tax issues in real estate partnerships: dealer vs

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Tax Issues in Real Estate Partnerships: Dealer vs. Investor Status, 163(j) Interest Limitations, Section 266 Election, 199A

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August 25, 2021

Tax Issues in Real Estate Partnerships: Dealer vs. Investor Status, 163(j) Interest Limitations, Section 266 Election, 199A

Kimberly Arndt

Director, National Tax Services

PricewaterhouseCoopers

[email protected]

Adam S. Feuerstein

Principal, National Real Estate Tax Technical Leader

PricewaterhouseCoopers

[email protected]

Notice

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determined through consultation with your tax adviser.

Tax Issues in Real Estate Partnerships

Adam Feuerstein,PwC - National Real Estate TaxTechnical Leader

KimberlyArndt, PwC - Real Estate National Tax, Director

August 25, 2021

Agenda

2

01

02

03

Dealer Property

163(j) Interest Limitations

199A

PwC | Tax Issues in Real Estate Partnerships

04 Carried Interests

05Qualified Opportunity Zones

Dealer Property

Implications of Dealer Property

• Implications of dealer property

- Gain on the sale of dealer property is treated as ordinary income.

- Tax Exempt Investors

◦ Gain on the sale from dealer property is treated as unrelated business taxable income for tax exempt investors.

- Real Estate Investment Trusts (REITs)

◦ Sale of dealer property is a prohibited transaction and subject to 100% tax on the gain on sale.

PwC | Tax Issues in Real Estate Partnerships 9

Dealer Property

• Dealer property is property that is either:

- Inventory or

- Held primarily for sale to customers in the ordinary course of a trade or business.


Determination of Dealer Property

• Whether property is treated as dealer property or property held forinvestment is a facts and circumstances question.

- Highly litigated and based on case law.

- The law will be based in the circuit of the taxpayer's principal place of business.

• When property is acquired with multiple purposes in mind, dealer property held

"primarily for sale" means "principally" or "of first importance."

- Malat v. Riddell, 383 U.S. 569 (1966)

• Determination made on a property-by-property basis.

- A taxpayer can be a dealer with regard to one property even if it is not with

respect to other properties.


Importance of Intent

• Focus on the intent of the taxpayer when determining dealer status.

- Intent at acquisition.

- Intent over the course of the holding period.

- Intent immediately before deciding to sell.

• Intent is typically subjective.

- Courts look at various objective factors to help assess the taxpayer's intent.

- Written documentation can assist with the objective considerations for intent.


Factors to Consider

• Extent of improvements made (e.g., subdividing, developing).

- Development of the property.

- Significant improvements to the property.

- Platting or subdividing.

• Duration of ownership.

- Shorter hold period may indicate an intent to hold for sale.

- Longer hold period indicates intent to hold the property for investment.

- A change in circumstances may mitigate a short holding period.


Factors (continued)

• Frequency, number, and continuity of sales.

- More frequent and high-volume sales, on a continuous basis may indicate

an intent to hold the property for sale.

• Nature and substantiality of transactions.

- The percent of income from the sale of the property over the total income.

- Basis of the property sold over the total basis of assets held.


Factors (continued)

• Extent of advertising to promote sales.

- Advertising, marketing, and soliciting offers for the most profit may indicate

property is held for sale.

- Unsolicited offers may indicate that property is held for investment.

- Significant time and effort spent developing, marketing, and selling other properties may indicate intent to hold property for sale.

• Use of agents to sell property and control or supervision over the sale or effort

involved in the sale.

• Liquidation.


163(j)Interest

Limitations

Interest Expense Limitation Generally

• Generally business interest expenses paid or accrued in a tax year is deductible.

- Limitation applies at the entity level.

• Section 163(j) limits the deduction to the sum of:

- 30% of adjusted taxable income (ATI),

- Business interest income, and

- Floor plan financing interest.

• There is an exception for any real property trade or business.


