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Summary of Key Takeaways: 

• Outsourcing your accounting function will improve your financial visibility and efficiency process efficiency. 

• An outsourced accounting team will reduce overhead, strengthen controls, and is very scalable. 

• A real estate-focused team understands your industry’s unique challenges. 

• Outsourced Accounting services provide strategic support, far beyond just bookkeeping. 

Is it time to outsource our real estate accounting?

If you’re a real estate developer or investor juggling multiple projects, entities, or financing partners, chances are you’ve asked this question. Maybe your controller just left, your reports are always late, or your team is struggling to keep up. Or maybe you do have the people—but growth is outpacing your team’s capacity, and you’re feeling the strain. If you’re spending more time chasing down numbers than making decisions, outsourcing your accounting might be the best next move. 

Let’s walk through what this shift can mean for your real estate business—and why an outsourced accounting team could be a better fit than a traditional internal setup. 

What can an outsourced accounting team do that my internal team can’t?

Most internal teams are under-resourced or stretched thin. Even if you have a bookkeeper or part-time controller, it’s hard to manage everything from draw requests and cost tracking to investor distributions and multi-entity consolidations. An outsourced accounting team built for real estate brings depth, structure, and real-time reporting. 

With cloud-based systems and integrated dashboards, you can: 

• Use key metrics to best manage your business 

• Monitor construction budgets  

• Track capital contributions and agreements 

• Track project spending 

• Provide stakeholders such as investors and lenders with timely, accurate reports 

You gain consistent, accurate financial data—without the patchwork that happens when your team is always one resignation away from chaos. 

Is outsourcing really more cost-effective?

Hiring, training, and retaining skilled accountants’ costs more than you think. Especially in today’s tight labor market, it’s hard to build a team that covers every level: bookkeeper, analyst, controller, and CFO. An outsourced accounting model gives you flexible, scalable and dependable support across all levels at a predictable monthly cost. 

Outsourcing also strengthens your financial controls. With standardized processes, clear segregation of duties, and a dedicated team monitoring your books, you reduce the risk of fraud, error, or compliance failures. 

Can outsourced accounting really scale with my projects?

Whether you’re acquiring new land, breaking ground on your next build, or managing stabilized assets, your accounting needs change as your portfolio grows. An outsourced accounting team is built to flex with you. Especially if you need help in any of these areas: 

• Bill pay and vendor management 

• Monthly close and accruals 

• Loan draws and capital reconciliations 

• Tracking 1031 exchange proceeds 

You can scale your services up or down depending on the phase of your project and your internal capabilities. Many firms even provide embedded team members—like a staff accountant reporting directly to your CFO—when needed. 

Will they understand real estate?

Real estate accounting isn’t generic. It involves understanding development timelines, lease-up periods, refinance strategies, waterfall analysis, and cost segregation. A good partner brings this industry knowledge to the table, so you don’t have to educate them from scratch. 

When working with Walter Shuffain’s outsourced accounting team you’ll benefit from: 

• A Detailed understanding of real estate accounting and key metrics 

• Strategic insights grounded in real estate cycles 

• Advisors who know lender expectations 

• Accurate investor reporting and capital tracking 

• Guidance on software systems and automation tools 

How do I know if outsourced accounting is right for me?

If any of these sound familiar, you likely are: 

• “I’m having a hard time hiring and retaining good accounting staff.” 

• “Our numbers change dramatically after tax prep or audit.” 

• “We never get financials on time.” 

• “We’re still cutting checks and doing things manually.” 

• “I need more help, but only have budget for one hire.” 

Real estate professionals who thrive with outsourced accounting support often need more than just a bookkeeper—but not a full in-house team. They want better processes, stronger reporting, and expert guidance in an eminently scalable solution. 

A Smarter Way to Grow

Outsourcing your accounting isn’t a shortcut—it’s a strategic investment. We will become an extension of your business, bringing the right expertise at the right time.  

Let’s talk about what outsourced accounting could look like for your real estate operation. Whether you’re building your first development or managing a multi-state portfolio, we’re here to help you scale with confidence. 

Contact us today to explore how a dedicated real estate outsourced accounting team can streamline your operations—and unlock your next stage of growth. 

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Property owners and developers are facing growing financial pressure. Interest rates have more than doubled in recent years, operating costs continue to climb, and tenant demand remains inconsistent, especially for office and retail space. These conditions make it increasingly difficult to refinance maturing loans on workable terms. 

