The Impact on the Real Estate Industry and Other Businesses That Operate as Partnerships Villanova University Tax Policy Symposium Peter A. Furci, Partner Debevoise and Plimpton, LLP James B. Sowell, Principal KPMG, LLP June 1, 2017

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Republican Proposals On June 24, 2016, House Republicans released their “Blueprint” for tax reform The “Blueprint” was developed by Ways and Means Chairman Kevin Brady, with broader input from the House Republican Caucus The “blueprint” lays out broad parameters for tax reform, with many of the details unspecified On April 26, 2017, President Trump released a one-page outline highlighting his goals for tax reform While following his campaign proposals in many instances, there are some significant differences The details of the plan are very thin, and despite the exclusion from Trump’s one-pager of items that are included in the Blueprint, it may be that such items still are being considered as part of this plan Senate – Chairman of Senate Finance Committee Hatch No formal plan released Prior to election, Chairman Hatch was focused on Corporate Integration

Individual tax proposals President Trump Chairman Brady Taxation of individuals Individual ordinary income rates: 10%-25%-35% Double standard deduction (increasing deduction to $24,000/married) Eliminate itemized deductions other than home mortgage interest and charitable deductions Provide benefits for childcare and dependent eldercare Eliminate unspecified tax breaks that mainly benefit the wealthiest taxpayers Top rate on business income from a sole proprietorship or pass-through entity of 15%, with unspecified limitations to prevent abuse by wealthy taxpayers Repeal AMT Taxation of investment income Repeal net investment income tax Retain 20% maximum capital gain rate Taxation of individuals Individual ordinary income rates: 12%-25%-33% Consolidate personal exemption/standard deduction into a larger standard deduction ($24,000/married) Eliminate itemized deductions other than home mortgage interest and charitable deductions (undisclosed changes might be made to home mortgage interest deduction) Enhanced child and dependent care tax credit Top rate on active income from a sole proprietorship or pass-through entity of 25% - amount equal to reasonable compensation would be taxed as ordinary income Repeal AMT Taxation of investment income Repeal net investment income tax as part of House Republicans’ vision for health care reform 50% deduction for capital gains, interest, and dividends

Proposals Relating to Estates and Bequests President Trump Chairman Brady Repeal estate tax Repeal estate and generation-skipping transfer taxes

General Business Proposals President Trump Chairman Brady 15% business tax rate Eliminate tax breaks for special interests Lower corporate rate to 20% Allow businesses to fully and immediately expense the cost of investment in tangible property (such as buildings and equipment) and intangible assets (such as intellectual property), but not land Allow businesses to deduct interest expense against interest income, with any net interest expense that is not deductible being carried forward indefinitely NOLs to be carried forward indefinitely and indexed for inflation, but no carry back, and carryforwards would be limited to 90% of the net taxable amount for the year of the carryforward Eliminate various “special interest deductions and credits” designed to encourage particular business activities (e.g., section 199 domestic manufacturing deduction and other unspecified incentives) Repeal corporate AMT

International Business Proposals President Trump Chairman Brady Territorial tax system with unspecified features Deemed repatriation at unspecified one-time tax rate U.S. international tax system moves toward a destination-based tax system under which the taxing jurisdiction for business income would be based on the location of consumption – where goods are sold or services are performed – rather than the location of production Two core features Replace current system of taxing U.S. persons on their worldwide income with a territorial tax system Provide for border adjustments exempting exports and taxing imports System would provide a 100% exemption for dividends from foreign subsidiaries Foreign earnings accumulated under old system repatriated by paying tax of 8.75% to the extent held in cash or cash equivalents or 3.5% otherwise (payable in installments over 8 years)

Partnerships, and the Rate Structure The Blueprint says very little about partnerships. It refers to small and closely held businesses organized as partnerships and S corp – pass-throughs – and recognizes that these entities compete with C corps. Differential tax treatment drives inequities. With the lowering of rates for corps to 20%, they would lower the rate on “small business income,” “business income,” or “active business income” earned by pass throughs and sole proprietorships to 25%. Under the Blueprint, the business income rate of 25% is part of a new rate structure where investment income – interest, dividends, and capital gain – would be taxed at 16.5% and non-business, non-investment income would be taxed at a 33% rate. President Trump would tax business income at a rate of 15%, capital gains at 20%, and ordinary income at a top marginal rate of 33%.

Other Issues Other significant points raised by the Blueprint that could impact pass-through entities and real estate.  Immediate expensing of capital expenditures other than land. Non-deductibility of net interest expense. Unlimited NOL carryforward, with carryforward year use of NOLs limited to 90% of taxable income, indexed for inflation. Territorial destination-based tax system where imports or sales within the US are taxable, and exports are not. Tax on imports is imposed by denying a deduction or basis for imported property. President Trump provides no details on these issues other than to provide that the U.S. would move to a territorial tax system.