Electing Real Property Trade or Business

• Real Property Trade or Business ("RPTB")

- RPTB defined as a real property development, redevelopment, construction,

reconstruction, acquisition, conversion, rental, operation, management,

leasing, or brokerage trade or business.

- Notice 2020-59 provides a safe harbor for a qualified residential living facility

to be considered a RPTB.

• Irrevocable election made by the entity holding real property.

• Electing taxpayers are required to use the alternative depreciation system (ADS).


Partnership Applicationof 163(j)

• The partnership determines its 163(j) limitation.

• The excess business interest expense (EBIE) is the amount of disallowed business

interest expense with respect to a partnership for a taxable year.

- EBIE is allocated to the partners and carried forward indefinitely at the partner

level.

◦ EBIE can only be used to offset ATI from the partnership from which the

EBIE was derived.

- Deduction of EBIE allowed in a future year if there is excess taxable income

(ETI) or excess business interest income allocated to the partner from the

same partnership.

- Partner's basis in the partnership is reduced by the EBIE but not below zero.


Partnership Applicationof 163(j) (continued)

• The excess taxable income (ETI) is the amount of excess capacity a

partnership has to deduct interest expense.

- ETI equals

ATI X 30% of ATI – (BII - BIE – Floor Plan Financing Interest Expense)

30% of ATI

• ATI is increased by a partner’s distributive share of ETI.


Section 266

• The regulations under section 266 provide that a taxpayer can capitalize an

expense that is otherwise deductible under Subtitle A.

• The 266 election allows taxpayers to capitalize certain:

- Taxes

- Interest

◦ Interest on a loan for real property.

◦ Interest on a mortgage for unimproved and unproductive real property.

- Carrying charges

• The regulations provide that if the item is not deductible, it may not be

capitalized under this election.

- Application to Section 163(j) limitation

- Application to NOL limitation


199A General Overview

• Passthrough deduction of 20% for qualified business income (QBI) in a qualified

trade or business (QTB).

- Qualified REIT dividend income and publicly traded partnership income are

eligible for the deduction without limitation.

• Entities that qualify:

- Partnership,

- Sole proprietorship,

- Limited Liability Company (taxed as partnership),

- S Corporations,

- Trusts and Estates.

• Effectively reduces the rate on pass-through income to 29.6%.


Determining QBI

• QBI is separately calculated for each trade or business and is determined at the

partner, shareholder, or individual level.

• Included in QBI

- Income or deductions attributable to a trade or business if taken into account

for taxable income purposes.

- Gains or losses under section 751 (“hot assets”).

- Must be effectively connected with a US trade or business.


Determining QBI (continued)

• Excluded from QBI

- Capital gains and losses.

- Interest income not otherwise properly allocable to a trade or business.

- Income for services rendered to a partnership by a partner.

- Guaranteed payments under section 707(c).

- Reasonable compensation from an S corporation.

- Dividends and dividend equivalents.

- Gains/loss from certain commodities transactions, or foreign exchange

gains, certain gains from notional principal contracts, non-business annuity

income, and any item of deduction or loss properly allocable to any of the

previous amounts.


Qualified Trades or Businesses (QTB)

• Defined in section 162 and based on case law.

- Good faith intention to enter into the activity and carry on a profit.

- Regular and continuous activity.

- Rev Proc. 2019-38 provides a safe harbor for a rental real estate enterprise

to be treated as a trade or business.

• A trade or business other than the business of:

- Being an employee, or

- A Specified Service Trades or Businesses (SSTBs).

• An entity may have multiple trades or businesses.

- An analysis is required for each trade or business.


Thresholds and Phase In/Outs

• Additional limits for taxpayers above threshold amounts.

- $157,500 for individual taxpayers.

- $315,000 for married filing jointly taxpayers.

- The limitations are phased in over a range of $50,000 for individual filers (i.e.,

$157,500 - $207,500) and $100,000 for married filing jointly taxpayers (i.e.,

315,000 - $415,000).

