Contributed By McGuireWoods LLP
Gains generated from the sale of real estate are typically subject to a 20% federal capital gains tax. The gains may also be subject to tax at the state and local level, where the rates vary greatly among the states and municipalities. At the state and local level, the sale or purchase of real estate may also be subject to a transfer tax, unless any exemptions apply. Parties often negotiate to determine who will bear the transfer tax costs, as they may be significant in certain jurisdictions.
A commonly employed method for reducing federal, state, and local taxes is utilizing tax-efficient structures. In some cases, it may be advantageous to structure a real estate sale as a sale of equity interests rather than a sale of the real estate asset itself. Given the nuances of state and local tax laws and particular deal terms, tax-efficient structures are designed for the transaction at hand. Often, such structures can achieve tax deferral and, in some cases, reduction.
Municipal taxes (and the exemptions thereto) vary greatly among the municipalities.
Foreign passive investors are generally subject to US income tax withholding on their “FDAP” (fixed, determinable, annual or periodic) income, which includes dividends and rents from real property. The 30% withholding rate on FDAP income is reduced if there is an applicable income tax treaty between the US and the foreign investor’s home country. Foreign active investors, on the other hand, are generally subject to the same rates as US taxpayers: 21% for corporations, and 37% for individuals.
When a real estate asset is sold in either an asset deal or an equity deal, tax withholding should be considered regardless of whether the foreign investor is active or passive. The Tax Cuts and Jobs Act imposed additional withholding requirements when a foreign investor sells a partnership interest. Given the heightened concerns on withholding, foreign investors may find it advantageous to invest in US real estate through a “blocker” corporation (including REITs) to alleviate withholding and other tax concerns.
There are a number of tax benefits available from owning real estate, including deductions for depreciation, property taxes, and mortgage interest payments. The latter two deductions have been curtailed under the Tax Cuts and Jobs Act but remain available in limited circumstances. Furthermore, depending on how the real estate asset is held, there may be a 20% business pass-through deduction available.
More than just tax deductions, taw law is abound with several real estate-specific tax incentives, like tax deferral for “like kind” exchanges, and more general ones, like the rehabilitation tax credits, energy infrastructure tax credits, and capital gains tax deferral under the Opportunity Zone program. Identifying key tax benefits applicable to owning certain real estate through certain investment vehicles potentially leads to greater economic returns.
The Tax Cuts and Jobs Act brought sweeping changes to federal tax law at the end of 2017. One of the key areas affecting commercial real estate investment was the advent of the Opportunity Zone program, which allows investors to defer the capital gains tax by rolling over such proceeds into a qualified opportunity fund. In turn, the fund mustinvest its capital directly (or indirectly) into business property located in an opportunity zone, which is a designated tract in the US, generally identified as low-income and distressed areas. Depending on how long the investment is held in the fund, the investor may reduce 10%, 15%, and even 100% of the capital gains tax that was owed on the initial capital gains tax.
As the Department of Treasury and Internal Revenue Service continues to roll out regulatory guidance on the new Opportunity Zone program, real estate investors are finding ways to participate in the redevelopment of the areas designated as opportunity zones. Many real estate investors are seeking to invest in a qualified opportunity fund this year to take advantage of the 15% capital gain tax reduction available.