Big real estate moguls win as smaller investors denied tax break
A perk pitched as a boon for mom-and-pop businesses in President Donald Trump’s tax law could shut out smaller real estate investors while benefiting the industry’s largest property developers.
The Treasury Department released final rules recently detailing how owners of businesses such as limited liability companies and partnerships can claim as much as a 20 percent deduction. The 2017 law generally allows professional real estate firms to fully claim the deduction, while restricting most high-earning service professionals, such as doctors and lawyers.
Some Democrats have slammed it as a giveaway to the wealthy and claim that several members of the administration, including Trump and his son-in-law and adviser Jared Kushner, whose family has extensive real estate holdings, would benefit. Republicans have defended the deduction as a way for businesses to be on a more level playing field with corporations, which received a large rate cut.
But in a surprise twist, the regulations effectively suggest that part-time property owners who among other things, may spend less than 750 hours a year involved in the business, are more likely to face challenges from the IRS — unless they can jump through a new “safe harbor” hurdle that is far from safe for owners who rent a building to tenants under a common type of lease.
“It seems counter to the idea of allowing a tax break for small businesses,” said Marvin Kirsner, a tax lawyer at Greenberg Traurig. “A really big company isn’t going to have a problem with this.”
Under the benefit, taxpayers who earn less than $157,500, or $315,000 for a married couple, can deduct 20 percent of the income they receive via pass-through businesses from their overall taxable income.
The real estate industry cheered when lawmakers added a provision days before the Republican tax bill passed that effectively allowed owners of real estate businesses to tap the pass-through break, even if they earn above those amounts. The 20 percent deduction was extended to firms with large capital investments like buildings, but few employees.
The Republican law generally requires all taxpayers to be in what the Internal Revenue Service calls a trade or business to qualify for the deduction — a fuzzy term that some tax experts interpret to mean work conducted regularly, frequently and for profit, with an active role in operations and management involving at least 750 hours of direct work per year.
It’s surprising that Treasury’s final regulations don’t provide a clearer definition of a trade or a business, according to Jeff Bilsky, the technical practice leader for the national partnership taxation group at BDO USA.
Large commercial property developers usually meet the trade or business requirement, which comes from a long-standing separate tax rule that predates the GOP overhaul. So do most condo developers, according to Mark Stone, a corporate, international and real estate taxation partner at Holland & Knight.
In contrast, a casual investor who owns, say two rental houses or commercial buildings as a part-time gig to diversify his or her investments and just collects rent generally doesn’t qualify as a trade or business.
‘Gold Standard’ Leases
At first read, Treasury’s rules issues on Jan. 18 seemed to help smaller taxpayers by creating a proposed “safe harbor” that allows investors who spend less than 750 hours but at least 250 hours conducting the business — and keep detailed records — as eligible. But the regulations also say that such taxpayers who use so-called triple net leases are blocked from the deduction. Those who spend fewer than 250 hours are also barred from the break completely.
The move was “shocking,” said David Miller, a tax partner at Proskauer Rose. He added that he was concerned that the IRS may eventually try to expand the barring of triple net leases to professional developers as well.
Triple net leases are structured so that the tenant, such as a hotel chain or small business, pays the landlord for maintenance, insurance and property taxes in addition to rent and utilities — leaving little management and operations for the property owner. The leases are a “gold standard” in the commercial real estate industry, according to Barbara Crane, president of commercial real estate group CCIM Institute.
The rules are “bad news” for any investor who owns a building and has a single tenant with a triple net lease — “like a well-to-do investor triple netting to Walgreen’s,” according to Kirsner.
Since the trade or business definition is more art than science, Holland & Knight’s Stone said it was “an untested question” whether a property owner with four or five building with triple net leases might qualify as being engaged in a trade or business. “When you have a lot of buildings, stuff happens,” like boilers exploding that require the property owner to step in and take a more active role, he said.
One potential tax loser: Adam Neumann, chief executive and co-founder of office space giant WeWork Cos, who owns four buildings and rents them to WeWork. One of the buildings — 88 University Place in New York — is a triple net lease, according to Dominic McMullan, a company spokesman. That means he may not qualify for the deduction on that building. WeWork has faced criticism from investors who say Neumann’s rental arrangement potentially poses a conflict of interest, according to a report earlier this month in the Wall Street Journal.
Investors who snapped up one or two single-family homes on short sales following the housing crisis are also likely to be denied the break, according to Kirsner.
The rules “are going to detract from the benefit of making a real estate investment,” he said.