The Dark Side of the New Tax Reform Act for Multifamily Investors

by | BiggerPockets.com

Multifamily (and other commercial) real estate investors got a beautiful holiday present when the President signed the new tax law into effect in late December. Commercial real estate investing had already been provided among the most powerful tax breaks available in the U.S., but the new rules make it even sweeter.

I was not completely shocked by this, given our current president’s career, but I must say that even my team was surprised at the significant level of tax benefits that commercial real estate investors will realize under this new law.

This article, from National Real Estate Investor reviews many of the reasons experts predict high-net-worth investors will be more focused than ever on the commercial real estate sector. Here is a quick overview:

  1. High-net-worth investors will receive a 20-percent deduction on income from pass-through business entities. This applies to ownership via partnership, LLCs, and investors in public and private real estate funds.
  2. Taxpayers can factor in 2.5 percent of the original purchase price of commercial real estate assets as part of their 20 percent deduction. The combined effect of these first two benefits could create a 25 percent tax reduction (10 points – from a 39.6-percent to 29.6-percent rate).
  3. Section 179 of the tax code has long allowed limited deductions for capital improvements in the current tax year. The new law expands this allowance significantly, which could result in significant paper losses for some capital improvements. For example, a new roof or HVAC system, which would have been depreciated over many years before, can possibly be fully deducted in the current year under the new law.
  4. Though the new law eliminated the tax-deferred 1031 exchange for many asset types (like airplanes and other types of personal property), it was retained for real estate. This is a wonderful benefit we got while others lost out.

Steven Ginsberg, co-founder of the Chicago-based law firm Ginsberg Jacobs, says, “All in all, real estate represents probably the most accessible way for high-net-worth investors to profit from the tax law.”

My company doesn’t invest in (or recommend that others invest in) an opportunity solely for the tax benefit. It must first be a sound investment with solid risk-adjusted cash flow—and an opportunity for capital appreciation.

Another Less Obvious Benefit of Tax Reform

In addition to these direct benefits to multifamily syndicators and investors, a less obvious but very powerful multifamily benefit is the doubling of the standard deduction for tax filers.

In a new article on tax reform’s effect on multifamily, Brian Croce expands on this issue:

“By doubling the standard deduction, Congress has greatly reduced the value of the mortgage-interest and property-tax deductions as tax incentives for homeownership,” says the National Association of Realtors. “Congressional estimates indicate that only 5 percent to 8 percent of filers will now be eligible to claim these deductions by itemizing, meaning there will be no tax differential between renting and owning for more than 90 percent of taxpayers.”

Sepi Ghiasvand, an attorney with Hopkins & Carley in Palo Alto, California, says this is “another disincentive for people considering a home purchase.”

John Isakson, chief capital officer at Preferred Apartment Communities, says doubling the standard deduction is going to “keep people who rent renters for longer because it takes away one of the bigger incentives to own a home.”

Related: How the Final GOP Tax Bill Will Affect Real Estate Investors

The Dark Side of the New Tax Law

There’s got to be a downside, right?

Initially, it was hard to find one. And I don’t see a downside in this sweeping new legislation. But this law may have a side effect that will create new challenges for multifamily syndicators.

In a Bigger Pockets article that I penned late last year, I predicted that the multifamily market frenzy was nearing the top, and that we would likely see a softening of prices and competition in 2018 and beyond.

I think I was wrong.

As I speak to investors and other syndicators, I have been sensing that the tax reform act has injected new life into a market that most thought was past its peak. This short post published in National Real Estate Investor (NREI) confirms my suspicion.

Last November, only 26 percent of NREI readers believed the market would continue to expand. Just two months later, that number jumped to 41 percent, which is over a 50 percent jump (15 percent ÷ 26 percent = 57 percent increase). And their survey showed that the number of respondents who believe the market had peaked dropped from 59 percent to 45 percent.

Though we don’t depend only on investor sentiment, let’s face it… sentiment and widespread beliefs will drive behavior.

Related: The Ultimate Metric You Need to Find Value-Add Apartment Deals

What Does This Dark Side Mean For Multifamily Investors?

Just like last year (and every year), there can be a temptation among some commercial real estate syndicators to overpay for an asset. To bank on the capital appreciation more than the current cash flow. To acquire a marginal asset to pocket the fees and hope the investors won’t mind. Or to allow the tax tail to wag the investment dog.

I find this reprehensible.

Yes, that’s a strong word, but that’s how I feel.

I’m calling on multifamily syndicators and individual investors to never knowingly overpay for a multifamily asset or bank on it’s appreciation potential at the expense of its current and projected cash flow.

