Among the 52 expiring federal tax code provisions that were considered by congress this past December, several were signed into law and are of importance to the real estate industry. The final “tax extender” package included measures that boosted affordable housing, energy efficiency and leasehold improvements as well as reforms to the Foreign Investment in Real Property Tax Act (FIRPTA) that would roll back punitive tax laws that discourage foreign investment in domestic real estate and infrastructure.
The FIRPTA reforms are, “the most significant reforms of FIRPTA since its enactment in 1980” according to Real Estate Roundtable CEO , Jeff DeBoer. The key changes include lifting ownership restrictions on a foreign person who has an interest in a publicly traded domestic REIT so as to avoid FIRPTA implications upon a sale of stock or capital gains dividends. Currently, the limit is 5 percent; that ceiling has now been raised to 10%, allowing for more foreign investment in domestic real estate. The change harmonizes the “portfolio investor” definition with that which applies to foreign investment in U.S. debt securities and most U.S. tax treaties. Importantly, the new language also gives the green light to foreign pension funds that invest in American real estate and infrastructure without triggering tax liability under FIRPTA. The law now fully exempts “qualified foreign pension funds” and entities owned by them from FIRPTA. Collectively, these changes were designed to remove the barriers to foreign investment in U.S. real estate and spark more real estate activity, employment and economic growth.
REITS came out a winner in other areas as well. The final version applies the portfolio exception to certain publicly held foreign collective investment vehicles which own interests in REITs and relaxes the rules established for determining whether an enterprise is “domestically controlled” (a REIT in which 50% of ownership is held by U.S. persons) under FIRPTA. Another useful change was that publicly traded REITs can now presume that any shareholders with less than a 5% interest are U.S. residents unless the REIT has actual knowledge to the contrary. Further modification affected a safe harbor to insulate sales from the prohibited transaction rules. Bans on preferential dividends for publicly traded REITS and limitations on tax-free spin offs of REIT by C corporations were reversed .
In other noteworthy areas, the original 39 year depreciation for leasehold improvements was fixed at 15 years, reflecting the reality of the economic life of the improvements. The fifty percent bonus depreciation provision and Section 179D of the Code, a deduction for energy efficient commercial and multifamily buildings of four stories or more, were extended for properties placed in service prior to January 1, 2017. The deduction is worth up to $1.80 per square foot for energy efficient buildings. Amongst the other twenty provisions in the bill related to real estate is the permanent extension of the limitation of expenses in Section 179, including the language narrowing the use of the expensing allowance for qualified real property expenditures. The law also updates the ASRAE standards which is an improvement for the industry. Investors should cheer.
Affordable housing developers and investors also received relief. One of several uncertainties facing developers and their financial partners in low income housing tax credit (LIHTC) financed transactions is the precise equity that can be generated by each dollar in federal low income tax credits. Of course, some of this uncertainty is a result of basic market forces, including the demand by Community Reinvestment Act (CRA) investors. However, there is another risk which the federal government has now partially eliminated: the floor or minimum tax credit rate to investors. The value of the tax credits are determined for 70% (commonly known as 9% credit) and 30% present value (4% credit) which floats based on a formula that fluctuates with federal borrowing rates. As a result of reductions in the federal borrowing rates over the past several years, the credit rates have declined. Presently, actual LIHTC credit rates are about 7.5% for “9%” credits and 3.2% for “4%” credits. In end of year action, congress temporarily fixed a minimum floor for the value of the 9% credits so that those who are awarded the credit can depend on it being worth the full 9% of eligible basis in a project. Leading accountant Michael Novogradac estimates that the bonus depreciation provision could add an extra 0.5 to 1.5 cents per dollar of equity for each housing tax credit. Collectively, these provisions have the potential to add equity to a deal, which will become even more important if interest rates rise as expected, increasing the amount of equity that must be in the deal. Unfortunately, the efforts to extend the minimum 4% floor for LIHTC deals didn’t make the cut in the final bill signed by the president. Given the extraordinarily demand for affordable housing production and preservation, it’s unfortunate that the 4% floor was allowed to expire. This will translate to fewer deals getting done and fewer families in decent affordable units. Congress and the President will have an opportunity to solve this problem in 2016. This “extenders” drama will be played out again at the end of this year, most probably after the presidential election during an end of year “lame duck” session.
In related news, Congress extended the EB-5 Visa program for ten months in order to avoid a lapse and give policy makers in Washington the time to craft a long term reform bill which addresses national security and fraud concerns as well as the needs of lower income areas. The EB-5 provides 10,000 visas per year to foreign investors who invest at least $500,000 in certain U.S. businesses. The investment must lead to domestic job creation. The program has been used to provide low cost, flexible mezzanine type debt to larger developers of real estate.
The nearly $700 billion dollar tax bill was driven by the desire to extend and make permanent the Research and Development tax credit. The R&D tax credit may be the most popular temporary tax credits. Policy goals will be enhanced by its permanence. However, the other tax provisions that were extended temporarily may have a more uncertain fate at the end of the year absent the necessity of extending the R&D credit. Those in the industry who depend on these other temporary provision would be well advised to stay alert to the change in political dynamics.
Ultimately, the new law resolved a number of outstanding and important issues effecting the real estate industry. It provides the certainty that real estate investors crave and it sweeps away barriers to investment that will boost development and create jobs. There was a narrow political window prior to the start of the campaign silly session and this time Congress jumped through it.