The Impact of Tax Reform on The Real Estate Sector

photo by Sergiu Bacioiu

Congress passed the tax reform act on December 20, 2017 and President Trump is supposed to sign it by the end of the week. A lot of ink has been spilled on the impact of tax reform on homeowners, but less on real estate as an investment class. It will take lawyers and accountants a long time to understand all of the in ands outs of the law, but it is pretty clear that commercial real estate investors will benefit significantly. Most of the provisions of the act are effective at the start of the new year.

Homeowners and the businesses that operate in the residential real estate sector will be impacted in various ways (the net effect on any given taxpayer will vary significantly based on a whole lot of factors) by the increase in the standard deduction; the limits on the deductibility of state and local taxes; the shrinking of the mortgage interest deduction; and the restrictions on the capital gains exclusion for the sale of a primary residence. There are tons of articles out there on these subjects.

The impact on real estate investors has not been covered very much at all. The changes are very technical, but very beneficial to real estate investors. There are a couple of useful resources out there for those who want an overview of these changes. The BakerBotts law firm has posted Tax Reform Act – Impact on Real Estate Industry and the Seyfarth Shaw law firm has posted Tax Reform for REITs and Real Estate Businesses.

To understand the impacts on the real estate industry in particular, it is important to understand the big picture.  The new law lowered the highest marginal tax rates for individuals from 39.6% to 37% (some individuals will also need to pay unearned income Medicare tax as well). The highest marginal tax rate applicable to long-term capital gains stays at 20% for individuals. The other big change was a reduction in the corporate tax rate to 21%. Because qualified dividends are taxed at 20%, the effective tax rate on income from a C corp that is distributed to its shareholders will be 36.8% (plus Medicare tax, if applicable).

Benefits in the new law that particularly impact the real estate sector include:

  • REITs and other pass-through entities are eligible for as much as a 20% deduction for qualified business income;
  • favored treatment of interest expense deductions compared to other businesses;
  • Real estate owners can still engage in tax-favored 1031 exchanges while owners of other assets cannot; and
  • Some types of commercial real estate benefit from more favorable depreciation provisions.

While it is clear that real estate investors came out ahead with the new tax law, it is not yet clear the extent to which that is the case.

What’s with 1031 Exchanges?

photo by www.rentalrealities.com

US News & World Report quoted me in Why 1031 Exchange Investments Are Worth a Look. It opens,

With tax reform nearing final passage in Congress, one of the most underlooked, but potentially overpowering, tax-advantaged investment tools is the 1031 exchange, which was spared major changes in the proposed legislation.

The 1031 exchange, especially when related to real estate investments, is all about “timing and taxes” and the better you manage the two, the more money you can make.

What is a 1031 exchange? By and large, IRS Section 1031 covers “exchanges” or swaps of a specific investable asset (such as real estate) for another. The end game for the taxpayer/investor is to avoid having exchanges listed as taxable sales. But if they’re executed within the confines of a 1031 exchange, taxes are either significantly reduced or eliminated altogether.

The primary benefit of 1031 exchanges related to real estate investments is tax deferral, or avoidance of capital gains taxes on the sale of appreciated investment property, says Kevin O’Brian, a certified financial planner at Peak Financial Services, in Northborough, Massachusetts.
“If held inside owner’s estate at death, the asset would receive a step-up in cost basis to the market value, as of the date of death,” O’Brian says. “Therefore, heirs could avoid capital gains taxes, if sold after inheriting it as well.”
Others note that following IRS guidelines on Section 1031 are a must.
“1031 exchanges allow a real estate investor to sell one property that has appreciated in value and not pay capital gains tax so long as the investor buys another property,” says David Reiss, a professor at Brooklyn Law School. “This is a powerful tax deferral tool that many sophisticated real estate investors use. It is, however, somewhat complicated to pull off and involves some additional costs and planning so it is not for those looking for a quick and easy way to defer capital gains.”
What are the rules for a 1031 exchange? The rules governing 1031 exchanges have to be followed carefully and it makes sense to plan for it with an appropriate team of professional advisors and a reputable 1031 exchange company, Reiss says.
“Generally, the investor needs to sell the property that has appreciated in value; place the proceeds in escrow with an intermediary; and then use those proceeds to buy a replacement property within a certain period of time,” he says. “If the investor fails to follow the requirements for the exchange, he or she may be taxed on the full capital gain.”
Investors should also be sure to use a 1031 exchange company that meets specific criteria. “Not the least of which is that it’s properly insured to protect you in case your funds disappear from escrow,” Reiss says. “This has been known to happen.”

The Impact of Tax Reform on Real Estate

Cushman & Wakefield have posted The Great Tax Race: How the World’s Fastest Tax Reform Package Could Impact Commercial Real Estate. There is a lot of interesting insights in the report, notwithstanding the fact that ultimate fate of the Republicans’ tax reform is still a bit up in the air. Indeed, C&W estimates that there is a 1 in 5 chance that a bill will not pass this year.

Commercial Real Estate

C&W states that history

suggests that tax law changes by themselves are often not key drivers for transactions or for investment performance. However, there is likely to be a period of transition and market flux as investors restructure to optimize tax outcomes with implications for the underlying asset classes. Corporations are likely to separate the real estate aspects of their businesses. (2)

The commercial real estate industry is largely exempt from the biggest changes contained in the House and Senate bills. 1031 exchanges, for instance, have not been touched. C&W sees corporations being big beneficiaries, with a net tax cut of $400 billion over the next 10 years; however, they “anticipate that the tax cut will be preferentially used to return capital to shareholders or reduce debt, rather than to increase corporate spending.” (2)

Residential Real Estate

C&W sees a different effect in the residential real estate sector, with a short-term drag on home values in areas with high SALT (state and local tax) deductions, including California, NY and NJ:

The drag on home values is likely to be largest in areas with high property taxes and medium-to-high home values. There is also likely to be a larger impact in parts of the country where incomes are higher and where a disproportionate proportion of taxpayers itemize. Both versions of the tax reform limit property tax deductibility to $10,000. While only 9.2% of households nationally report property taxes above this threshold, this figure rises to as high as 46% in Long Island, 34% in Newark and 20% in San Francisco according to Trulia data.

The Mortgage Bankers Association (MBA) estimates that 22% of mortgages in the U.S. have balances over $500,000, with most of these concentrated in high costs areas such as Washington, DC and Hawaii—where more than 40% of home purchase loans originated last year exceeded $500,000. This is followed by California at 27%, and New York and Massachusetts at 16%. (6)

C&W also evaluated tax reform’s impact on housing market liquidity and buy v. rent economics:

The median length of time people had owned their homes was 8.7 years in 2016—more than double what it had been 10 years earlier. Now that interest rates have begun to tick upward from their historic lows, the housing market may face a problem called the “lock-in” effect, where homeowners are reluctant to move, since moving might entail taking out a new mortgage at a higher rate. This leads to the possibility of decreasing housing market liquidity in high-priced markets.

All things considered, the doubling of the standard deduction and the cap on the property tax deduction is likely to have the largest impact on the buy vs. rent incentive, especially as it seems likely that there will be minimal changes to the mortgage interest deduction in any final tax reform bill. (7-8)