Inflation Reduction Act of 2022: Tax Implications for Real Estate Investment Trusts (REIT), EV Incentives and 1031 Exchanges

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Inflation Reduction Act of 2022: An Overview

 

Article Summary

 

  • Aim of the Inflation Reduction Act (IRA)
  • Carried interest treatment
  • Changes to Section 179D Incentives and Qualifications
  • Increases to the R&D Tax Credit
  • 15% minimum tax on large corporations (AMT)
  • 1% excise tax on stock buybacks for publicly traded company stocks
  • “Clean” vehicle credit for qualifying new and used clean vehicles
  • Clean Energy credits for businesses and individuals
  • Prescription drug-price reform
  • Funding for an IRS rebuild 

 

Aim of the Inflation Reduction Act

 

The Inflation Reduction Act of 2022, is a $430 billion dollar spending package that was introduced by the senate as a compromise for the much larger Build Back Better legislation. The bill was ultimately signed into law by President Biden on August 16, 2022.

The aim of the act is to raise $740 billion in revenue over 10 years and to help combat inflation, climate threats, specific medical costs and grow the IRS to capture additional tax revenue.

Specifically, the act offers multiple incentives, including the expanded Section 179D deduction, increased ability to leverage the R&D credit to offset payroll taxes for eligible start-up businesses, and a few new and modified clean energy credits.

 

 

Carried Interest Tax Break: No Changes to Current Code

 

Carried interest is defined as the interest in partnership profits a general partner receives from investing partners for successfully managing an investment and taking on the entrepreneurial risk of a venture.  

Historically, the concept of “carried” interest dates back to the Middle Ages and the time of Columbus where it was used in Italy, Greece and Egypt to help finance the costs of ship construction, trade and the risks of exploration ventures. (The origin story of carried interest is available here on NPR). 

In modern times, it is a part of the US tax code that allows asset managers or partners to receive a set percentage of profits as part of their compensation. Investors and advocates view this money as a performance bonus because the more a fund makes, the more profit there is for managing partners to share and it incentivizes risk-taking.

Opponents of the carried interest method often refer to it as a loophole that allows wealthy private equity, hedge fund and other investment managers to pay a lower tax rate than most employees and other American workers. Under the “carried interest loophole”, it is income which is taxed at the lower capital gains tax rate (20%) rather than the higher earned income tax rate (37%).  

The Inflation Reduction Act, in its final form, excludes any changes to the current carried interest rules, 1031 Exchange rules, no updates to the $10k state and local tax cap, or include any changes to Section 174 to restore full expensing of research and experimental (R&E) costs.

Although the carried interest rate hike was excluded from the Inflation Reduction Act to help ensure its passage, it is likely that the administration will continue to seek changes to the carried interest tax break in future legislation.

The real estate industry should also be aware of provisions that didn’t make it into the legislation but could come back in the future. Like the BBBA, the Inflation Reduction Act came very close to expanding the carried interest rules to lengthen holding period requirements from 3 to 5 years, accelerate gain on transfers, and include gain from the direct sale of rental real estate. Further revenue raises to be on the long-term watch for include a potential expansion of the 3.8% Net Investment Income Tax, potential surtaxes on individuals, and the 2021 Wyden partnership tax proposals (which would introduce fundamental changes to the current state of partnership taxation). All in all, the real estate industry dodged a bullet and can actually benefit from the energy incentives that are provided in the new act.

 

Increased Eligibility (and Complexity) to Section 179D Deductions

 

The Inflation Reduction Act will significantly increase the eligibility requirements and credit amounts of the energy-efficiency tax incentive under IRC Section 179D for the architecture, engineering, and construction industries (AEC), including commercial building owners.

These changes will apply to any qualifying property placed in service after December 31, 2022. Importantly, real estate investment trusts (REITs) are now able to claim this deduction; and eligibility for the deduction can now be extended to designers of buildings for not-for-profit and tax-exempt organizations in addition to designers of buildings owned by government entities.

The act increases the possible tax deduction rate from $1.88, which is a tax year 2022 inflation-adjusted maximum, to $5 per square foot. The deduction rate increases on a sliding scale for each percentage point by which energy cost savings is improved above 25%, up to a cap at a 50% reduction. The standard base deduction rate ranges from 50 cents to $1 per square foot, while properties qualifying for the increased bonus deduction rate range from $2.50 to $5 per square foot.

