On the last day that Congress was in session for the 2015 calendar year, Washington, D.C. lawmakers finalized a $1.1T spending bill containing holiday gifts for Democrats and Republicans alike. Passage of the 2009-page legislation was accompanied by the Protecting Americans from Tax Hikes (PATH) Act of 2015, which was filled with $622B worth of tax cuts according to the Joint Committee on Taxation’s calculations of lost tax revenue. Below, we examine the tax credits and those pieces of the new legislation that affect the commercial real estate industry. Please note that we focus on the most relevant issues pertaining to CRE use and ownership; an in-depth exploration of changes to REIT taxation is beyond the scope of this report. The Appendix contains a look at general corporate tax changes that may be relevant for businesses operating in the U.S.
Generally speaking, occupiers of commercial real estate will benefit from accelerated depreciation and bonus depreciation for qualified improvements made under a lease (including interior space build-outs) as well as the ability to expense—rather than depreciate—certain real property expenditures, including energy–efficient upgrades. Owners of commercial real estate may see increased interest from overseas buyers and investors; taxes due upon the sale of property have been lifted or eased for some foreign sellers.
Tax Law Changes for Occupiers of Commercial Real Estate
I. Accelerated Depreciation for Interior Improvements
Qualified Leasehold Improvement Property (Sec. 123, PATH Act 2015)
Nonresidential real property is typically depreciated on a straight-line basis over 39 years. However, more rapid depreciation schedules exist for certain types of property, including improvements made under a lease. A 15-year depreciation schedule applies to any improvement to an interior part of a building that is nonresidential real property, provided that:
- The improvement is made under or according to a lease by the lessee (or any sublessee) or the lessor.
- The improved part of the building is to be occupied exclusively by the lessee (or any sublessee).
- The improvement is placed in service more than 3 years after the date the building was first placed in service.
Improvements cannot occur between related persons, or pertain to 1) the enlargement of the building 2) any elevator or escalator 3) any structural component benefiting a common area or 4) the internal structural framework of the building.
Previously, any qualified leasehold improvement property, qualified restaurant buildings or qualified retail improvements had to have been placed in service before January 1, 2015. Now, there is no deadline for putting the property in place; the tax treatment is made permanent. (For more detail, please see Title 26, Code § 168 - Accelerated Cost Recovery System and IRS Publication 946, Ch. 3.)
II. Tax Deduction In Lieu of Depreciation for Smaller Real Property Purchases or Improvements
Section 179 Expensing (Sec. 124, PATH Act 2015)
A taxpayer may elect to treat the cost of certain real property as an expense and deduct it in the year the property is placed in service instead of depreciating it over several years. Previously, the dollar limit for Section 179 expensing was $25,000 (for any year starting after 2014) with a phase-out beginning when total costs exceeded $200,000.
Section 179 will be made permanent at the $500,000 level. Businesses exceeding a total of $2 million of purchases in qualifying equipment will have the Section 179 deduction phased out dollar-for-dollar; the benefit will be completely eliminated for spending above $2.5 million. Additionally, the Section 179 cap will be indexed to inflation beginning in 2016, with any adjustment rounded to the nearest $10,000. The special rules that allow expensing for off-the-shelf computer software and qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) also are permanently extended. (There will now be no limits on the amount of Section 179 property that may be attributable to qualified real property for years after 2015; the limit for 2015 is set at $250,000.) Additionally, air conditioning and heating units, which were previously not eligible for Section 179 expensing, are now eligible. (For more detail, please see Title 26, Code § 179 - Election to Expense Certain Depreciable Business Assets and the IRS’ comments on “Net Operating Loss Carryback, Sec. 179 Deduction and Other ARRA Business Provisions.”)
III. Bonus Depreciation for Leasehold Improvements
Extension and Modification of Bonus Depreciation (Sec. 143, PATH Act 2015)
Taxpayers may claim an additional 50% bonus depreciation allowance for property with a recovery period of 20 years or less, including computer software or qualified leasehold improvement property that is placed in service before January 1, 2015.
The provision extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50 percent for property (such as equipment) placed in service during 2015, 2016 and 2017 and is reduced in phases to 40 percent in 2018 and 30 percent in 2019. The provision continues to allow taxpayers to elect to accelerate the use of AMT credits in lieu of bonus depreciation under special rules for property placed in service before 2020.
Beginning in 2016, the new provision allows additional first-year depreciation for qualified improvement property without regard to whether the improvements are property subject to a lease, and also removes the requirement that the improvement must be placed in service more than three years after the date the building was first placed in service. (For more detail, please see Title 26, Code § 168(k) – Special Allowance for Certain Property.)