Borrowers with previously low fixed-rate debt are now confronting higher payments, lower cash flow, and tighter lending standards. Sometimes, lenders are unwilling to refinance unless the property’s performance or equity position improves significantly. 

For many real estate investors, these aren’t distant concerns—they’re current realities. Understanding your options when debt becomes unsustainable isn’t just helpful. Protecting your capital, managing tax exposure, and making confident decisions in uncertain conditions is essential. 

Key Takeaways

• Market pressures are mounting: Rising interest rates, persistent vacancies, and refinancing uncertainty are straining real estate owners and developers. 

• Not all debt is treated equally: Recourse and non-recourse debt follow different tax paths during restructuring, short sales, or foreclosures. 

• Restructuring can trigger taxable income: Debt forgiveness often results in “cancellation of debt” (COD) income. However, exceptions like insolvency, bankruptcy, or qualified real property business indebtedness (QRPBI) election may apply. 

• Each scenario carries different implications: From partial forgiveness to short sales and foreclosures, the structure of your debt and your solvency status determine your tax exposure. 

• Early action matters: Financial distress usually surfaces in operational metrics months before it hits your financial statements. Engage with your CPA and lender early. 

• This is not DIY territory: The tax outcomes are complex and deeply situational. If anything here sounds familiar, it’s time to call your advisory team. 

What is Distressed Debt in Real Estate

Distressed debt refers to a loan obligation that a borrower struggles to meet. This could stem from: 

• A balloon payment that can’t be refinanced under current market conditions. 

• Buildings with persistent high vacancy or declining lease rates. 

• Rising costs (interest rates, maintenance, insurance) that push cash flow into the red. 

• Market shifts (e.g., lower post-2020 demand for office space) eroding property value below debt levels. 

Distressed debt is not just about delinquency—it’s when servicing debt requires injecting personal or business capital to keep the project afloat. 

What are the Early Warning Signs of Financial Distress?

Here are some signals to monitor: 

• Multiple quarters of negative cash flow 

• Debt service coverage ratio dropping below 1.0 

• Sharp increases in tenant improvement costs without rent growth 

• Deferred maintenance is piling up due to a lack of capital 

• Declining occupancy rates outpacing market trends 

For many owners, these red flags appear in financial statements 6–12 months before a crisis. Early recognition allows you to approach lenders from a position of strength, not desperation. 

What are the three types of debt restructuring?

When debt becomes unserviceable, three common paths emerge: 

1. Restructure with the Lender

You renegotiate terms (e.g., extend maturity, reduce principal). If any portion is forgiven, this typically triggers income. But you may qualify for relief: 

• Insolvency exemption: If your liabilities exceed assets, forgiven debt may not be immediately taxable. 

• Bankruptcy exclusion: COD income is not taxable if discharged in a Title 11 bankruptcy. 

• QRPBI election: You can elect to reduce your basis in the property rather than recognize income. 

2. Short Sale (Forgiveness on Sale)

You sell the property, and the lender forgives the shortfall between the sale price and the loan balance. 

• Recourse debt may trigger ordinary COD income. 

• Non-recourse debt typically results in capital gain or loss, not COD income. 

3. Foreclosure or Deed-in-Lieu

The lender takes the property to satisfy the debt. 

• With recourse debt, the difference between debt and fair market value may be taxable as ordinary income. 

• With non-recourse debt, the entire debt is treated as the “amount realized,” triggering a potential capital gain. 

What’s the Difference Between Recourse and Non-Recourse Debt?

Understanding this distinction is critical: 

• Recourse debt allows the lender to pursue the borrower personally for unpaid balances. 

• Non-recourse debt limits the lender’s claim to the collateral property only. 

This difference affects how forgiveness is taxed and how foreclosures are treated. It’s not just a legal nuance—it shapes your tax outcome. 

Talk with your advisor early.

Whether navigating a potential restructure, exploring a property sale, or anticipating a shortfall, knowing how your debt is structured—and what scenarios trigger different tax consequences—can help you make informed, proactive decisions. From assessing insolvency status to evaluating forgiveness income or basis reductions, your ability to act with clarity gives you leverage. 

If any of this sounds familiar—or you’re trying to get ahead of a looming issue—contact our team. We help real estate developers understand the financial and tax consequences of restructuring decisions.  