To qualify for the increased deduction rate, prevailing wage and apprenticeship requirements must be met for any laborers and mechanics employed by the taxpayer or contractors associated with the installation.

Also, the lifetime cap of $1.80 per square foot on a building was removed and replaced with a three-year cap. This means buildings where subsequent energy-efficient upgrades were made after previously claiming a full deduction for past work are now eligible to utilize additional Section 179D deductions.

The IRA also creates a new deduction path for renovation projects based on reducing a building’s energy use intensity by 25% or more.

The complexity of the IRC Section 179D changes underscores the need to choose a professional CPA firm who can help perform risk assessment and tax compliance, especially considering that the Inflation Reduction Act also includes $80 billion in IRS enforcement of the changing tax code.

 

Increased R&D Tax Credit for Eligible Start-up Businesses

 

The IRA provides increased credits for start-ups to invest in R&D within the U.S. as originally enabled by the 2015 PATH Act (Protecting Americans from Tax Hikes).

The PATH Act revised Section 41 to add a payroll credit election which enables start-ups that are qualified small businesses to utilize their R&D credits against the employer’s portion of Social Security tax on their employees.

The Inflation Reduction Act changes the existing payroll credit election for tax years beginning January 1, 2023.  It now increases the max payroll credit election from $250,000 to $500,000 per year.

The new additional $250,000 credit can be leveraged to offset the employer’s Medicare payroll tax of 1.45%. Up to $250,000 of the credit amount can be used to offset the 6.2% Social Security tax paid by employers and up to $250,000 can be used to offset the employer’s 1.45% Medicare tax liability.

All payroll credits remaining after the current quarterly payroll tax is offset would be rolled forward to following quarters, until the credits have been used up. While the maximum amount eligible for a payroll election will be $500,000 each year, utilization of the payroll credit carryovers is limited by the amount of payroll tax owed in future quarters.

 

Creation of a 15% Corporate Minimum Tax Rate

 

One of the key features of the IRA includes reducing the deficit with a new minimum corporate tax rate of 15%. Corporations with at least $1 billion in income will now be subjected to the new alternative minimum tax rate (AMT).

This rate hike was mainly aimed at large tech companies and other specific industries ridden with tax avoidance. 

The minimum tax doesn’t apply to S corps, REITs, smaller-scale real estate developers or regulated investment companies (RICs). Approximately 200 taxpayers will be subject to this minimum tax.

 

1% Excise Tax on Stock Buybacks

 

Although the carried interest component was removed from the bill, in its place is a 1% excise tax on corporations when they repurchase stock from their shareholders. This measure will likely generate as much or even more revenue as the carried interest proposal and is estimated to raise $74 billion.

The Act imposes a new 1% excise tax on repurchases of stock by certain publicly traded corporations. Specifically, the excise tax would apply to repurchases of stock by domestic corporations with stock traded on an established securities market. This excise tax applies to redemptions, and to certain acquisitions and repurchases of publicly traded foreign corporation stock. 

The excise tax doesn’t apply in some situations, including repurchases that are part of a tax-free reorganization under Code Section 308, repurchases treated as a dividend, when total repurchases during the tax year are $1 million or less, and certain other transactions.

Repurchases include acquisitions by affiliates of such stock where the affiliate is more than 50% owned directly or indirectly by vote or value.

 

Expanded Tax Credits for New and Used EVs

 

There will be little or no assistance for purchasers in the near future, and only individual buyers with annual incomes of less than $150,000, less than $300,00 if married filing jointly, will qualify for assistance.

In an effort to bring electric vehicle production to the U.S.,the act will extend an existing $7,500 consumer tax credit for EVs until 2032. The ultimate goal of the proposal is to raise battery component manufacturing and assembly for EVs in North America from 50% to 100% by 2028.

The act actually tightens up the EV requirements that would allow electric vehicles to qualify for this tax credit. Only EVs that were built in the U.S. are now eligible. Restrictions focus on battery production, requiring a minimum percentage of the battery components be manufactured or assembled in North America. A certain amount of lithium and nickel, both minerals necessary to manufacturing the batteries, must be sourced in the U.S. or from its free-trade partners. Around 40% of the battery minerals must be mined and processed in the U.S. or partner countries, increasing to 80% after 2026.