IV. Tax Deduction for Energy Efficient Upgrades
Energy-Efficient Commercial Buildings Deduction (Sec. 190, PATH Act 2015)
The provision allows an above-the-line deduction for energy efficiency improvements to interior lighting, heating, cooling, ventilation, hot water systems and/or building envelope systems (insulation, exterior windows and doors and roofing) of commercial buildings. For non-government buildings, the organization or person who bears the expenditure for the retrofit is eligible to receive the deduction, which may be the building owner or a tenant or lessee who performs an upgrade.
The provision was extended through 2016. The amendment applies retroactively to property placed in service after December 31, 2014. The tax deduction allows up to $1.80 per square foot for the installation of energy-efficient systems that reduce the building’s total energy and power costs by 50 percent relative to a reference building. Additionally, Section 341 of the PATH Act of 2015 modifies the deduction for energy efficient commercial buildings by updating the energy efficiency standards to reflect the new standards of the American Society of Heating, Refrigerating, and Air Conditioning Engineers (ASHRAE) beginning in 2016. (For more detail, please see Title 26, Code § § 179D - Energy Efficient Commercial Buildings Deduction.)
Tax Law Changes for Owners of Commercial Real Estate
I. EB-5 Visa Program Continues “As Is”
The EB-5 program grants permanent green cards (and eventual citizenship) to a limited number of foreign investors and their family who make a specified investment in a “new commercial enterprise” that creates a certain number of jobs. Such investments are frequently made in commercial real estate developments.
Nothing. The EB-5 regional center immigrant investor program continues “as is” through September 2016. No changes are made to investment amounts, the definition of a targeted employment area or job creation requirements. Several EB-5 proposals had been introduced into Congress (H.R. 616, H.R. 3370 and S. 1501) though none was passed.
II. Broader Appeal of CRE Investment for Foreign Pension Funds and Other Overseas Investors
Exception for Real Property Interests Held by Foreign Retirement or Pension Funds (Sec. 323, PATH Act 2015)
FIRPTA or the Foreign Investment in Real Property Tax Act of 1980 (Title 26, Code § 897 and Title 26, Code § 1445) was enacted to treat foreign and domestic investment in U.S. real property more comparably, and applies to foreign persons who dispose of U.S. real property interests. While the U.S. generally does not tax capital gains of non-U.S. investors on investments not related to a US trade or business or who are not physically present in the U.S, since 1980 most non-U.S. investors in U.S. real property interests (USRPIs) are required to pay full U.S. tax on their gains from disposition. The gains are treated as “effectively connected income” (ECI)—income connected with a U.S. trade or business.
What constitutes a U.S. Real Property Interest (USRPI)?
A USRPI not only includes interest in real property (such as fee ownership and leaseholds of land) in either the U.S. or the U.S. Virgin Islands, but also the stock of a U.S. Real Property Holding Corporation (USRPHC). A USRPHC is any domestic corporation where the fair market value of the corporation’s USRPIs is equal to or greater than 50 percent of the combined fair market value of all its real property interests (U.S. and worldwide) and all its assets used or held for use in a trade or business during a testing period (the shorter of the duration of the taxpayer’s ownership of the stock after June 18, 1980, or the five-year period ending on the date of disposition of the stock.) However, stock in “domestically-controlled” REITS and regulated investment companies that are USRPHCs—where direct or indirect foreign ownership is less than 50%—are not considered USRPIs, making distributions from these domestically-controlled qualified investment entities free from FIRPTA. FIRPTA taxation overrides any tax treaties between the U.S. and other countries; note there is no protection against U.S. taxes due from the disposition of USRPI.
Generally speaking, ECI is taxed at graduated rates similar to those applicable to U.S. corporations, which currently range from 15% - 35%; foreign corporations may also be subject to an additional 30% “branch profits tax.” Title 26, Code § 1445 (Withholding of Tax on Dispositions of United States Real Property Interests) requires that the transferee (any person, foreign or domestic) who acquires a USRPI via a disposition of a U.S. real property interest by a foreign person withhold a tax equal to 10% of the total amount realized by the foreign person on the disposition (for example, 10% of the purchase price) that is used to offset the transferor’s ultimate tax liability. The liability for withholding rests with the purchaser, even though it is the seller who is financially responsible for payment of any taxes due.
The new provision exempts any U.S. real property interest held by a foreign pension fund from taxation due to gains or losses from disposition, and does not require FIRPTA withholding on the part of the transferee. The legislation applies to direct investments or investments that the foreign pension fund makes through partnerships or private equity funds. Notably, while the FIRPTA tax exemption applies to disposition gains on behalf of foreign pension funds, sovereign wealth funds are NOT exempt from the FIRPTA tax.
