A real estate investment trust, or REIT, can be a riddle for real estate fund sponsors seeking to scale beyond the “friends and family” investment stage. Some sponsors see the REIT as the “next stage” of the fund’s growth style – almost like a rite of passage to becoming a large-cap fund. Sometimes the sponsor is right, and a REIT really is the best fit for the sponsor’s needs. Many times, however, what the sponsor actually wants is not a REIT, but rather a better vehicle for accepting institutional capital. This determination often has nothing to do with tax. For example, a sponsor may be seeking an “open-ended” or “evergreen” fund to grow and maintain an existing portfolio of stabilized assets or a closed-end fund to raise capital more efficiently for development activities. A REIT may be helpful in attracting investment funds to achieve those goals, but a REIT is not necessary for achieving those goals. In many situations, a REIT may serve as little more than a cost burden and compliance headache. For this reason, a sponsor needs to know when to consider a REIT and when to avoid it. This article considers this matter at a basic level.

A REIT is merely a tax classification that allows an entity that would otherwise be taxed as a corporation to avoid “double taxation” and achieve tax treatment similar to – but in some important ways, different than – a tax partnership. Instead of passing through all items of gain, loss, deduction, and credit to its partners to avoid double taxation, a REIT avoids double taxation via a “dividend paid deduction.” The dividend paid deduction reduces the REIT’s taxable income dollar-for-dollar based on the amount of dividends paid — or deemed paid — to its shareholders in a given taxable year. Thus, a REIT may avoid corporate income taxation entirely — and most REITs do — by distributing an amount equal to 100% of the REIT’s taxable income each year to its shareholders as dividends. Shareholders, in turn, pay tax on REIT dividends received at tax rates that correspond to the underlying nature of the income generating the cash for the dividend. For example, dividends funded by cash from operations, such as rental income – and other sources that would be taxable at ordinary rates if earned directly by an individual – are taxed at ordinary income rates, and dividends funded by cash from the sale of business or investment assets held by the REIT for more than one year generally are taxed at capital gains rates. By encouraging the passing through of all cash received as dividends, Congress envisioned the REIT as serving as a sort of “mutual fund for real estate,” whereby non-institutional and institutional investors could invest in a pool of real estate assets held by a passive investment vehicle. Over the years, the once strict REIT rules have been relaxed, and certain tax benefits have arisen that have expanded the usefulness of REITs beyond that initial vision.

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Interested and eligible manufacturers, developers, and sponsors looking to pursue new advanced energy project tax credits under Internal Revenue Code Sections 48C and 45X have been faced with an important question: Should you apply for the Advanced Energy Project Tax Credit under Section 48C or claim the Advanced Manufacturing Production Credit under Section 45X?

These options should be analyzed carefully because your selection could have significant financial consequences.

Section 48C refers to the Qualifying Advanced Energy Project Credit, which offers a credit equal to up to 30% of the taxpayer’s basis in qualified investments – generally speaking, equipment and other tangible personal property – made as part of a qualifying advanced energy project.

Section 45X refers to the Advanced Manufacturing Production Credit, which offers tax credits of varying amounts depending on the type of “eligible component” – such as components within solar panels, wind turbines, batteries, and other products – produced by the taxpayer and sold to third parties. Due to the overlap, many taxpayers eligible for the Section 48C Credit are also eligible for the Section 45X Credit – however, a taxpayer cannot claim a Section 45X credit and Section 48C credit for products produced at the same “facility”, so the two tax credits are generally1 mutually exclusive.

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On February 22, 2023, Governor Holcomb signed Senate Bill 2 (SB 2), allowing elective pass-through entity taxation (PTET) for partnerships, S corporations, and LLCs taxed as S corporations or partnerships. The Indiana PTET and accompanying deductible expense election allow the pass-through of reduced federal taxable income to small Indiana business owners, thereby allowing qualifying owners to avoid the Federal $10,000 SALT deduction limit on their individual returns. Indiana law reflects a nationwide trend of state income tax responses to the $10,000 state and local tax (SALT) deduction limit on individual federal tax returns implemented in the Federal Tax Cuts and Jobs Act of 2017
(TCJA). Indiana PTET law corresponds to the IRS’s invitation after the TCJA for state-level legislation in Notice 2020-75. With the changes introduced in SB 2, the State of Indiana is among thirty-five states that allow PTET relief. Pertinent details include:

PTET retroactivity for tax year 2022:

  • PTET elections for tax year 2022 must be made after March 31, 2023, and before August 31, 2024.
  • Tax year 2022 returns filed on or before April 18, 2023, may be amended to elect PTET. For original 2022 returns filed after that date, the PTET election must be on an original return.
  • PTET Election:
    • For tax years after 2022, PTET elections must be made annually by the earlier of:
      • (i) the PTE’s tax return due date, or
      • (ii) the date the PTE files its return.
    •  PTET election is irrevocable for a particular tax year.
  • Qualifying Entities:
    • Pass-through entities that qualify to make the PTE election include partnerships, S
      corporations, and LLCs taxed as an S corporation or partnership.
    • The election is not available to disregarded single-member LLCs and qualified subchapter S subsidiaries.
    • Qualifying Owners:
      • A “Qualifying Owner” includes direct or indirect PTE owners, including entity
        owners, or a beneficiary of an estate or trust. Financial institutions do not qualify as owners.
      • Must include all qualifying PTE owners.
  • PTE Tax:
    • The PTET rate is Indiana’s individual income tax rate on the last day of the PTE’s tax year (3.23% tax rate for 2022).
    • Nonresident owner tax calculated after PTET allocation and apportionment.
    • Resident owner tax calculated either before or after PTET allocation and apportionment – but the electing entity must use the same method for all resident direct owners.
    • For taxable years ending after June 30, 2023, a single estimated payment must be made on or before the end of the tax year.
  • State Tax Credit:
    • Qualifying owners receive a PTE tax credit against their Indiana income tax liability. The credit accounts for the PTE’s tax payment for each owner’s share of taxable income even if entity election not made – up to the amount of PTET paid.
    • PTE taxes paid to other states included in the Indiana tax credit if the other state
    • PTE tax is “substantially similar” to Indiana’s PTE tax.
    • Entity-level income tax withholding requirements reduced by amount of PTET
      credited to owners.

Bottom Line: Indiana’s PTET provides a new opportunity for closely-held business tax planning. As the state and local income tax landscape continues to evolve, Taft’s State and Local Tax Practice is ready to assist.

“Spend a little more time trying to make something of yourself and a little less time trying to impress people.” — Vice Principal Richard Vernon, The Breakfast Club

In order to make a tax free like kind exchange, replacement property must be identified within 45 days of the sale of the old property and the replacement property must be acquired within 180 days of the sale. As you might expect, these timelines can be challenging to meet.

Taxpayers can also defer gain by investing in a Qualified Opportunity Zone (QOZ) investment. The QOZ rules also require that the investment (in a Qualified Opportunity Fund (QOF)) be made within 180 days of the date of sale of their property. However, unlike a 1031 exchange, there is no tracing rule so an investor can use funds from any source (including debt) to invest in the QOF. Also, the investor only needs to invest an amount equal to the amount of gain that they want to defer, unlike a 1031 exchange where they must reinvest all of the proceeds (gain and return of capital) to avoid recognizing gain.

Consequently, if an investor is unable to identify replacement property within 45 days, they could obtain return of the proceeds held by the 1031 qualified intermediary (QI) and invest them into a QOF. Even if an investor is able to identify a property within 45 days, the deal might not close, or might not be able to be closed within 180 days. While the investor may not be able to obtain return of their funds from the QI prior to the 180th day, they may be able to borrow funds to bridge a QOF investment.

The benefits of a QOZ investment are a little different than, and in some respects, not as good as those of a like kind exchange, and in some respects better. An investment in a qualified opportunity fund has two benefits 1) deferral of gain but only until December 2026 (there are legislative proposals to extend this date), and 2) no tax on the gain from a subsequent sale if the held for 10 years. By contrast, in a 1031 exchange, while the gain can be deferred indefinitely, upon a sale event, that gain will be taxable.

Bottom Line: If your like kind exchange fails or is going to fail, keep in mind a QOZ investment to help mitigate the tax consequences.

Work is the greatest thing in the world, so we should always save some of it for tomorrow.” – Don Herold

First of all, you may be thinking, “Why would you ever want to do that?” Sometimes in transactions (such as a merger or acquisition), it is desirable to have management exchange otherwise vested equity for equity that vests over time in order to retain the key individuals. Aside from the obvious business considerations, the first thought that would likely occur to the holder of the equity is that this arrangement would convert the capital gain inherent in the equity to ordinary income. Obviously, this is undesirable since ordinary income is taxed at a substantially higher rate than capital gains. However, by making a Section 83(b) election, the capital gains treatment can be preserved.

Usually, when equity is subject to vesting restrictions, the service provider realizes ordinary income at the time the equity vests. Taxpayers can elect under Section 83(b) to include in income the excess of the fair market value of the unvested equity over the amount paid for that equity in the year in which it is received. Accordingly, assuming that the unvested stock received in exchange for the vested stock has the same value, there is no excess of the fair market value over the amount paid (i.e., the value of the stock given up), so there is no income to report. The fact that the transferee paid full value for the property received does not preclude the ability to make an 83(b) election.