• Above the $415,000/$207,500 taxable income, the limitations fully apply.


199A Limitations

• The 20% deduction is limited to the greater of:

- 50% QTB’s W-2 wages or

- 25% W-2 wages plus 2.5% of unadjusted basis in qualified property

immediately after acquisition (UBIA).

• Trades or businesses can be aggregated when:

- Commonly controlled trades or businesses to be aggregated,

- Items for each trade or business are reported on returns in same tax year,

- None of the trades or businesses are SSTBs, and

- Two out of of three interdependency and relatedness elements.

• Generally, not available for income attributable to businesses performing

certain activities, referred to as “specified service trades or businesses” (SSTBs).


Specified Service Trade or Business (“SSTB”)

• SSTBs are defined as:

- The performance of services in the fields of health, law, accounting, actuarial

science, performing arts, consulting, athletics, financial services, or brokerage

services or where the principal asset of such trade or business is the reputation

or skill of one or more of its employees or owners [section 1202(e)(3)(A)]; or

- Which involves the performance of services that consist of investing and

investment management, trading, or dealing in securities, partnership

interests, or commodities.

• The Final Regulations provide that the performance of services of investing and

investment management does not include directly managing real property.


De Minimis Rule

• A business that otherwise would be an SSTB will not be treated as an SSTB (and

disallowed from taking the 20% deduction) if the de minimis rule applies.

• Thresholds:

- If Gross receipts are $25M or less: less than 10% of gross receipts attributable

to performance of services in the defined SSTBs.

- If Gross receipts are more than $25M: less than 5% gross receipts attributable

to performance of services in the defined SSTBs.


Providing Services or Property to a SSTB

• A portion of a qualifying trade or business will be considered a separate SSTB

and treated as such if:

- It provides services or property to an SSTB, and

- There is 50% or more common ownership between the SSTB and the

qualifying trade or business.

• Common ownership can be direct or indirect.

- Look for ownership of related parties to see indirect ownership.

- Reference sections 267(b) and 707(b) for related party rules.

• The treatment of the SSTB is only with respect to the related parties.


Wyden's Proposed TaxChanges

• Would limit the deduction to individuals.

- No deduction is allowed for trusts and estates.

• Married taxpayers required to file jointly.

• Changes the deduction to 20% of the least of:

- QBI of taxpayer;

- Threshold amount ($400,000); or

- Taxable income of the taxpayer reduced by net capital gain.

• Qualified REIT dividends are now limited as QBI.

• QTB is redefined as "any trade or business other than the trade or business

of performing services as an employee."

- SSTBs are no longer limited.


Carried Interests

Section 1061

Application of 1061 to Interest Holders

• Section 1061 extends the holding period for certain profits interests issued in

connection with services (i.e., carried interests).

- Specifically, Section 1061 extends the holding period required for certain

taxpayers to obtain long-term capital gain ("LTCG") treatment from more than

one year to more than three years with respect to an "applicable partnership

interest" ("API").

• Section 1061(a) recharacterizes the amount by which an API holder's One Year

Gain Amount exceeds its Three Year Gain Amount as short-term capital gain

("STCG").

- The Final Section 1061 Regulations (the "Final Regulations") refer to the

amount subject to Section 1061(a) as the "Recharacterization Amount."


Applicable Partnership Interest(API)

• An API is a partnership interest transferred to a taxpayer in connection with the

performance of substantial services by the taxpayer or a related person in any

applicable trade or business (ATB).

- ATB means raising and returning of capital in connection with either:

◦ Investing in or disposing of specified assets, or

◦ Developing "specified assets."

◦ Real estate is a specified asset.

• Once an API, always an API.


Determining the Existence of an API

• An API arises when a partnership interest is transferred or held in connection

with providing substantial services in an ATB.

• The Final Regulations presume that, if a taxpayer provides any services in an

ATB and receives or holds an API, those services are considered “substantial.”