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In the dynamic world of real estate development, not every project reaches completion. Changes in market conditions, regulatory landscapes, or project viability can lead to the difficult decision of abandoning a project. While such situations are challenging, understanding the tax implications and opportunities for deductions can mitigate financial losses. This article outlines the key considerations for real estate developers and investors on when and how to write off abandoned project costs to maximize tax benefits.

Understanding Abandoned Project Costs

Abandoned project costs refer to expenditures associated with a real estate project not completed or carried through to fruition. These costs can include land acquisition expenses, preliminary survey fees, architectural and engineering design costs, and other developmental expenses incurred up to the point of abandonment.

When Can You Deduct Abandoned Project Costs?

The Internal Revenue Service (IRS) allows taxpayers to deduct losses for abandoned real estate projects, provided conditions are met. To qualify for a deduction, the abandonment must be absolute, meaning there must be a clear intent to discard the property and no expectation of recovering its cost. The decision to abandon a project should be substantiated with evidence such as board resolutions, public announcements, or documented changes in strategic direction.

Maximizing Deductions for Abandoned Projects

It’s crucial to strategically time the deduction to align with your tax profile and current income composition to maximize deductions for abandoned real estate project costs.

Abandoned project costs are typically classified as ordinary losses. Recognizing these costs as ordinary losses can be highly beneficial if you’re in a year with a significant amount of ordinary income. Ordinary losses reduce your ordinary income, typically taxed at a higher rate than capital gains.

This strategic timing hinges on intricate tax code nuances. Furthermore, the taxpayer should be careful not to treat the abandonment as a sale or exchange, as such transactions could trigger capital losses, which could cause significant tax inefficiencies. Consulting with a tax professional who can navigate these complexities and optimize your tax outcome based on your specific financial scenario and the timing of your abandoned real estate project is advisable.

Special Considerations for Developmental Costs

Abandoning a real estate project is never an easy decision, but understanding the tax implications and opportunities for deductions can provide a silver lining.

Developmental costs can be complex, with specific IRS rules determining their treatment for tax purposes. It’s important to consult with a tax professional to ensure that these costs are correctly classified and that the timing of any deductions is appropriate. For example, the IRS has specific provisions regarding the abandonment of depreciable property, which may require adjustments to the basis of the property before a loss deduction can be claimed.

For expert guidance on the costs associated with abandoned projects, reach out to Walter Shuffain. Our firm is at the forefront of the Real Estate Industry and is equipped with a team of specialized advisors with comprehensive knowledge of the real estate market. Discover the wide range of services we offer to the Real Estate sector.

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The Massachusetts Millionaire’s Tax, a significant fiscal policy aimed at taxing the state’s wealthiest individuals, has become a pivotal factor for high-net-worth individuals (HNWIs) considering their residency status, especially those with real estate holdings across multiple states. As these individuals evaluate their future, particularly with retirement on the horizon, understanding the tax’s implications and the requirements for changing domicile becomes crucial. This article delves into the Massachusetts Millionaire’s Tax, its impact on HNWIs, and key considerations for those contemplating a move to another state.

Recap: The Massachusetts Millionaire’s Tax

The Massachusetts Millionaire’s Tax imposes an additional surtax on annual income exceeding $1 million, targeting high earners to contribute more to state revenues. This includes income from wages, investments, and certain capital gains, which can significantly affect HNWIs with diverse income sources, including real estate investments across states. To read more about the Massachusetts Millionaire’s tax, check out this article on our blog.

The Impact on High-Net-Worth Individuals

For HNWIs with real estate in Massachusetts and other states, the Millionaire’s Tax introduces complex considerations for tax planning and residency decisions. The tax affects their income and complicates decisions regarding where to declare residency, especially for those nearing retirement or planning to relocate. We recently put together an article that outlines strategies for easing the tax burden in light of this legislation; read it here.

Considering a Move: Domicile and Residency

The concept of “domicile” is central to understanding one’s tax obligations to Massachusetts. Domicile refers to where you intend to make your permanent home, where you return after being away. You can have multiple residences but only one domicile. For Massachusetts to recognize a change in domicile, thereby releasing an individual from the obligation to pay the Millionaire’s Tax, clear evidence demonstrating a permanent move must be provided.

