rates.

Taxation of pass-through entities There is significant uncertainty about the particulars of President-elect Trump’s proposal regarding the taxation of pass-through entities (e.g., partnerships, disregarded entities, S corporations). While the proposal does not include many details, it appears that owners of pass-through entities deriving active income could elect for the pass-through entity to be subject to a flat 15% entity level tax on its re-invested earnings. It is unclear which types of real estate activities would be treated as active. There is a good bit of uncertainty regarding the impact of this proposal. Specifically, there is a question as to whether electing individuals would be subject to individual tax on their proportionate share of this income derived through pass-through entities (once distributed) in addition to the 15% tax at the pass-through level. If so, it remains unclear whether such distributions would be subject to ordinary rates or preferential capital gain / QDI rates (or even no tax). The House Republican Plan also proposes a new pass-through business income tax system which calls for an entity level tax with a 25% top rate for active business income. We anticipate further details on President-elect Trump’s proposal regarding the taxation of pass-through entities in his budget proposal, if not before. Asset managers should closely follow developments in this respect, as well as the interplay with the House Republican Plan. If enacted, the introduction of an entity-level tax for pass-through entities would significantly impact the asset management industry, both at fund and investment levels.

Capital gains & qualified dividends President-elect Trump’s tax proposals would retain existing rules and rates for capital gains and qualified dividend income (QDI), and adapt them to the proposed tax brackets discussed above. Long-term capital gains and QDI derived by individuals subject to a 33% marginal tax rate under the new tax brackets would be subject to a maximum 20% US federal income tax rate. Note, this is different to the House Republican Plan under which qualified investment income would be eligible for a 50% exclusion, with the remainder taxed at ordinary income rates. This would replace the current preferential rates for long term capital gains and QDI. With a proposed top 33% rate for ordinary income, qualified investment income would be subject to a top effective rate of 16.5%.

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Impact of rate reduction on REITs While REITs generally do not pay a corporate income tax if they distribute 100% of their taxable income, REITs should pay close attention to the potential changes in rates as the relative tax rates for other vehicles could affect the relative benefit of the REIT structure. For example, the benefit of a corporation considering a REIT conversion may be lessened if the corporate tax rate is reduced. By the same token, real estate funds and other investors in real estate that are deciding whether to invest in a regular C corporation or a REIT might come to a different conclusion going forward if the tax rates on C corporations is dramatically reduced.

Carried interest President-elect Trump has called for closing the carried interest “loophole” and for asset managers/principals to be subject to tax at ordinary rates on their performance and incentive based returns. This is broadly similar to the position supported by Democratic Presidential nominee Hillary Clinton and many Democrats. While the House Republican Plan does not address the issue of carried interest, a 2014 tax reform bill introduced by then-House Ways and Means Chairman Dave Camp (R-MI) proposed to exempt real estate partnerships from his proposal to treat a portion of carried interest as ordinary income. Managers of real estate that receive a carried interest should focus their attention on any significant tax legislation which could become a magnet for proposals addressing the taxation of carried interest and how it would impact real estate. A change to the carried interest provisions would seem especially likely in the context of comprehensive tax reform. Recipients of carried interests may want to consider how they might want to manage potential changes to the taxation of carried interests.

Like-kind exchanges Like-kind exchange provisions have been staple in the tax code for decades and have allowed owners of real estate, and other assets, to exchange the assets that they hold for other similar assets and to defer gain. There are many strong policy reasons to allow taxpayers to defer tax when they merely exchange assets of like-kind. That said, this has been commonly cited as a provisions that might be eliminated from the tax code to help pay for a reduction in rates. While Hillary Clinton specifically proposed significantly limiting the availability of like-kind exchanges, neither the President-elect’s proposals nor the House Republican Plan specifically call for revisions of the like-kind exchange rules. Still, it is unclear whether general calls for simplification and the elimination of tax preferences envision changes to the like-kind exchange rules.

Depreciation and interest expense There have been a variety of tax reform proposals that would affect depreciation and interest expensing. With respect to depreciation, some proposals have called for changing the period over which property is expensed. With respect to interest expenses, several proposals have called for limits to interest deductibility. Changes to depreciation lives and interest deductibility could have a dramatic impact on the general taxation of real estate. The House Republican Plan has proposed to eliminate interest deductibility but to allow for complete expensing of buildings upon acquisition. While the details of the proposal are not fleshed out, real estate owners and investors may want to consider how this trade off would affect them and whether such a trade-off would be beneficial. As a practical matter, it is important to note that historically, an interest deduction has been a permanent reduction to income while depreciation has been a temporary deduction (which may be recaptured at the time of sale).