• An ATB means any activity for which the ATB Activity Test is met.



Determining the Existence of an API (continued)

• The ATB Activity Test is met if Specified Actions are conducted and the total

level of activity, including the combined activities of all Related Persons, satisfies

the level of activity that would be required to establish a trade or business

under Section 162.

- The Final Regulations use the general definition of a person or entity that

is related under Section 707(b) or 267(b) to determine who is a Related

Person.

• Specified Actions are the combination of Raising or Returning Capital Actions

and Investing or Developing Actions.

Exceptions to the Definition of an API

• The Internal Revenue Code provides for three exceptions to the application of

Section 1061:

- Interest granted for services exclusively provided to one entity,

- Corporations, and

- Capital interests.

• The Final Regulations add an additional exception:

- Bona Fide Purchaser Exception.


General Mechanics

• The amount that an Owner Taxpayer must treat as STCG under Section 1061(a)

is called the Recharacterization Amount.

• Recharacterization Amount is the excess of Owner Taxpayer’s One Year Gain

Amount over their Three Year Gain Amount.

- One Year Gain Amount: The Owner Taxpayer’s (1) combined net API One Year

Distributive Share Amount from all APIs held during the taxable year and (2)

the API One Year Disposition Amount.

- Three Year Gain Amount: The Owner Taxpayer’s (1) combined net API Three

Year Distributive Share Amount from all APIs held during the taxable year and

(2) the API Three Year Disposition Amount.

• The owner’s holding period of the asset sold controls (i.e., a partnership interest

or an asset of the partnership) subject to certain lookthrough rules.


Exceptions to Income Recharacterization

• Section 1231 gain

- Gain from the sale of certain business property.

- Generally, gains are treated as long-term capital gains and losses are treated

as ordinary losses.

• Qualified dividend income

- Dividends paid by domestic and certain foreign corporations on common

stock held more than 60 days during the 121-day period that begins 60 days

before the ex-dividend date (or on preferred stock held more than 90 days

during the applicable 181-day period.

- Subject to preferential long-term capital gains rates.


Exceptions to Income Recharacterization (continued)

• Mixed Straddle gain

- Capital gain from certain offsetting positions in which one leg is a Section

1256 contract.

• Section 1256 gain

- Gain from certain specified contracts, including regulated futures

contracts, foreign currency contracts, and non-equity options, among others.

- Annual mark-to-market treatment of 60% long-term capital gain and

40% short-term capital gain.


Wyden's Proposed TaxChanges

• Proposes a new section 1299 to replace section 1061.

- Section 1061 would be repealed, and all carried interest would be subject to

these provisions.

• Requires a taxpayer who receives or acquires a partnership interest in connection

with the performance of services to recognize annual ordinary income in

an amount equal to the deemed compensation amounts with respect to all

partnership interests.

- The taxpayer would also recognize an offsetting long-term capital loss.

- Expands the definition of APIs to include:

◦ All services, as opposed to “substantial” services and

◦ Applicable loans.


Qualified Opportunity

Zones

Qualified OpportunityZone (QOZ) Overview

• A tax incentive for investors to defer capital gains by investing into a

defined QOZ.

• Investors have a short window to invest gains in a qualified opportunity

fund (QOF) in order to receive the full benefit.

- Set to sunset by the end of 2026.

• Required to maintain the investment through for a specified time period

to receive the full benefit.


OZ Incentives

• The Opportunity Zones program offers investors three incentives for

putting their capital to work rebuilding economically distressed communities:

- A temporary deferral: An investor can defer capital gains taxes until 2026

by investing and keeping unrealized gains in an OZ Fund.

- A reduction: The original amount of capital gains on which an investor has

to pay deferred taxes is reduced by 10% if the OZ Fund investment is held for 5

years and another 5% if held for 7 years.

- Newly invested gains will only be eligible for the 10% reduction.