Establishing a New Domicile

Contemplating a move from Massachusetts to retire in another state requires substantial planning and documentation to authenticate a change in domicile, especially if you retain real estate in Massachusetts. The process is far from straightforward and involves more than just ticking boxes on a checklist. It requires considerable effort and understanding that the transition is nuanced, involving various factors beyond the basic steps. The planning and documentation to prove the shift in domicile can include:

• • Physical Relocation: Moving one’s belongings and family to the new state.
  • Changing Legal Documents: Updating your driver’s license, voter registration, and legal documents to reflect your new state of residence.
  • Economic Ties: Shifting banking, investment accounts, and business interests to the new state.
  • Social Ties: Joining clubs, religious institutions, and community organizations in the new location.
  • Facts and Circumstances Test: Massachusetts employs a “facts and circumstances” test to assess domicile. This means the state will consider all aspects of an individual’s life to determine their domicile.

The Millionaire’s Tax Complication

Introducing the Millionaire’s Tax adds a layer of complexity for HNWIs planning to change their domicile. The tax incentivizes the state to scrutinize claims of domicile change more closely, given the potential loss in tax revenue. This scrutiny means that individuals must diligently establish and document their ties to a new state. The Department of Revenue is intensifying its efforts to verify or refute claims. For instance, they examine data from external sources, including E-ZPass and telephone records.

Key Considerations

Massachusetts residents who own real estate in other states but wish to keep a residence in Massachusetts due to family connections must exercise caution. It’s possible to be considered domiciled in Massachusetts and, as a result, be obligated to pay taxes in the state.

For those contemplating a move, it is vital to:

• • Plan Ahead: Begin the domicile change process well before the move to ensure all documentation and changes reflect your new state of residence.
  • Maintain Records: Keep detailed records of all steps to establish a new domicile, including receipts, memberships, and any other evidence of a permanent move.
  • Consult Professionals: Work with tax and legal professionals specializing in multi-state residency and tax planning to navigate the complexities of the Millionaire’s Tax and ensure compliance.

Conclusion

If you’re contemplating a change in residency, understanding the complexities of being deemed domiciled in Massachusetts based on facts and circumstances is crucial. It involves much more than simply ticking off items on a checklist, such as changing your address or doctor. The effort required is substantial and encompasses a wide array of considerations that go beyond the superficial aspects of relocation. It’s not a straightforward process; it may necessitate a multi-year plan to establish residency in a new state fully.

Additionally, it’s important to remember that other states have their own specific criteria for determining residency, nexus, and domicile. These factors can significantly impact your tax obligations and legal residency status. Given these complexities, you may want to thoroughly reassess your relocation plans, ensuring you fully understand the implications and commitments of such a significant decision.

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For Businesses: Incentives to Sustain and Grow

Several key provisions have been introduced to support business growth and adaptability:

Research and Experimentation Expenses:

Under current law, domestic research and experimental expenditures paid or incurred in tax years beginning after December 31, 2021, are required to be amortized over a five-year period. In tax years prior to 2021, these expenses could be immediately deducted in the year in which they were paid or incurred. Costs attributable to research or experiments outside the U.S. must be deducted over a 15-year period. The proposed law would delay to tax years beginning after December 31, 2025 the application of this rule with regard to research and experimental costs attributable to domestic activities. There would be no change for activities outside the U.S. The bill provides transitional rules applicable to interactions with research credits, as well as making accounting changes.

Bonus Depreciation:

The Act extends the 100% bonus depreciation for qualifying property placed in after December 31, 2022, and before January 1, 2026. This extension allows businesses to deduct the full cost of eligible property in the year of service, promoting investment in new assets. The provision retains 20-percent bonus depreciation for property placed in service after December 31, 2025, and before January 1, 2027.

Section 179 Deduction:

The deduction limit under Section 179 is increased for tax years starting after 2023, allowing businesses to expense up to $1.29 million and phase out thresholds starting at $3.22 million, indexed for inflation thereafter. Under current law, the maximum amount a taxpayer may expense is $1 million of the cost of qualifying property placed in service for the taxable year.

Business Interest Limitation:

For tax years starting after 2023 and before 2026, businesses can compute adjusted taxable income (ATI) for interest limitation with reinstated depreciation, amortization, and depletion deductions, enhancing cash flow.

Combating Fraud and Ensuring Compliance:

The Act introduces stringent measures to curb fraudulent claims, specifically targeting the misuse of the Employee Retention Tax Credit (ERTC). If signed into law, the proposed tax package would shorten the deadline to file all ERC claims to January 31, 2024.

For Families: A More Generous Child Tax Credit

The Child Tax Credit (CTC) sees a notable expansion for individuals. This credit calculates the refundable portion per child once the taxpayer’s earned income exceeds $2,500 by 15%. For tax years 2023 through 2025, the credit increases to $1,800, $1,900, and $2,000, respectively, offering substantial savings for families. Additionally, for the tax years 2024 and 2025, taxpayers can calculate their CTC based on the previous year’s earned income, providing flexibility in fluctuating income.

