Now that interest expense of up to 30% of taxable income can be deducted under tax reform, financial planners are being advised to explore real estate activity among alternative investment vehicles.

“There is a carve-out in that interest provision for certain real estate investments,” said David Sites, an international tax partner at Grant Thornton LLP. “Investors can mitigate the interest limitation by focusing on qualified real estate transactions. The partnership deduction can also be applied more favorably upon real estate businesses.”

The fact that the corporate tax rate has been cut from 35% to 21% makes investing through a corporate structure more beneficial than it was in the past when compared with a flow-through or pass-through structure. As a result, the C corporation could now be a viable investment vehicle, according to Sites, who lectured at a New York alternative investment round table on January 25 called “U.S. Tax Reform: Opportunities and Challenges.”

“You traditionally would never think about a corporate structure to invest from an alternative perspective,” said Sites. “Now investors will want to evaluate whether it makes sense to lower that first incidence of taxation to 21% so that there is more money to reinvest or if it’s more beneficial to pay the tax at the individual level and then distribute enough money to shareholders to pay that individual tax.”

A company can only deduct interest expense up to 30% of earnings before interest, taxes, depreciation and amortization.

“Because of the limitations on interest deductions, we're going to see a shift in the global demand for leverage,” Sites said. “We may see an asset manager consider putting 40% leverage on a business instead of 80% in order to alleviate some of the disallowed interest expense and return more of it to equity.”

As a result, hedge funds and private equity funds are expected to be more focused on businesses that are going to return the most after-tax cash flow.

“What that means for the alternative space in the U.S. is less of an ability to invest in a pool of debt securities or buy a bundled, collateralized obligation and more demand for equity from the public markets, private markets, private equity, hedge funds or owner-operated businesses that have reinvested their earnings,” Sites said.

The interest limitations play off expensing provisions, Sites said, which highly favor capital- and labor-intensive industries.

“The tax law is not as beneficial, on both the domestic and the international side, to technology companies or pharma companies, which are more knowledge- and IT-based, as opposed to businesses heavily invested in machinery, equipment or building plants,” he said.

This means that alternative investments with interests in manufacturing could produce higher returns for advisors and their clients.

“When you're evaluating not only long-term returns but cash flow and immediate ROI, you're going to see some businesses that have access to those immediate expensing provisions and [also businesses that have access to] that lower corporate tax rate do better in the short terms of ROIs,” said Sites. “Certainly, hedge funds and private equity funds that focus in that market may benefit.”

An upside of the new tax law is that, from a cash flow and after-tax investment return perspective, the U.S. may be more attractive than it was in the past.

That’s because the tax law eliminates the individual investor’s ability to carry back net operating losses, which now carry forward.

“It’s causing some different thinking from people about generating deductions as part of a deal, and the ability to monetize those amounts as part of a deal,” Sites told Financial Advisor.

Under the old tax code, a net operating loss accrued at a corporate or individual investor level could be carried two years back and recovered in the present, which would generally be used to offset regular taxable income.

“The ability to immediately monetize some net operating losses was something that alternative investments took into account when structuring cash flows,” Sites said.

Not anymore.

Since net operating losses can no longer be carried back, they are limited in how much taxable income they could offset in the year that they're carried forward to.

“You can only offset 80% of your taxable income with a net operating loss carried forward,” said Sites.

In other words, investors will end up paying some tax for which there's no credit while net operating losses are going to take longer to use because they’re going to be limited to 80% of the investor’s taxable income limit—and yet there’s an upside.

“The carry-forward is beneficial because it's unlimited, [while] under the old law there was a 20-year limitation imposed on [net operating losses] that were carried back,” Sites said.