- An exemption: Any capital gains on investments made through

the Opportunity Fund accrue tax-free as long as the investor holds them for at

least 10 years.


The Initial Investment

• Gains eligible for investment

- Gross capital gain that is otherwise subject to federal income tax.

◦ Cannot arise from a sale or exchange of property with a related party.

- Section 1231 gains.

- Section 1231 gains and capital gains do not have to be reduced by loss.

• Timing of investment

- Generally, within 180 days of gain realization.

• Partner's timing of investment with partnership gain:

- Begins on the last day of the partnership taxable year in which the partner's

distributive share of the partnership's eligible gain is taken into account.


Sample Opportunity Zone Structure


Qualified Opportunity Fund (QOF)

• Must be taxed as a corporation or a partnership.

• Must hold at least 90% of its assets in QOZ property.

- Assets are QOZ stock, partnership interest, business property.

- Tested on the last day of the first 6-month period of the taxable year of

the fund and on the last day of the taxable year of the fund.

- Reasonable cause exception for failure to meet this test (no penalty).

- Exception for exclusion of recently contributed property:

◦ Must be solely in exchange for an interest in the QOF, and

◦ Held continuously in cash, cash equivalents, or debt instruments with a

term of 18 months or less.

• QOF must self-certify that is satisfies the eligibility requirement (Form 8996).


QOZ Business Requirements

• 70% tangible property owned or leased by business must be QOZ

business property.

• 50% total gross income of QOZ business derived from active conduct of

the business within the QOZ.

• 40% intangible property used in the active conduct.

• Less than 5% average of aggregate unadjusted bases of the property

attributable to nonqualified financial property (NQFP).

- NQFP is debt, stock, partnership interests, options, futures,

forward contracts, warrants, notional principal contract, annuities and other

similar property.


Working Capital SafeHarbor

• Safe harbor makes it easier for a QOZB to satisfy some of the QOZB

requirements during the safe harbor period.

• Requirements for the safe harbor:

- Amounts must be designated in writing for the development of a trade

or business in a QOZ.

- The QOZB must have a written schedule consistent with the ordinary start-

up of a trade or business for the expenditure of the working capital assets.

- Working capital assets must actually be used in a manner that is

substantially consistent with the writing and written schedule.

- Working capital must be spent in 31 months.


QOZ Business Limitations

• QOZ business cannot engage in more than de minimis amounts in

certain businesses:

- Private or commercial golf course, country club, massage parlor, hot

tub facility, suntan facility, gambling, and any store the principal business of

which is the sale of alcoholic beverages for consumption off premises.

• Triple Net Lease – needs to be more than mere investment to qualify as

QOZ business property.


QOZ Business PropertyEligibility

• Eligible property to be used in a QOZ is tangible property used in a trade

or business of a QOF if:

- It was acquired by the QOF by purchase after December 31, 2017.

- The original use of the property commenced with the QOF or the

QOF substantially improved the property.

- During at least 90% of the QOF's holding period, at least 70% of the use of

the property was in a QOZ.

• Considerations for QOZ Business Property

- Cannot be property purchased from a related party.

◦ Stricter requirements for related parties – sections 267(b) and 707(b)

but substituting 20% for50%.

- Can include leased property.PwC | Tax Issues in Real Estate Partnerships 54

QOZ Business Property Eligibility (continued)

• Original Use

- QOF is the first person to place the property in service in the QOZ

and take depreciation/amortization or QOF places property in service that has

been vacant for a requisite amount of time.

• Substantially Improved

- During a 30-month period beginning after the acquisition, additions to basis

of the property in the hands of the QOF exceed the amount of the adjusted

basis of such property immediately after acquisition.

- Land does not need to be substantially improved if purchased after December

31, 2017.


Exiting the QOZ Investment

• Inclusion event during 10-year period:

- Acceleration of original deferred gain.

• Inclusion event after 10-year period:

- Complete exemption of gain on sale of QOF interest.


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