International Relations: U.S. and Taiwan

In a significant move, the bill extends tax treaty-like benefits to Taiwan to avoid double taxation, which may impact businesses with operations or interests in Taiwan.

Disaster Relief: Continued Assistance

Disaster relief provisions from the Taxpayer Certainty and Disaster Tax Relief Act of 2020 are extended. This includes benefits for those affected by federally declared disasters between January 1, 2020, and 60 days post-enactment of the new bill.

Simplifying Tax Reporting:

The reporting threshold for Form 1099-NEC and 1099-MISC increases from $600 to $1,000 for payments made after December 31, 2023, easing the administrative load for small businesses.

Promoting Affordable Housing:

The bill boosts the 9% low-income housing tax credit ceiling by 12.5% for calendar years 2023 through 2025 and reduces the bond financing threshold to 30% for projects financed by bonds issued before 2026.

Practical Implications:

This Act presents a mosaic of opportunities and considerations. Small business owners and professionals must promptly assess how these changes impact their operations and tax strategies. As the provisions have retroactive effects, it’s crucial to consult with tax professionals to maximize benefits and navigate the complexities of the new law.

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• Evaluate Structure and Tax Consequences of Real Estate Debt Workout Transactions
• Prepare for Proposed Limit on Domestically Controlled REIT Status That Would Subject More Foreign Investors to U.S. Tax
• Consider Electing Real Property Business Exception from Section 163(j) Business Interest Expense Limitation

Evaluate Structure and Tax Consequences of Real Estate Debt Workout Transactions

In a recent memorandum decision, the Tax Court has held that a taxpayer had Section 1001 gain or loss, and not cancellation of debt (COD) income, with respect to the sale of real property subject to a nonrecourse loan that was canceled or retired as part of the sale transaction (Parker v. Commissioner, T.C. Memo 2023-104).

This decision serves as a reminder of the importance of properly evaluating and structuring a debt workout transaction in light of possibly alternative federal income tax consequences.

Based on the particular facts and circumstances, taxpayers may wish to consider whether such a transaction can be structured to generate COD income or Section 1001 gain. For example, a taxpayer may be eligible for one or more exceptions to the recognition of COD income under Section 108. Full or partial exclusion of COD income may be more beneficial than recognition of capital gain resulting from a Section 1001 transaction. Structuring a transaction to achieve either capital gain or COD income is complex, with numerous pitfalls and traps for the unwary.

Tax Treatment of Recourse Versus Nonrecourse Debt

It is essential to understand the difference in the income tax treatment of retirement or cancellation of recourse versus nonrecourse debt as part of a sale or exchange of the underlying property collateral.

If the debt is nonrecourse, the gain will generally be Section 1001 gain or loss (generally capital gain or Section 1231 gain, assuming the real property collateral is not dealer property) rather than COD income, which is characterized as ordinary income.

Conversely, if the debt is recourse, there will be COD income to the extent the debt balance exceeds the fair market value of the real property collateral and Section 1001 gain or loss to the extent the fair market value exceeds (or falls short of) the adjusted tax basis in the property.

Alternatively, if a nonrecourse loan is not retired but instead is substantially modified and assumed or taken subject to by the buyer, the transfer may trigger COD income that generally will be allocated to the seller under Reg. §1.1274-5(b).

Similarly, COD income can be generated from a substantial modification of a nonrecourse loan that is not part of a sale or exchange of the underlying real property collateral.

Gross Income Exclusions

COD income may qualify for one of several gross income exclusions under Section 108, e.g., the exclusion for qualifying real property business indebtedness under Section 108(c). Conversely, Section 1001 gain does not qualify for any such exclusion.

Determining Whether Debt Is Recourse or Nonrecourse

Determining whether a debt is recourse versus nonrecourse is not always easy. For this purpose, the Section 1001 regulations provide guidance as to whether a liability is recourse versus nonrecourse. When analyzing a partnership debt workout, the definition of recourse versus nonrecourse under Section 752 should generally not be used.