Real Estate and the Rate Structure How does real estate fit into the rate structure? Is real estate all business – 25% under Blueprint for rent and capital gain? American Business Competitiveness Act (the “ABC Act”) introduced by Rep. Nunes might imply this. Is passive rent and capital gain under the Blueprint 16.5% and active rent 25%? Is passive rent possibly 33% under the Blueprint because it is not a specifically described investment income (interest, dividends, and capital gain) and it is not active business income? Mainstreet Fairness Act (the “MSF Act”) introduced by Rep. Buchanan might imply this. Similar issues under Trump’s plan  Introduces possibility of lower 15% rate on business income (e.g., “dealer” sales activity) than 20% rate applicable to capital gain.

Service Partners For equity-owner/service providers, how is the service component of their income taxed? Blueprint says owner operators will be subject to 33% tax rate on service income. Under current tax system, operating income and wages are taxed at the same rate. Taxwriters do not want to allow service providers to avoid wage income treatment by operating through pass-through entities and taking all income out at 25%. Taxwriters concern goes beyond carried interest, but obviously carried interest could get caught up in this. Has been mention of a straight 70/30 rule (i.e., 70% at 33% rate and 30% at other rates). Also talk of allowing a return on capital at lower tax rates and everything else is compensation at 33% (which is like the Levin Bill). It also is possible that rate for capital gain allocable to a carried interest could be addressed separately. Under Trump’s plan, there is no discussion of how the service component of partnership income might be addressed. Statements made in connection with release of plan imply that unspecified limitations would be imposed to prevent abuse by wealthy taxpayers. Separate statements made with regard to addressing the inequitable treatment of carried interest.

Trade-Off of Expensing of Capital Improvements and Loss of Interest Deductions Expensing is stated to be a trade off for loss of interest in the Blueprint. How does this trade off play out for real estate? Get present value benefit of accelerated losses and growth of NOL, although can only offset 90% of income with carryovers. The expensing will reverse when the property is sold, so the benefit is only time value of money vs current taxes, except for the growth factor of the NOL. If reinvest sale proceeds on a fully deductible basis, original benefit will continue (i.e., not be recaptured), but no new benefit is created (because deduction merely prevents recapture). Interest is a lost deduction, so you will have more total income over time under the Blueprint unless the growth factor on the NOL is greater than lost interest deductions.

Interest and Guaranteed Payments Under Blueprint, interest is subject to tax at a 16.5% rate and interest deductions are limited to interest income. To the extent interest is subject to deduction limits and lower tax rate, do guaranteed payments for capital paid by a partnership get the same treatment as interest? Under Trump plan, there is no beneficial rate for interest.

NOLs and Excess Interest Under the Blueprint, do NOLs flow out of a partnership for possible use at the partner level? Similarly, do excess interest deductions flow out of a partnership for possible use at the partner level?

Nonrecognition in Partnership Transactions To what extent do the flexible nonrecognition rules in the partnership continue to apply? ABC Act raises concerns for partnership distributions.

Section 1031 How does 1031 fare in a world of expensing, as described in the Blueprint? For some, expensing of property can provide for an effective equivalent of 1031, given that a deductible reinvestment of proceeds can offset the gain recognized. For real estate, land cannot be expensed. In addition, given the application of section 704(c) for gain from contributed property, the deduction for property purchased will not always go to the same party who is allocated the income from the sale of the property. Need for coordination of income and expense character to permit offset. Under the Blueprint, expensing would reduce 25% rate business income whereas some portion of gain may be capital gain, which the Blueprint treats as ordinary, but provides a 50% deduction.

REITs Do REITs continue as part of the tax system under the Blueprint? If so, a number of issues must be addressed. Will dividends be taxed by reference to rates that would apply to the underlying income? How will expensing of buildings and resulting NOLs be accounted for? How will distributions be taxed – that is, when will a distribution be taxed as a dividend? Under current law, NOL carryovers do not reduce current earnings and profits? How may NOLs be utilized, given the limitation on the use of NOL carryovers by reference to 90% of taxable income? How does lack of deductibility of interest affect the distribution requirement (i.e., creates income that is not matched by cash)?

International Rules and FIRPTA Under the international regime described in the Blueprint, it appears that transactions would be taken into account only if the counterparty is a U.S. taxpayer. Accordingly, income received from customers that are U.S. taxpayers would be taken into account, but expenses (consumption) paid to non-U.S. taxpayers would not. It would appear that, in a typical scenario, a U.S. business purchaser of imported goods would not receive any basis for cost of goods sold related to such products, so that 100% of the sales proceeds of any subsequent sale of such goods within the U.S. would be subject to tax and such taxpayer would be unable to recover such costs through expensing (e.g., a U.S. business purchaser of building components would not receive basis subject to expensing if acquired from a non-U.S. seller). Chairman Brady appears receptive to repealing FIRPTA as part of tax reform. It is unclear how repeal of FIRPTA would impact transactions involving non-U.S. taxpayers in an international tax regime that involves “border adjustments.” Trump plan provides for “territorial” tax system, but no indication as to details of program.

Transition Rules Under the Blueprint, would there be transition rules for expensing relating to property acquired prior to the effective date? Similarly, would there be transition rules for deductibility of interest for debt incurred prior to the effective date?

Questions

Presenter’s Contact Information Peter A. Furci, Partner Debevoise and Plimpton, LLP 212-909-6114 pafurci@debevoise.com James B. Sowell, Principal KPMG LLP 202-533-5710 jsowell@kpmg.com

Thank you!

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