Mortgage interest deduction The mortgage interest deduction is another item that is commonly cited as a tax expenditure that could be revised to pay for a reduction in tax rates. However, the House Republican Plan states that it “will preserve a mortgage interest deduction.” The Plan states that the Ways and Means Committee will “evaluate options for making the current-law mortgage interest provision a more effective and efficient incentive for helping families achieve the dream of homeownership.” It also states that any such changes will not affect “existing mortgages or refinancings of existing mortgages.” Real Estate Tax Alert | November 2016

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Potential FIRPTA reform The Foreign Investment in Real Property Tax Act of 1980 (FIRPTA) currently subjects non-U.S. persons to tax on the gain on sales of U.S. real estate even if the taxpayers are not engaged in a U.S. trade or business. While neither President-elect Trump nor the House Republican Plan specifically call for specific changes to FIRPTA, they both have called for significant international tax reform. President-elect Trump has called for meaningful international tax reform which would increase the US’s competitiveness and reduce the appeal of inversions. The House Republican Plan would move the US tax system towards a territorial system, under which foreign earnings of US businesses derived from active operations would effectively not be subject to US federal income tax. While these proposals would not necessarily envision any changes to FIRPTA, the simple fact that there may be a willingness to rethink the basic tenets of international taxation opens the door for policy makers to reconsider FIRPTA and whether those provisions should be revised. This is another area in which real estate companies and investors should focus their attention.

Conclusion Comprehensive tax reform is increasingly possible over the next two years with the Republicans having control of the House, Senate and White House. While not offering a detailed plan for many of his proposals, the known elements of President-elect Trump’s tax plan could, if enacted, significantly impact U.S. real estate companies, funds and their investors. Further clarity on some of these proposals is expected in the next few months. Notably, there could be considerable changes to both individual and business tax rates and changes to the taxation of pass through entities. The real estate industry generally would be expected to welcome the proposed rate reductions. However, they would need to consider whether there will be any offsets to pay for those rate reductions which may include provisions that would adversely affect the real estate industry. Possible offsets include changes to the taxation of carried interest, limits on the ability to defer tax on like-kind exchanges, increases in depreciable lives of real estate assets and limits on interest deductibility. Given the stakes involved, real estate companies, funds and investors should closely monitor US tax policy developments over the next year and assess the potential impact on existing and future investments, fund structures, as well as returns for the ultimate investors.

For additional information concerning this issue, please contact: Adam Feuerstein 703-918-6802 [email protected]

Larry Campbell 202-414-1477 [email protected]

David Leavitt 646-471-6776 [email protected]

Rohit Kumar 202-414-1421 [email protected]

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PwC Real Estate Tax Practice – National and regional contacts: National David Voss US Real Estate Tax Leader New York 646-471-7462 [email protected] Regional Atlanta

Los Angeles, cont.

New York, cont.

Chris Nicholaou 678-419-1388 [email protected]

Erica Hanson (213) 217-3290 [email protected]

James Oswald 646-471-4671 [email protected]

Steve Tyler 678-419-1224 [email protected]

Phil Sutton 213-830-8245 [email protected]

Oliver Reichel 646-471-5673 [email protected]

Miranda Tse 213-356-6032 [email protected]

Paul Ryan 646-471-8419 [email protected]

Boston Rachel Kelly 617-530-7208 [email protected] John Sheehan 646-471-6206 [email protected] Chicago Jill Loftus 312-298-3294 [email protected] Alan Naragon 312-298-3228 [email protected] Dallas William Atkiels 214-754-5388 [email protected] Denver Robert Lund 720-931-7358 [email protected] Los Angeles Adam Handler 213-356-6499 [email protected]

Real Estate Tax Alert | November 2016

New York Brandon Bush 646-471-2498 [email protected] Eugene Chan 646-471-0240 [email protected]

Christian Serao 646-471-0694 [email protected] Dmitriy Shamrakov (646) 471-8561 [email protected] San Francisco

Dan Crowley 646-471-5123 [email protected]

Howard Ro 415-498-6842 [email protected]

James Guiry 646-471-3620 [email protected]

Neil Rosenberg 415-498-6222 [email protected]

Dan Haggard (646) 471-2046 [email protected]

Washington, DC

Sean Kanousis 646-471-4858 [email protected] Christine Lattanzio 646-471-8463 [email protected] David Leavitt 646-471-6776 [email protected]

Karen Bowles 703-918-1576 [email protected] Adam Feuerstein 703-918-6802 [email protected] Laura Hewitt 617-530-5331 [email protected]

Kelly Nobis 646-471-3201 [email protected] 5

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