In contrast to Section 752, where recourse versus nonrecourse is determined based on the partners’ economic risk of loss, the determination of recourse versus nonrecourse status under Section 1001 depends on whether the creditor’s rights are limited to a particular asset or group of assets. Recourse indebtedness for Section 1001 means all the debtor’s assets may be reached by creditors if the debt is not paid, while nonrecourse indebtedness is where the creditor’s remedies are limited to the collateral for the debt. See Raphan v. United States, 759 F.2d 879 (Fed. Cir. 1985).

Depending on the facts (e.g., a full recourse loan to a limited liability company with no guarantees by the LLC members or their affiliates), it may be unclear whether debt is recourse or nonrecourse for Section 1001 purposes. The Tax Court in Great Plains Gasification Associates v. Commissioner, T.C. Memo 2006-276, agreed with the IRS when it appeared to argue that Section 752 and the regulations thereunder determine whether partnership debt is characterized as recourse or nonrecourse. However, the IRS appeared to reverse its position in CCA 201525010 when it ruled that the implication created by Great Plains Gasification was erroneous. The IRS further stated that Section 752 is limited to determining the partners’ basis in the partnership. As primary authority for this conclusion, the IRS cites Reg. §1.752-1(a), which states that the definitions of recourse and nonrecourse liabilities found in this paragraph only apply “for purposes of Section 752.” In some cases, it may be possible to conclude that there is substantial authority for either position.

Planning Considerations

Taxpayers may prefer COD income to capital gain or vice versa depending on the taxpayer’s specific situation. For example, a taxpayer may prefer COD income if the taxpayer is insolvent, in bankruptcy, or otherwise eligible for another COD income exclusion. Another taxpayer who is eligible for the lower capital gains rates but not eligible for a COD income exclusion would generally prefer capital gain to COD income.

There may be tax planning opportunities in these situations. Key factors to be considered include the following:

• Is there a preference for COD income over capital gain?
• Is any property being transferred as a result of the workout?
• Is the liability recourse or nonrecourse?

With careful and proactive planning, achieving desired results may be possible. For example, if the taxpayer would prefer COD income where the debt is nonrecourse, the debtor could negotiate a reduction of the debt. The forgiveness of all or a portion of a nonrecourse debt without the transfer of the collateral will result in COD income rather than gain from the sale of the property. Alternatively, the debtor could possibly transfer cash equal to the fair value of the collateral instead of transferring the collateral to the lender. In Gershkowitz v. Commissioner, 88 T.C. 984 (1987), the Tax Court appeared to allow results similar to these situations.

However, in a later opinion, 2925 Briarpark, Ltd. V. Commissioner, T.C. Memo 1997-298, aff’d 163 F.3d 313 (5th Cir. 1999), the Fifth Circuit Court of Appeals in affirming the Tax Court decision held against the taxpayer where the lender had agreed to release the property from all liens if the debtor sold the property for a minimum sales price. The court reasoned that the sale of the property and the cancellation of the debt were too closely intertwined to be treated as two separate transactions. Therefore, the debtor was required to recognize gain from the sale of the property rather than COD income.

These two court cases show that while not easy, it may be possible to accomplish a taxpayer’s desired results through careful planning.

Prepare for Proposed Limit on Domestically Controlled REIT Status That Would Subject More Foreign Investors to U.S. Tax

Proposed Treasury regulations (REG-100442-22) issued in December 2022 would limit the eligibility of a real estate investment trust (REIT) to qualify as a “domestically controlled REIT,” thereby curtailing – potentially retroactively – the common use of such structures to avoid U.S. income tax on foreign investors’ gains on sales of REIT stock.

Many private real estate partnership funds hold U.S. real property through REITs. The general rule under Section 897(a)(1) and (c) is that gain to a foreign investor on the sale of a “United States real property interest” (USRPI) is treated as “effectively connected income” and, thus, is subject to U.S. income tax. For this purpose, under Section 897(c)(1) and (2), a USRPI includes stock of a “US real property holding corporation,” which generally includes a REIT that holds U.S. real property as its primary asset.

However, U.S. income tax is generally not imposed if the REIT qualifies as a “domestically controlled REIT” (DC REIT), which includes a REIT in which less than 50 percent of the value of its stock was held, directly or indirectly, by foreign investors at all times during the REIT’s existence during the five-year period preceding the sale of the REIT stock. Although attribution rules are provided in several other contexts under Section 897, the statute does not define the term “directly or indirectly” for this purpose.