That’s how multitudes of single family home investors were burned in the last downturn, and we won’t play that game.

Appreciation is great, and we hope for it in every deal, but appreciation is like a bipolar friend. It’s great when we get it. But we should never count on it.

I’m studying Warren Buffett’s investing philosophies and he said something I want to mention here: “It’s better to buy a great company at a fair price than to buy a fair company at a great price.”

For my firm, I translate this as follows: “We endeavor to acquire great multifamily assets in excellent locations for a fair price… rather than to overpay for home run properties in marginal locations and bank on their appreciation.”

We believe that time will prove that this is the path to profitable, safe returns for our investors and our families. History has proven this for centuries, and it won’t change anytime soon.

Do you have any concerns about the new tax code?

Share your opinions below!

About Author

Paul Moore

Paul is author of The Perfect Investment – Create Enduring Wealth from the Historic Shift to Multifamily Housing, which you should probably get if you want to learn to invest in multifamily. He is a Managing Partner at Wellings Capital, a multifamily and self-storage investment firm, and hosts the How to Lose Money podcast. Paul was 2-time Finalist for MI Entrepreneur of the Year, has flipped 60 homes and 30 waterfront lots, developed a subdivision, and appeared on HGTV. Paul’s firm invests heavily to fight human trafficking and rescue its victims.

19 Comments

  1. Christopher Smith

    There seems to be this notion that the new law benefits (of 199A), are available only to pass through entities, when in fact that terminology appears nowhere in the legislation to my knowledge. Assuming your trade or business qualifies under the new provision no legal entity (e.g., partnership, LLC, etc.) is required.

    • Paul Moore

      Thanks Christopher. I kind of thought the same thing, but I admit I’ve never thoroughly studied it. So if you are right, then what type of situation does NOT qualify? Would it be profits from a C Corp?

      Thanks.

    • Ken Virzi

      I have been trying to figure how much forming an LLC would benefit me. How much would one have to make in rent in order to justify the costs of an LLC? I am not referring to liability but simply costs vs tax savings. Any insight would be much appreciated.

      • Kris Wong

        I am not a CPA, but this is what I have seen, and been told by CPAs – for the purpose of simply holding real estate, there is no tax benefit to having an LLC. In the eyes of the IRS, a legal entity is not required to qualify as a business. What’s required is revenue associated with business activity.

      • Paul Moore

        Hi Ken.
        So one of the main benefits to a corporate structure is the possibility that you can take a base salary for the work you do and allow the rest to flow through as profit. So a realtor I know, for example, got more automated over time and makes almost all his money from his system, not his labor. But his $100k or so annually was paid as wages with the FICA taxes (15.3%) attached.

        By doing an LLC, he began paying himself about $40k annually in wages, and the other $60k in profit. Savings on that is about $9,000 annually for him. And it’s all legit. So the cost of setup at say $2,000 or less pays for itself about 4x annually.

        I hope that helps.

  2. James Free

    I’m disappointed in the clickbait-y nature of this article. The headline screams that there’s some sort of tax gotcha, but the only “dark side” is the belief that prices will go up more, which to most real estate investors is a good thing.

    Overpaying can happen in any market. The author did nothing to tie overpayment to recent tax changes.

    I understand that there’s a partisan divide among investors as to whether to invest primarily for cash flow or appreciation, but it doesn’t seem necessary to me to act as though greater appreciation is itself a downside.

    • Paul Moore

      James,

      Thanks for your comments. It may seem that way to some, but to those of us who have spent years of our lives and countless hours looking for deals to acquire, and we keep coming up short again and again, it certainly feels that this new injection of optimism is a huge dark side. It certainly is dark to me, my team, and many of my investors who want to be part of these investment opportunities. But remain unwilling to overpay.

  3. Darin Anderson

    It’s hard to make a case for any of the new tax benefits to be used to justify over-paying for a property.

    The new benefits as laid out above are 20% deduction on net business income and enhanced section 179 depreciation.

    The 2.5% basis calculation just allows real estate investors an easier path to reaching the 20% deduction. It does not increase the 20% deduction of net business income. 20% is still the maximum deduction based on income. And the 1031 exchange is not enhanced for real estate investors. It just simply wasn’t removed like it was for other entities, so that benefit is unchanged by the tax law.

    So the two that do help only help if you have net taxable income.

    But the suggestion here is that the tax law is going to make some multi-family investors who may have previously thought the multi-family market was getting too expensive suddenly find it is worth it now to over-pay because the tax benefits will make up for the fact that they over-paid (I think that is the argument because I don’t know why else tax benefits would make you want to potentially over-pay).

