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.

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)

Smarter Housing Tax Breaks

Matt Rossman has posted a timely article, In Search of Smarter Homeowner Subsidies, to SSRN just as Congress debates the future of the mortgage interest deduction and other tax perks of homeownership. The abstract reads,

Critics have long assailed the federal tax code’s homeowner subsidies as lucrative tax breaks for upper income households that are essentially worthless to lower income households financially constrained from purchasing a home. This article examines the subsidies through a different lens and reveals another serious flaw that has received little attention. It demonstrates how the homeowner subsidies do very little to contain the negative housing externalities that other federal policies seek to abate and, worse yet, probably undermine these policies by subsidizing behavior that exacerbates the externalities. These policies are wide-ranging and include: (i) combating blight, deterioration and public health risks in disinvested housing markets, (ii) decreasing economic and racial housing segregation, and (iii) lessening environmental degradation that results from housing choices, while reducing the vulnerability of those who reside in environmental hotspots.

This article provides several explanations for this disconnect. Among these is an idealization of homeownership, reflected in the tax code, which sees only its positive externalities. Accordingly, the tax code subsidies reward homeowner decisions at large and without regard to the negative externalities that often follow from homeowner location and form decisions. This serves as the basis for this article’s contention that the current subsidies are not “smart.”

This article then explores whether and how the homeowner subsidies might be made smarter. Applying public finance research on the track record of more targeted, development subsidies at the state and local levels, the article identifies three conceptual legal models for smarter subsidies. It also identifies a host of accompanying challenges, many related to trying to tackle multiple housing externalities that vary across and within thousands of different localized housing markets. The article calls attention to the recent revolution in the quantity, quality and access to market, submarket and property specific real estate data, which is fueling a significant uptick in the sophistication of strategic housing planning at the community level. These advances may be the best reason to think that smarter federal homeowner subsidies are possible. This article closes by suggesting that Congress authorize HUD to pilot a program of community-specific homeowner subsidies, seeking to foster community level innovation that might later be more broadly adaptable.

The article challenges us to think of tax reform as an opportunity to do more than just move money up or down an income bracket:

The prospect of smarter homeowner subsidies is tantalizing. When considering the sheer scale of what the federal government currently invests in homeowner subsidies that inure primarily to the benefit of higher income households and are completely insensitive to negative housing externalities, it is difficult not to wonder what a more carefully considered system of allocating subsidies might yield. If done right, a powerful tool could be added to the mix of federal housing strategies. (59)

The current state of affairs in DC does not give me much hope that Congress has the stomach to think big about housing tax policy right now, but this article will provide much food for thought when it does.

Republicans and the Mortgage Interest Deduction

photo by Nick Youngson

There is a lot to hate in the Republican tax reform plan contained in the proposed Tax Cuts and Jobs Act. (click here for a summary and here for the text of the bill itself). Overall, the bill is extraordinarily regressive, heavily favoring the wealthy. There will, of course, be all sorts of compromises to this proposal as Republicans work to get it passed. But it is worth highlighting what is good about the bill as it would be a shame to lose sight of it while the sausage is being made in Congress.

The best real-estate related provision from a policy perspective is the reduction of the mortgage interest deduction. In a section of the summary with the Orwellian title, Preserving the Mortgage Interest Deduction, the Republicans outline how they will slice the deduction in half:

For so many Americans, buying a home is often the largest investment – and perhaps most important – investment they will make in their lifetime.

The Tax Cuts and Jobs Act will continue to support the American dream of homeownership by preserving the Mortgage Interest Deduction.

This ensures that hardworking families can continue to access this important tax relief as they buy, own, and maintain their home.

Policy Specifics

• Increasing the standard deduction means a simpler, fairer, and flatter tax code in which fewer taxpayers need to go through the trouble of determining whether they should itemize.

• Under the Tax Cuts and Jobs Act, taxpayers will still be able to deduct mortgage interest in excess of the standard deduction, in combination with other remaining itemized deductions, including charitable contributions and property taxes.

• The mortgage interest deduction would be available for interest paid on new mortgages for up to $500,000 in home acquisition indebtedness on principal residences.

• For existing mortgages, the plan allows for current law deduction on indebtedness of up to $1,000,000 and up to $100,000 in home equity to help taxpayers who may have relied on the current mortgage-interest deduction.

How This Policy Helps the American People

Preserving the home mortgage – and the deduction for state and local property taxes – will help more Americans of all income levels achieve the American dream of homeownership. (15-16)

This plan would cut the principal amount of a mortgage that would be eligible for the mortgage interest deduction from the current maximum of $1,000,000 to $500,000. Given that wealthy households generally take the mortgage interest deduction more often and get more bang for their buck from it, it is a regressive aspect of the tax code.

It is striking that a provision with such broad support such as the mortgage interest deduction is actually on the table. It will be interesting to see how special interests in the real estate industry will respond. My bet is that at the end of day the deduction will remain mostly untouched, even though this particular Republican proposal makes good policy sense.

Rental Housing Landscape

A Row of Tenements, by Robert Spencer (1915)

NYU’s Furman Center released its 2017 National Rental Housing Landscape. My two takeaways are that, compared to the years before the financial crisis, (1) many tenants remain rent burdened and (2) higher income households are renting more. These takeaways have a lot of consequences for housing policymakers. We should keep these developments in mind as we debate tax reform proposals regarding the mortgage interest deduction and the deduction of property taxes. When it comes to housing, who should the tax code be helping more — homeowners or renters?

The Executive Summary of the report reads,

This study examines rental housing trends from 2006 to 2015 in the 53 metropolitan areas of the U.S. that had populations of over one million in 2015 (“metros”), with a particular focus on the economic recovery period beginning in 2012.

Median rents grew faster than inflation in virtually every metro between 2012 and 2015, especially in already high rent metros.

Despite rising rents, the share of renters spending more than 30 percent of their income on rent (defined as rent burdened households) fell slightly between 2012 and 2015, as did the share spending more than 50 percent (defined as severely rent burdened households). Still, these shares were higher in 2015 than in 2006, and far higher than in earlier decades.

The number and share of renters has increased considerably since 2006 and continued to rise in virtually every metro from 2012 to 2015. Within that period, the increase in renter share was relatively larger for high socioeconomic status households. That said, the typical renter household still has lower income and less educational attainment than the typical non-renter household.

Following years of decline during the Great Recession, the real median income of renters grew between 2012 and 2015, but this was primarily driven by the larger numbers of higher income households that are renting and the increasing incomes of renter households with at least one member holding a bachelor’s degree or higher. The real median income of renter households with members with just a high school degree or some college grew more modestly and remained below 2006 levels in 2015.

Thus, the recent decline in the share of rent burdened households should be cautiously interpreted. The income of the typical renter household increased as the economy recovered, but part of this increase came from a change in the composition of the renter population as more high socioeconomic status households chose to rent their homes.

For almost every metro, the median rent in 2015 for units that had been on the market within the previous year was higher than that for other units, suggesting that renters would likely face a rent hike if they moved. The share of recently available rental units that were affordable to households earning their metro’s median income fell between 2012 and 2015. And in 2015, only a small share of recently available rental units were affordable to households earning half of their metro’s median income. (3, footnote omitted)

Is Trump a Negative for the Housing Market?

TheStreet.com quoted me in Is Trump a Negative for the Housing Market? It opens,

At first blush, real estate industry professionals saw a lot to like with the election of Donald Trump to the presidency. