H2C SELLER STRATEGIES SERIES:

How Tax Reform Could Impact

Healthcare Real Estate Sellers

August 13, 2019

 

Tax law changes have created potential challenges as well as opportunities for sellers of healthcare real estate. In this three-part series from Hammond Hanlon Camp LLC (“H2C”), H2C provides a summary of several notable changes to the tax law and present transactional strategies that may offer sellers the ability to mitigate potential tax consequences. The series will explore changes to capital gains and income tax rules that resulted from 2017 tax reform; the impact of these changes for owners, investors, and developers; and action steps healthcare real estate owners, investors, and developers should consider.  

 

Long-term healthcare real estate owners or investors with a low cost basis in their properties relative to market value often rule out the idea of a sale because of the tax consequences they might face. It’s an issue that may be exacerbated by tax reform.

 

The 2017 Tax Cuts and Jobs Act included a number of provisions that could have a deep impact on healthcare real estate owners, investors, and developers, including:

 

• Changes to corporate tax rates 

• New rules around deducting the interest from real estate loans

• The repeal of personal property exchanges 

 

These changes likely will cause disruption for many healthcare real estate owners—but they also present new opportunities for healthcare real estate investors.

 

Changes to Tax Laws Under 2017 Tax Reform

The 2017 Tax Cuts and Jobs Act amended real estate income tax laws with respect to depreciation expense, personal property consideration, and interest expense. Some healthcare real estate owners are adjusting their investment strategy in response to these changes. 

New investments in personal property. Under tax reform, property owners can deduct the cost of new investments in personal property, which previously could only be deducted at 50 percent upon expense. However, this new provision is only scheduled to last until 2022. After that, a higher tax base will go into effect. 

 

To qualify, the personal property must have been placed into service after Dec. 31, 2017.

 

Eligible property includes:

 

• Roofs

• HVAC equipment

• Fire protection and alarm systems 

• Security systems

 

The new law also expands the definition of eligible property to include depreciable tangible personal property used predominantly to furnish lodging. Examples of such property include:

 

• Beds and other furniture

• Appliances

• Other equipment used in the living quarters of a lodging facility, such as an apartment, house, dormitory, or other facility where sleeping accommodations are provided and rented out

In addition, the maximum Section 179 deduction increased to $1 million under tax reform, up from $500,000. Under the law, Section 179 deductions cannot create or increase overall tax loss from business activities thus requiring positive business taxable income to take full advantage of the deduction. 

New interest expense. Healthcare property owners can still deduct the net interest expense from real estate loans, but under tax reform, they must elect out of new interest disallowance tax rules except when gross receipts total $25 million or less. The impact: more limited deductions of net interest expense. The new interest limit, which took effective in 2018, applies to existing debt.

New depreciation rules. Property owners that opt to use the real estate exception to the interest limit must depreciate real property under longer recovery periods, resulting in lower annual depreciation expenses to offset income. The new rules are important for healthcare real estate owners because flexibility has been added where owners can utilize an expanded set of “bonus depreciation deductions” until Dec. 31, 2022, to potentially immediately depreciate 100 percent (up from 50 percent) of the qualified property in the first year. 

 

The recovery periods are as follows:

 

• Nonresidential property: 40 years

• Qualified interior improvements: 20 years

• Qualified leasehold improvement property: 15 years

 

The “20 Percent Pass-Through Deduction.” The 2017 Tax Cuts and Jobs Act creates a new tax deduction of 20 percent for pass-through businesses such as limited liability corporations, estates, and trusts. Taxpayers with incomes above a certain threshold are limited to:

 

• The greater of 50 percent of the W-2 wages paid by the business, or

• 25 percent of the of the W-2 wages paid by the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of depreciable property

 

The 20 Percent Pass-Through Deduction is important for healthcare real estate owners because it allows them to potentially utilize the deduction for their owned management companies, which typically qualify as a pass-through entity. We would expect to see an increase in the number of “management fees” through a wholly-owned subsidiary due to this provision. Additionally, individual REIT investors are eligible for the same 20 percent deduction as direct investors with respect to their qualified REIT dividends. 

 

Under tax reform, depreciable property includes structures, but not land (which has never been able to be depreciated). According to Mitchell Wiggins & Company, LLP, clarification is required to determine whether the deduction applies to rental real estate.

Losses incurred in an active trade or business. The tax law restricts taxpayers from deducting losses incurred in an active trade or business from wage or portfolio income. This restriction, which went into effect in 2018, applies to existing investments. For owners of healthcare properties, this means fewer opportunities offset income with losses from other business or assets. 

 

Personal property changes. The tax law repealed or modified personal property exchanges from Section 1031. This includes heavy equipment and machinery and more. For healthcare investors carrying significant personal property investments, such as a hospital or skilled nursing facility with beds and significant furnishings, this impact can be material.

 

Under the new tax law, the potential tax impact of the sale of a property or portfolio is as follows:

 

• Deprecation recapture tax: 25 percent

• Federal capital gains tax: 20 percent or 15 percent, depending on taxable income

• Net investment tax: 3.8 percent (when applicable)

• State taxes: Vary by state

 

Navigating the New Tax Landscape

 

The changes that result from tax reform likely will impact a significant number of healthcare real estate owners that implement investment strategies based on previous rules around deductions. They also will have implications for real estate owners seeking to sell property and avoid capital gains taxes. In upcoming articles in this series, H2C will explore existing and new transaction strategies that may help sellers defer or mitigate tax consequences.

For more information on the information presented in this article, contact us.

 

Up next in H2C’s Seller Strategies Series: 1031 Exchanges and Delaware Statutory Trust Investments.

Disclaimer

 

This article has been prepared for informational purposes only. H2C does not provide tax or legal advice. All decisions regarding the tax implications of investments should be made in consultation with your tax advisor.