FIRPTA Tax Lifted to 15%
Increase in Rate of Withholding of Tax on Dispositions of U.S. Real Property Interests (Sec. 324, PATH Act 2015)
The new legislation raises the rate of withholding on U.S. real property interest dispositions from 10 percent to 15 percent. While the legislation does not impose any new tax, the increase in FIRPTA withholding likely was designed to ensure that FIRPTA taxes are collected in full. (Note that the increase in FIRPTA withholding, which takes effect February 17th, 2016, does not apply to the sale of a personal residence where the amount realized is $1 million or less; the 10% withholding rate remains in effect for personal residences valued above $300,000 and below $1 million.)
Increase in REIT Ownership for FIRPTA Exemption
Exception from FIRPTA for Certain Stock of REITs (Sec. 322, PATH Act 2015)
Several other changes to FIRPTA were made as well: Section 322 increases from 5 percent to 10 percent the maximum stock ownership a foreign shareholder may have held in a publicly-traded REIT in order to avoid having that stock treated as a U.S. real property interest on disposition. Section 133 also extends similar treatment for any publicly-traded regulated investment company (RIC) that is a USRPHC; a distribution from a RIC to a foreign entity that is attributable to the sale of USRPI is exempt from FIRPTA as long as the foreign entity (or corporation) did not own more than 10% of the RIC in the year period prior to the distribution. (The preferential treatment for RICs—in line with REITS—had expired at the end of 2014; it is now permanent.)
Section 322 also carves out an exemption for “qualified shareholders” who own stock of U.S. REITs directly or through one or more partnerships such that their holdings are not considered USRPIs, and distributions from any gain as a result of a sale or exchange are not considered ECI under FIRPTA. Benefits from this provision will exempt listed Australian property trusts that have comprehensive tax treaties with the U.S., for example.
APPENDIX: Select Corporate Tax Law Changes
(Not specific to commercial real estate)
I. Extension of R&D Tax Credit with Increased Benefits for Start-Ups
R&D Tax Credit (Sec. 121, PATH Act 2015)
The research and development (R&D) tax credit provides a credit equal to 20 percent of the amount by which qualified research expenses for the year exceed a base amount, with a minimum base amount set at 50 percent of qualified research expenses for the year. Alternatively, a taxpayer may opt for a simplified credit equal to 14 percent of qualified research expenses.
The credit was made permanent. Additionally, beginning in 2016, eligible small businesses (those that have average annual gross receipts less than $50 million for the preceding three taxable years) may claim the credit against regular tax and alternative minimum tax (AMT) liability. Certain start-up firms (with $5 million or less in gross receipts for the taxable year and no gross receipts for the prior five tax years), may utilize the credit against their payroll (i.e., FICA) liability up to $250,000. (For more detail, please see Title 26, Code § 41 - Credit for Increasing Research Activities.)
II. De Facto Increase in Temporary Visa Limits
H-2B visas, which allow foreign nationals to perform seasonal or one-time temporary non-agricultural work, will continue to be capped at 66,000 per fiscal year.
Workers who have already received an H-2B visa in the last three fiscal years (2013, 2014 or 2015) will be excluded from the cap, which effectively increases the number of seasonal workers in the country.
III. Higher Cost for Visas for Skilled Workers
H-1B and L-1 Visas
H-1B visas, which allow foreign nationals to perform high-tech and skilled work, and L-1 visas, which permit employees of an international company with offices in both the United States and abroad to relocate to the U.S, will see employer costs double.
An additional fee of $4,000 per H-1B petition and $4,500 per L-1 petition will now apply to filings by companies with more than 50 employees in the United States, where at least 50 percent of the employees are in H-1B or L-1 status.
IV. Cadillac Tax Delayed
Levy on Employer-Sponsored Health Plans
The excise tax on high-end health plans (informally known as the “Cadillac Tax”) was scheduled to be implemented in 2018 as a 40% levy on employer-sponsored health plans whose value exceeds $10,200 for an individual and $27,500 for a family, indexed to overall, rather than healthcare inflation. (Notably, workers' deductibles and out-of-pocket costs do not figure into a health policy's value, but wellness programs and tax-free contributions to health savings accounts do.)
After passage of the spending bill, the implementation of the tax will be delayed by two years until 2020. Separately, a tax on health insurers will be delayed by one year until January 1, 2017.
Ms. Learner analyzes the macroeconomic and legislative environment affecting commercial real estate markets on a national and regional basis and develops real-time measures of supply and demand for commercial space.