Many car manufacturers have expressed their concerns about these strict requirements. Ford, GM, and others are seeking more time to be able to meet these requirements as well as an expansion of options that they will be able to source the minerals from. Currently, only about 15% of minerals used in battery production are extracted or processed in the U.S. or by its trade partners, with the majority being from China. These restrictions aim to decrease reliance on China for production and create jobs in the U.S.

As it stands right now, very few electric vehicles qualify for this tax break. The few that do must be placed in service after 2022 and are eligible for a maximum credit of $7,500. The clean vehicle credit is available for vehicles with an MSRP less than $80,000 for vans, sports utility vehicles (SUVs), and pickups, and $55,000 for any other vehicle.

Additionally, the act creates a credit for previously owned clean vehicles. Qualified previously owned clean vehicles with a sales price of $25,000 or less and placed in service after 2022 are eligible for a credit equal to the lesser of $4,000 or 30% of the vehicle’s sales price.

The previously owned clean vehicle credit isn’t available to taxpayers with modified adjusted gross income exceeding $150,000 (married filing jointly) or $75,000 (single) for the current or preceding tax year.

 

Clean Energy Tax Credits

 

The Inflation Reduction Act includes numerous investments in climate protection, including tax credits for households and businesses to offset energy costs, investments in clean energy production and tax credits aimed at reducing carbon emissions.

Some of the incentives that were extended and modified in the act include the new energy-efficient home credit for businesses that manufacture or construct energy-efficient homes through 2032, the production tax credit (PTC) for businesses that produce electricity from certain renewable sources, and the investment tax credit (ITC) for qualified energy property.

Some of the new business credits included in the act are the qualified commercial clean vehicle credit, alternative fuel refueling property credit, and zero-emission nuclear power production credit. 

Individuals can claim tax incentives for making energy-efficiency improvements in their homes, including: solar panels; energy-efficient water heaters; heat pumps and HVAC systems to name a few.

 

Prescription Drug Price Reform

 

One of the most significant provisions of the Inflation Reduction Act will allow Medicare to negotiate the price of certain prescription drugs, bringing down the price beneficiaries will pay for their medications. Medicare recipients will have a $2,000 cap on annual out-of-pocket prescription drug costs, starting in 2025.

 

Additional IRS Funding

 

The Inflation Reduction Act claims that by investing $80 billion over the next ten years for tax enforcement and compliance, the IRS will collect $203 billion (a net gain of approximately $125 billion in tax revenue). The act allocates the 10-year funding for the IRS in the following categories:

  • $3,181,500,000 for taxpayer services,
  • $45,637,400,000 for enforcement,
  • $25,326,400,000 for operations support,
  • $4,750,700,000 for business systems modernization.

The Inflation Reduction Act summary claims, “no use of the funds is intended to increase taxes on any taxpayer with taxable income below $400,000.”

Significant concerns are that the IRS’s increased budget will be used to audit the middle-class while the wealthy will be able to continue dodging taxation since they are more likely to be able to afford sophisticated tax counsel.

 

Extension of Limitation on Excess Business Loans

 

The Inflation Reduction Act includes a two-year extension of the excess business loss (EBL) rules under Section 461(l).

The EBL rules created a limitation on the amount a noncorporate taxpayer can deduct from a pass-through entity or sole proprietorship. Under the Tax Cuts and Jobs Act, the EBL rules were set to expire for tax years beginning in 2027, but the Inflation Reduction Act extends the limitation by two years.

 

Millan & Co. is Here to Assist You

Learn more about how the Inflation Reduction Act of 2022 could impact your business. Our comprehensive approach allows our unique clients to confidently navigate the complexities of taxation as new laws are implemented into the tax code. 

Contact us to learn how we can help you create a strategy that meets your goals.

 

Millan & Co.
Personalized Financial and Accounting Services
Peer Reviewed by Texas State
Board of Public Accountancy
812 San Antonio Street
Suite L17
Austin,TX 78701
Phone: 512-479-6819

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