    But if you over-pay for an asset that was already high priced driving it even higher you are now into an area where you are purchasing exclusively for appreciation as indicated in the article. That means you are getting little to no cash flow. If you are getting little to no cash flow then after depreciation you definitely have a tax loss on that property. If you have a tax loss that reduces the benefit of the 20% deduction because that deduction is only on taxable income. Over-paying would have made more sense prior to the new tax law because the amount of taxes you would save by over-paying would have been greater before. Now they cost you part of the benefits of the new tax law when your income is reduced. The new tax law makes it more beneficial to buy a property that is net income positive and makes it less beneficial to buy one that has a net tax loss which is what will likely happen if you over-pay.

    The enhanced section 179 depreciation might be somewhat attractive but then at the same time using it also reduces the benefit of the 20% business income deduction. The best way to get that depreciation is to enhance existing properties, not to over-pay for another property simply to get a higher depreciation deduction, when the end result is going to be a large tax loss that removes the benefits of your 20% deduction all while saddling you with a property that you may loss money on.

    If they are hoping for appreciation and actually get it the new tax law won’t help them there. If they don’t sell then its not taxed either way. If they sell and do a 1031 that is also unchanged from before. if they sell and don’t exchange then they pay capital gains and those are not eligible for the new 20% deduction because that is only on qualified business income which capital gains are not, so there is no benefit in the new tax law for gains from appreciation.

    People tend to be really bad at predicting what they are going to do. People also tend to be really bad at understanding tax laws until they have a year or two of experience and CPA advice under their belt.

    I would be quite surprised if savvy multi-family investors came to the conclusion after a year of experience that the new tax law made it more beneficial to over-pay for investments once they get a firm grasp on that fact that doing so will reduce their tax benefits under the new tax law, not increase them.

    • Paul Moore

      Darin,

      Thanks for your very detailed and helpful comments. This is a great analysis. But my analysis is more simple-minded than yours. I’m not sure which of us is right.

      My analysis boils down more to emotion. Which is the proven bottom-line driver for every decision (no matter how left-brained the decision-maker).

      What I am saying is that the new tax law is touted as a great new opportunity for tax savings for those who invest in commercial real estate. Currently, there are far more investors in the stock market (etc.) than in commercial real estate. The new tax law… perhaps coupled with recent market volatility… draws more attention to commercial real estate. More eyes, more inquiries, and ultimately more investors.

      And more capital & interest will lead to more syndicators who are eager to do deals. And more newcomers who are counting on appreciation rather than cash flow. And syndicators who are reaching into tertiary markets to find deals.

      And this will result in more buyers who are chasing more deals. Which will tilt the supply and demand curve even more in the favor of sellers, and even further away from buyers.

      It’s a great time to be a seller of multifamily.

  4. Alex Franks

    This is a great article and great insight. Yet unfortunately most of the deals we have looked at in NC and SC. Have been overpaid and still be overpaid for. I sat and had lunch with a friend that owns 5800 units. Hearing his take on the market is always refreshing. Get your capital ready as I think late 2018 -2019 could be some opportunities for the folks who overpaid and hoped. I have seen the same thing from the SFR rentals folks way overpaying thinking they can also continue to raise the rents. Something will and has to give soon.

    • Paul Moore

      Alex,

      Thanks. You could be right. I know of a guy who is raising a hundred million just to wait for the opportunities that may come in the next few years.

      But what if the continually increasing demographics and other trends supporting multifamily continue to keep the cap rates compressed (= high prices) for a decade or more to come? It could happen.

  5. Domenick T.

    Great insights! I wonder which will have a bigger overall impact on supply and demand of rentals: the disincentive to own a home from losing the full property tax deduction or the incentive to create new rentals because of these new tax benefits.

    My guess is the incentive to build more rentals will far outweigh the disincentive to own, causing rents to steadily decline going forward. This could minimize the benefits of the tax incentives.

    What do you think?

  6. Paul Moore

    Domenick: That is a great point. Developers look carefully at occupancy rates, projected occupancy (generally referred to as “Absorption Rates”), future interest rates, etc. So it may cause more development but that future development will still be subject to these other issues that will always be accounted for. Good thinking!

  7. Paul B.

    “I’m calling on multifamily syndicators and individual investors to never knowingly……….bank on it’s appreciation potential at the expense of its current and projected cash flow.”

    Buying for appreciation is a strategy just like buying for cash flow is. It’s just important to understand the risks involved, and communicate those risks to your investors.

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