It appears to be well accepted that the foreign status of a REIT’s direct and indirect owners is determined by looking through to the partners in a U.S. partnership that owns stock of the REIT. By contrast, the IRS ruled in PLR 200923001 that a U.S. corporation owned by foreign investors is treated as a U.S. shareholder of the REIT, i.e., there is no look-through to the foreign shareholders of the U.S. corporation. Under this approach, foreign investors can own more than 50 percent of the stock of a DC REIT, i.e., 49 percent directly and the balance indirectly through a U.S. corporation. Moreover, the favorable result in PLR 200923001 was cited with approval in the legislative history to section 322(b)(1)(A) of the Protecting Americans from Tax Hikes Act of 2015, Public Law 114-113, div. Q.

Accordingly, the REIT structure with foreign investors owning more than 50 percent of REIT stock, in part through a U.S. corporation, has been adopted by many private real estate partnerships in anticipation of the U.S. income tax exemption for foreign investors’ gain on the sale of DC REIT stock.

On December 29, 2022, the Treasury and the IRS issued Proposed Reg. §1.897-1(c)(3), which, if adopted in final form, would substantially curtail eligibility for DC REIT status. The proposed rule would require a look-through to the domestic or foreign status of the shareholders of a nonpublic U.S. corporation for this purpose unless the U.S. corporation is owned, directly or indirectly, less than 25 percent by foreign shareholders, in which case the U.S. corporation would qualify as a domestic REIT shareholder for this purpose. Moreover, this rule would effectively apply retroactively because of the five-year lookback in determining DC REIT status.

Planning Considerations

These proposed DC REIT regulations have caused a fair amount of controversy, and the Treasury has indicated that it is considering how the effective date provisions might be changed to grant relief from the retroactive effect of the regulations.

Nevertheless, it would appear prudent to avoid excess foreign direct and indirect ownership of a REIT for which the foreign shareholders may be seeking favorable U.S. income tax treatment on stock sale gains. Companies should assess the risks and opportunities that may be available through DC REIT status.

Consider Electing Real Property Trade or Business Exception from Section 163(j) Business Interest Expense Limitation

Some taxpayers engaged in construction and other real property trades or businesses that are subject to the business interest expense limitation under Internal Revenue Code Section 163(j) may benefit from making the real property trade or business election. There are some key factors to review when considering this potentially underused election.

Section 163(j) Business Interest Expense Limitation

Enacted changes to Section 163(j) provided a new limitation on the deduction for “business interest expense” of all taxpayers unless a specific exclusion applies under Section 163(j). Section 163(j) generally limits the amount of business interest expense that can be deducted in the current year and is effective for tax years beginning after December 31, 2017. Under Section 163(j)(1), the amount allowed as a deduction for business interest expense is limited to the sum of (1) the taxpayer’s business interest income for the taxable year; (2) 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year; and (3) the taxpayer’s floor plan financing interest expense for the taxable year.

The term ATI means the tentative taxable income of the taxpayer adjusted for various items including business interest expense and net operating loss deductions, among others.  For taxable years beginning on or after January 1, 2022, a taxpayer is no longer allowed to add back depreciation and amortization in calculating ATI.  As a result, more taxpayers are being subjected to the Section 163(j) business interest expense limitation. Therefore, it is more important to determine whether a taxpayer qualifies for a specific exclusion from Section 163(j).

Section 163(j)(3) provides an exemption for certain small businesses if the average annual gross receipts of such entity for the three-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25 million ($29 million for taxable years beginning in 2023). Aggregation rules apply when determining the annual gross receipts limitation.

Real Property Trade or Business Election

Of particular interest to taxpayers in the real estate industry who do not qualify for the small business exemption is the electing real property trade or business (RPTOB) exception under Section 163(j)(7)(B). Any trade or business which is described in Section 469(c)(7)(C) and which makes an election under Section 163(j)(7)(B) is eligible for this exception. Taxpayers who make an RPTOB election are required to use the alternative depreciation system (ADS) for nonresidential real property, residential real property, and qualified improvement property (QIP).

The real property trades or businesses listed in Section 469(c)(7)(C) include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Planning Considerations

Real estate businesses that fall into the above categories and have interest limited under Section 163(j) should consider whether it is beneficial to file an RPTOB election. The RPTOB election may be underutilized for certain taxpayers, such as taxpayers in the construction and management industries.  Additionally, since these types of real estate companies may not own significant real property, there may be very little to no downside for making the election in the form of reduced depreciation deductions.