Often, the vested equity exchanged for the unvested equity will have appreciated in value over the amount paid for it or previously included in income. This creates the potential for accelerating taxation of the gain inherent in the vested equity upon the exchange. This
would need to be carefully evaluated in a taxable exchange. However, tax on gain will not be accelerated if the exchange occurs in the context of a non-taxable transaction, such as a tax-free reorganization, a rollover of equity in a partnership, or an exchange of stock or partnership interests of one class for stock or partnership interests of another class in the same corporation or partnership.

Bottom Line: An 83(b) election can prevent converting capital gain to ordinary income when the exchange of unvested equity for vested equity is a desirable strategy.

“By trying we can easily learn to endure adversity- another man’s, I mean.” – Mark Twain

The month of May was a busy one for the IRS, as the agency has been hard at work releasing new guidance and rules regarding energy tax credits. In Notice 2023-38, the IRS provides detail on how the “domestic content” tax credit rate adder can be satisfied. Notice 2023-44 offers guidance on the application process for the advanced energy project tax credit outlined in Section 48C. These notices are both intended to provide interim guidance until the IRS can publish proposed regulations on these topics. Finally, proposed rules (REG-110412-23 RIN 1545-BQ81) have been introduced to further clarify the procedures and criteria for applying for allocations to receive increased tax credits for solar and wind facilities in low-income communities. Despite the push, there are still a number of energy tax credit issues that remain outstanding, which range from the ministerial (e.g., publication of unemployment rates for the purposes of complying with the “energy community” adder) to those issues that are highly material to the success of the legislative goals intended by the Inflation Reduction Act (e.g., publication of guidance as to transferability of tax credits).

Domestic Content Adder – Additional Guidance via Notice 2023-38

Notice 2023-38 addresses the “domestic content” tax credit rate adder, which allows taxpayers to increase the base energy tax credit by 2% or 10% — assuming certain prevailing wage and apprenticeship requirements are met — for certain energy-related production and investment tax credits under Section 45, 45Y, 48, and 48E. Generally speaking, the domestic content adder is satisfied if (1) 100% of any steel or iron used in a project and at least 40% — or 20% if off-shore wind projects — of any manufactured product which is a component of a project, as of the completion of construction, was produced in the U.S. (the “Domestic Content Requirement”) and (2) certification as to compliance with the Domestic Content Requirement is timely and properly filed with the IRS. The notice provides guidance on the specific criteria that must be satisfied to meet the Domestic Content Requirement, with some of the more notable clarifying items listed below:

  • Clarification as to what types of components qualify for the Steel or Iron Requirement (e.g., steel/iron materials that are structural in function, as opposed to non-structural functions of manufactured product components such as nuts and bolts).
  • Clarification and examples as to how the “Adjusted Percentage Rule” applies with respect to the Manufactured Product Requirement when an applicable project contains both U.S. Manufactured Components and Non-U.S. Manufactured Components — and how to determine if a manufactured product is of U.S. origin.
  • A Safe Harbor for categorizing common project components is subject to either the Steel or Iron Requirement or the Manufactured Product Requirement.
  • Guidance as to how retrofitted projects can nonetheless satisfy the Domestic Content Requirement by following the “80/20 Rule” (i.e., the fair market value of the used property is not more than 20% of total value and the new property otherwise satisfies the Domestic Content Requirement).

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We are all familiar with common business structure in which the operating business is owned by the individual(s) through one entity, the real estate is owned by the same individual(s) through a separate entity and the operating business pays rent to the real estate entity. This is a great method of protecting the value of the real estate from the operating risks of the business. It does however create a self-rental situation under the Internal Revenue Code.

Under the self-rental rules, if a taxpayer materially participates in the operating business and the taxpayer’s self-rental activity produces net income, the regulations treat that income as non-passive income. However, if the rental activity produces a loss, the loss is treated as from a passive activity. This is the worst of both worlds! If the loss is passive, it cannot be used to offset the income from the business that uses the property. If the income is active, the income cannot be offset with losses from other investment real estate.

An effective strategy to circumvent the limitations of the self-rental rules is to elect to group their separately owned rental building with their separately owned business and treat the two of them as one activity for purposes of the passive loss rules. In order to be eligible to elect, the rental must be owned by an individual, an S corporation, or an LLC (not in a C corp), the owners must have the same proportional ownership, and the activities constitute an appropriate economic unit (i.e., common control, common ownership, interdependency between activities). Easily met in the commonly owned company scenario.

By electing to group the activities, taxpayers can use the losses from the rental activity to offset active income from the business.

Bottom Line: Electing to group rental activities can be a valuable strategy to avoid the limitations imposed by the self-rental rules.

“Sometimes the grass is greener because it’s fake….” – Lindsey Lee and Co.

You’re probably familiar with rep and warranty insurance in M&A transactions, but did you
know that you can get insurance against an undesired tax result in a transaction?

