The Tax Cuts and Jobs Act of 2017’s (TCJA’s) limit on the federal income tax deduction for state and local taxes (SALT) has proven costly for many owners of real estate businesses. However, more than 30 states1 have now enacted a workaround for pass-through entities (PTEs) that could provide some welcomed tax relief.
The Impact of the SALT CAP
Prior to the TCJA, individual taxpayers who itemized their federal income tax deductions could deduct the full amounts paid for SALTs. The TCJA, however, imposed a $10,000 limit on the SALT deduction.
The effect was significant for many owners of PTEs, including partnerships and S corporations. PTEs generally are not taxed at the entity level; instead, they “pass through” their income, gains, losses and deductions to the partners or shareholders, who report the items on their individual tax returns. These taxpayers could easily reach the deduction limit before even taking into account property taxes or other SALTs, losing out on what had previously been valuable deductions.
In response to the TCJA’s change, numerous states have enacted PTE taxes (PTETs). The statutory schemes vary greatly among states (including just which PTEs are eligible), but the general idea is to shift the state tax burden on PTE income from the individual owners to the entity itself — because the SALT cap applies only to individuals.
These states allow eligible PTEs to pay a mandatory or elective state tax on their income, which the businesses can claim in full as a business expense on their federal income tax returns. In turn, the owners receive some type of offsetting benefit, such as a full or partial tax credit, deduction, or exclusion on their individual state tax returns. Essentially, the company can pay the state tax on behalf of its owners and receive a federal income tax deduction.
In Illinois,2 for example, S corporations and non-publicly traded partnerships can elect to pay the PTET for tax years ending on or after December 31, 2021, and beginning before 2026 (the SALT limit is set to expire in 2026, absent congressional action). The tax rate is 4.95% of a business’s net income for the tax year. Each partner or shareholder can then take a credit against their own state tax equal to 4.95% of their distributive share of the business’s net income.
Impact on Real Estate
With the rise of state pass-through entity tax programs, more and more companies in the real estate space have had the opportunity to benefit. Residential and commercial rentals, management companies, agencies, brokerages, developers and more can qualify. The businesses must be profitable for the election to make sense. This can be evaluated by the business on an annual basis. In real estate, the sale of property can be a large taxable income producing event. Profits from the sale of real estate may present a very attractive opportunity for the business to make a pass-through election and turn a large state tax liability into a federal tax benefit. It is one of many tax planning considerations when selling a property and it is important to discuss your options with your tax advisor.
While the PTET is a useful option for many real estate companies, it is not always the right choice. Several considerations must first be weighed, particularly the nuances of the applicable state PTETs. In South Carolina,3 for example, the PTET is available only for “active trade or business income,” so income from rental activities might not qualify.
Each state has its own rules and guidelines that taxpayers will need to understand and follow. These rules are complex and could materially impact a company’s decision on whether to make the election or not. A few of many things for real estate businesses to consider:
- What percentage of ownership is required to make the election?
- What is the voting procedure?
- When is the election due each year?
- Are there limits on the shareholders’ ability to use the credit on their state returns?
- Will other states in which the PTE is doing business allow a credit for the PTET at the owner level?
- Are estimated tax payments due? What are the due dates?
The owners’ state of residence is important. Nonresident owners will not benefit from a PTET election if their own states do not allow a credit for taxes paid to another state (where the income is earned) at the entity level. That means an owner could be taxed twice on the same income.
PTETs also increase compliance burden, especially for multi-state companies subject to differing rules and requirements. Moreover, many states with PTETs require both resident and nonresident owners to file individual tax returns to claim their credits. Some owners could end up with individual filing obligations in every state where their business pays a PTET.
In general, it is important to understand the rules of the various states your company does business in. If your business qualifies for your state’s PTET election, the benefits for real estate businesses can be substantial. For taxpayers in the higher brackets, these previously limited state tax deductions may now result in 32-37% Federal tax savings.
The Big Picture
Determining whether your real estate business should elect a PTET requires a comprehensive evaluation of how it will play out for both your state and federal taxes. Please reach out to your ORBA advisor to discuss your specific situation. We can assist you with determining your eligibility for the state pass-through tax programs, calculating the possible tax benefits and making the election. If you have questions, you can also contact Justin Sylvan at [email protected] or 312.670.7444.
1Eileen Reichenberg Sherr, CPA. “Update on States Moving Ahead with Ptets.” Journal of Accountancy, Journal of Accountancy, 26 May 2023, www.journalofaccountancy.com/news/2023/may/update-states-moving-ahead-with-ptets.html.
2“Pass-through Entity Information (Publication 129) – Tax Publications.” Illinois Revenue, tax.illinois.gov/research/publications/pubs/pass-through-information.html#faq-3whatisthepassthroughentityptetax-faq.
3“1350 State of South Carolina Department of Revenue I-435 Active Trade.” dor.sc.gov/forms-site/Forms/I435_2021.pdf.