4 GOP Tax Proposals That Could Impact Commercial Real Estate
Commercial real estate (CRE) values in aggregate are impacted by a host of different factors including but not limited to the overall economy, interest rates, supply and demand, and government policies. As we head into 2018 and beyond, all of these factors will continue play a role in the CRE prices and returns. More specifically, under the government policies bucket, changes could be coming in the form of tax policies.
The tax reform bill has reached the desk of President Trump and currently under review for approval. There are several tax policy changes that could directly impact the CRE industry.
1. Changes in Pass-through Entity and Corporate Tax Rates
Commercial real estate investments are often made through pass-through entities, such as partnerships and limited liability companies (LLCs). In a pass-through entity the profits are not taxed at the entity level, but rather passed down to the partners and members of these entities and taxed at their individual tax rates. The tax bill indicates that members, owners, or partners will be able to deduct 20% of their taxable income earned annually. This deduction represents a reduction in the the maximum effective tax rate paid on profits from pass-through entities may be reduced from 39.6% to 29.6%. This tax rate has the ability to create an incremental boost of after-tax profits for real estate investors that are taxed at the maximum ordinary income rates.
The bill will also educe the effective income tax rate for all corporations from 35% to 21%. In a vacuum, this tax reduction could create billions of dollars in incremental after-tax corporate profits. While there will be additional changes in the tax plan for corporations that could somewhat offset these incremental after-tax profits, this is estimated to create an additional $1 trillion in profits for corporations. Any incremental profits would then either be reinvested into growing the corporation, or distributed as cash dividends back to shareholders. In either scenario, it is likely the incremental dollars will be pumped back into the economy in some form or another. Since CRE values in aggregate tend to trend with the overall health of the economy, this will be a plus for the strength of the CRE industry.
2. Commercial Real Estate Tax Deductions
Real estate investors are able to deduct the interest they pay on their mortgage (or debt financing) from their income in order to reduce their overall taxes they must pay. The GOP tax bill will reduce the maximum amount of mortgage interest that can be deducted from first or second homes from $1,000,000 of mortgage principal to $750,000. However, the bill does not propose any changes to interest tax deductions for CRE investments. While the mortgage interest deduction tax proposal could affect some homeowners, CRE interest deduction rules are expected to be held as they currently are.
Another form of tax deductions are capital expenditures, the dollars that real estate investors pay to renovate or rehab their properties. Currently, capital expenditures that a CRE investor pays can be depreciated over their useful life. The depreciation of these costs can then be deducted from the investor’s taxes. Under the final tax bill, the definition of Section 179 property will be expanded to include a range of new capital improvements that can be fully expensed for non-residential properties. When these capital improvements are considered expenses, they can be "written off" from the investments net operating income and thus reduce the investor’s taxable income by the entire value of the capital expenditures as soon as they occur. In summary, this proposed tax change allows CRE investors to realize the tax benefit of an expanded amount of capital expenditures immediately vs. depreciated over their useful life. When considering the time value of money, this change will be beneficial to after-tax CRE investment returns.
3. 1031 Exchanges
Currently, if a real estate investor sells a property and acquires a property of like-kind within 180 days from the sale of the original property, all taxes on the capital gains on the sale of the property can be deferred. This rule also applies to several other industries including Transportation and Warehousing, Equipment/Vehicle Rental and Leasing, Construction, Mining, and Oil Extraction. A 2015 study by EY notes that a total repeal of the 1031 rule could shrink the US economy by up to $13 billion annually. The 1031 rule will be repealed for several industries in which it currently utilized, however it will be spared for CRE transactions. In a vacuum, this is a positive for the CRE industry. However, if the 1031 rule is repealed for other industries, this could have the potential to discourage general business investment versus if the 1031 rule were to remain fully intact for all industries.
4. Carried Interest (Promote)
A common compensation structure for CRE investment partnerships involves carried interest, or promote, for the general partners (GPs) in the investment. Carried interest is a financial interest in the capital gains achieved on real estate investments. In a Limited Partnership structure, the GPs are awarded carried interest for investment returns that are achieved in excess of a certain annual preferred return that they promise to their silent limited partners (LPs) in the deal. For example, if there is an agreed-upon preferred return of 9% annually for LPs, then the GP will be entitled to a certain percentage of the returns achieved in excess of the 9%, commonly 20% of the excess returns. Carried interest provides incentive for the GPs to perform well for the LPs and makes up the lion’s share of compensation for GPs. Carried interest that is earned on real estate investments that are held for longer than 1 year (considered long-term) is currently taxed at the long-term capital gains tax rate of 15% or 20%, depending on the income tax bracket that the GP falls in. This tax rate is attractive for GPs as it sits significantly below the 39.6% maximum federal tax rate on ordinary income. The GOP tax bill will increase the definition of “long-term” under carried interest, to be investments held longer than 3 years versus longer than 1 year.
Currently, carried interest earned on investments that are held for less than 1 year is taxed at the ordinary income tax rate. It’s common for real estate investments to be held for more than 3 years, however with the carried interest reform in place , there is the possibility that it can reduce the number of CRE transactions that occur on an aggregate basis. The reason for this is that the chunk of CRE investments that are typically held for less than 3 years, CRE developments for example, would then have comparably higher odds of changing hands at a slower relative pace once the construction is complete (if complete in less than 3 years). The chances of the developments changing hands at a slower relative pace could result from developers holding out in order to earn the preferential tax treatment by holding for more than 3 years.
The GOP tax reform has created uncertainty for most businesses that exist today, including CRE. While there are some industry losers, CRE is poised for incremental advantages from the tax reform.
- CRE investors will achieve reduced effective tax bills through reduced pass-through entity tax rates.
- Certain capital expenditure tax deductions will be preferentially shifted for non-residential properties from being able to depreciate these capital expenditures over extended periods of time to being able to treat them as operating expenses that can be fully realized immediately after incurring.
- The 1031 exchange rule will remain intact for the CRE industry, however the rule may be repealed for several other industries, which could have negative trickle down economic impacts.
- The time period a real estate investment must be held in order to receive preferential tax rates on carried interest may be increased from 1 year to 3 years.
Each of these tax code changes could have the ability to impact CRE values in aggregate, and the changes are pointing towards creating positive impacts for CRE values and investment returns.