IRC Section 199A Considerations for Property Dispositions by Real Estate Funds
One of the most significant benefits under the TCJA was the introduction of the IRC Sec. 199A deduction for qualifying business income (“QBI”). In general, this new code section provides taxpayers with a deduction equal to 20% of their QBI. Since there are limitations on the availability of this deduction, real estate fund managers need to carefully consider how capital transactions affect the availability of the deduction for fund investors. Specifically, disposition of real estate during a taxable year may significantly impact the amount of the deduction. In certain cases, the deduction may not be available at all with respect to a property in a taxable year that such property is sold.
The general limitation that applies to the deduction is based on a threshold comprised of the greater of a) 50% of W-2 wages or b) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of qualifying property. Due to the prevalence of management fees paid in real estate enterprises rather than wages, UBIA will generally be the more applicable threshold to consider.
One of the requirements for property to be included in the computation of UBIA is that such property must be held by, and available for use in, the qualified trade or business at the close of the taxable year. After the proposed regulations for IRC Sec. 199A were released, one commenter suggested that the final regulations contain a rule for determining the UBIA of qualified property in a year of disposition. The approach suggested was a pro rata calculation based on the number of days the qualified property is held during the year. The Treasury Department and IRS, however, declined to adopt this suggestion because the statute specifically looks to qualified property held at the close of the taxable year.
The impact of this guidance is that when a disposition occurs during a taxable year which causes the property to no longer be held by, and available for use in, a qualified trade or business at the close of the taxable year, no UBIA will be available for taxpayers to use in calculating their 20% deduction. If there are no W-2 wages available for such year, the 20% deduction as to that property may be entirely unavailable. For example, if a property with $50 million of UBIA is sold in December, such UBIA would not be available for use in the Section 199A computation. If the property generated $1 million of QBI prior to the sale, the possible tax deduction of $200,000 (2.5% of $50 million is $1.25 million which provides the threshold needed) might be limited or reduced to zero. At the highest federal tax rate of 37%, the federal tax impact of the deduction may have been as high as $74,000.
The negative result that occurs when a property is disposed of during a taxable year means that significant tax planning must be undertaken. IRC Sec. 1231 gains which are treated as capital gains, the general character of gains from real estate dispositions, are not included as QBI. However, if a property is sold late in a taxable year, significant operating income might have been recognized prior to the date of sale. Such operating income is considered QBI. However without W-2 wages or UBIA, the 20% deduction may be significantly limited or reduced to zero. Furthermore, IRC Sec. 1245 gains may be generated on the sale of property due to depreciation recapture. These gains are included as QBI due to their treatment as ordinary income. Without W-2 wages or UBIA, such ordinary income will not be subject to a reduction under the IRC Sec. 199A rules.
In order to plan for such impacts on investors, fund managers need to analyze the tax impacts of real estate dispositions. For example, it may be worthwhile considering moving sales that are originally planned for late in the year to the following year. Managers should analyze the income generated from such properties as well as the potential impact of the IRC Sec. 199A deduction for fund investors.