The RPTOB election is made for each trade or business of a taxpayer. Therefore, if a taxpayer has more than one trade or business and one or more of the taxpayer’s trades or businesses are not eligible to make the RPTOB election, or the taxpayer chooses not to make the RPTOB election for an eligible trade or business, the taxpayer must allocate interest expense, interest income, and other items of expense and gross income between the taxpayer’s excepted and non-excepted trades or businesses. The allocation rules for this purpose are complex and are detailed in Reg. Section 1.163(j)-10.

Depreciation Considerations

As mentioned above, if a taxpayer has made an RPTOB election out of the Section 163(j) business interest expense limitation, the taxpayer must use ADS under Section 168(g) for nonresidential real property, residential real property, and QIP.

QIP is defined under Section 168(e)(6) as “any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service” ­­– but not including any improvement for which the expenditure is attributable to (i) the enlargement of the building, (ii) any elevator or escalator, or (iii) the internal structural framework of the building. QIP is depreciable over a MACRS recovery period of 15 years.

If the taxpayer has not made an RPTOB election and is not otherwise required to use ADS, the taxpayer’s cost of QIP may qualify for bonus depreciation. The bonus depreciation percentage is 100% for property placed in service before 2023 and 80% for property placed in service after December 31, 2022, and before January 1, 2024.

However, if a taxpayer has made an RPTOB election, the taxpayer is required to use ADS for QIP, and the taxpayer’s cost of QIP would not qualify for bonus depreciation. The ADS recovery period for QIP is 20 years.

It is important to analyze the effect an RPTOB election may have on the depreciation deductions of a taxpayer in order to quantify the potential benefits of making the election.

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Small and Regional Banks Remain a Significant Source of Real Estate Capital

Though rising interest rates and inflation have exerted pressure on small and regional banks, these institutions continue to be a large source of capital for real estate. Banks have remained the top non-agency lending group, accounting for 41.1% of first-quarter loan volume, according to CBRE’s Q1 Lending Momentum Index. The degree of investment from small and regional banks has grown steadily over the last few years and is up 7% from last year, according to MSCI’s U.S. Capital Trends Report. This trend is expected to continue as the rate of investment has tripled over the last decade. Small and regional bank investment has proven most significant for hotel and retail real estate, which can attribute 70% and 50%, respectively, of its capital to these banks, according to MSCI.

Government Funding is Declining

In 2022, real estate funding programs like commercial property-assessed clean energy financing and the Inflation Reduction Act introduced several capital options to residential and commercial real estate developers and property owners. However, these programs require adherence to clean energy and sustainability regulations, meaning they are not a realistic source of capital for all real estate companies. And while government funding buoyed real estate financing with loans, subsidies, and tax breaks over the last few years, particularly in response to COVID-19, an emerging fiscally restrictive House of Representatives could turn the tide on government funding as a source of capital for real estate. The expiration of legislation like the Employee Retention Credit and regional multifamily housing grants in 2023 could explain the steadily decreasing government funding influence, and with the U.S. government’s debt ceiling set to expire, the potential for federal legislation to enable funding to real estate could be further diminished.

Private Funds are Gaining Momentum

As economic uncertainty continues to impact the real estate market, risk-averse investors, particularly those investing in uncertain markets like office real estate, are scaling back their investments. This drives down valuations and creates opportunities for high-net-worth individuals (HNWIs) with a higher tolerance for risk. These HNWIs are equipped with long cash runways that allow them to take advantage of low valuations for a much higher potential payoff when the market rebounds.

Private real estate funds are a fairly significant source of capital as well. To date, private real estate has raised $63 billion across 141 funds, compared to $186 billion across 587 funds in 2022, according to Preqin. Also, according to the MSCI report, private money as a whole has taken a larger share of the capital market than in years prior, marking the third consecutive year of growth. This growth could be a result of higher potential returns on investments as well as a reaction to traditional lenders decreasing loan-to-value ratios.

To succeed in an uncertain and volatile economic environment, industry leaders should consider looking for capital where it’s currently available—not necessarily from the same sources as in the past. Real estate companies in search of funding are more likely to explore private capital as it takes a larger share of the market. The industry will also need to contend with declining government funding and can look to small and regional banks for capital even as they combat rising interest rates and inflation.

Finally, as investors tweak their strategies and adjust their portfolios in response to economic uncertainty, the industry will need to navigate the financial implications of these adjustments. Today’s challenging economic landscape requires that real estate firms take a creative, nimble approach to identifying capital sources and securing the financing they need to grow.

The post Following the money: Where is real estate capital coming from? appeared first on Walter Shuffain.