Tax insurance can apply to almost any transaction where there is a “known” tax question, but the result is uncertain. Tax insurance can cover a number of circumstances, including:

  • Issues that arise during diligence in an M&A transaction and as a “known” issue,
    are no longer covered by reps/warranties insurance (e.g., failure to file sales tax
    returns in a state where the state has not audited).
  • Transactions in which the authority is not altogether clear and the dollars at risk
    are high enough that insurance is desirable to hedge risk (e.g., tax equity financing
    in energy transactions)
  • Transactions where it would be desirable to obtain a private letter ruling, but the
    timeline cannot accommodate the necessary lead time for a ruling (e.g., nontaxable spinoffs).
  • Transactions where the taxpayer has already received a negative result, but believes it can win on the merits in an appeal (e.g., appealing a penalty assessment).

In such situations, it may be desirable to purchase a policy that will insure against an adverse tax consequence or even the cost of defending an unsuccessful allegation of taxability by the IRS. Most tax insurance policies will insure against the potential tax liability as well as the contest costs (whether you win or lose the audit or tax case). As you might guess, the expense of contesting a tax assessment can be substantial even when you win. The cost of the policy is typically set as a small percentage of the potential tax exposure (e.g., ~2% to 6%, depending specifics of the tax matter at issue). The premium is paid up front or the cost can often be financed.

Bottom Line: Transaction insurance isn’t just for reps and warranties anymore. Keep this
in mind when a client needs more comfort than your opinion.

“Listen, smile, agree, and then do whatever you were gonna do anyway.” — Robert Downey Jr.

The IRS, in recent guidance, concluded that the “rents” from many short-term rental arrangements are subject to U.S. self-employment taxes (“SE Tax”). In this guidance, the IRS ruled that a taxpayer was subject to SE Tax in the following situation.

The taxpayer (i) purchased real estate located near a beach, (ii) rented it to third parties., (iii) average rental was less than seven days; and (iv) materially participated in the rental activity (i.e., it was not operated by a management company). The rental was a fully furnished vacation property. They provided (i) linens and kitchen utensils, (ii) daily maid services, including delivery of individual use toiletries, (iii) access to dedicated Wi-Fi service, (iv) access to beach and other recreational equipment, and (v) prepaid vouchers for ride-share services to the nearest business district.

The IRS ruled that only payments for use of space and the services required to maintain the space for occupancy are excluded from self-employment income. If the owner performs substantial services such that compensation for services can be said to constitute a material part of the payment made by the tenant, the income is subject to SE Tax. Here the IRS determined that the exception did not apply because the owner rendered substantial services to the occupants.

A strategy for reducing (but not completely eliminating) the SE Tax in this situation may be to provide management services to your property company through an S corporation management company. By doing this, you can separate the service income from the rental income so that the rental income is not subject to SE Tax. In addition, depending on the facts, it may be possible to take only a portion of the earnings of the S corp as compensation subject to employment tax and then take the rest as dividends (not subject
to SE Tax).

Bottom Line: If you are managing your own short-term rental, be sure to consult your tax professional about reducing your SE Tax exposure.

“Accept who you are. Unless you’re a serial killer.” – Ellen DeGeneres.

As noted in a prior “Did You Know”, investing in real estate through a self-directed IRA can be a great strategy for increasing returns on that financial resource. However, IRAs, which are generally not taxed, are subject to income tax known as UBIT (unrelated business income tax) on certain types of income from real estate investments. The tax is imposed at the highest marginal rate (37%).

One way to reduce UBIT liability in a self-directed IRA is to invest through a blocker corporation. This is done by establishing a C Corporation and then investing the retirement funds into the C Corporation before the funds are ultimately invested into the planned investment. The “C Corporation Blocker” strategy will not eliminate all the UBIT tax because the business income would be subject to corporate tax, which is 21% in 2023. However, the 21% corporate tax rate is less than the 37% maximum UBIT tax rate.

UBIT may be further reduced by funding the blocker corporation in part with loans from the IRA. For example, the IRA may fund the blocker with 20% equity and then make a loan to the blocker for the remaining 80% which would then use the funds to invest in the underlying asset. The primary goal of leveraging the blocker is to take advantage of the interest deduction to reduce the amount of the blocker’s taxable income. When the blocker receives income from the investment, it will have a deduction for interest paid on the loan to the IRA to offset all or a portion of the taxable income.

Bottom Line: The use of blocker corporations funded in part with loans by self-directed IRAs can be an effective strategy for reducing or eliminating UBIT liability. Investors should carefully consider the pros and cons of this strategy and consult with a financial professional before making any investment decisions.

“Be nice to nerds. You may end up working for them. We all could.” – Charles J. Sykes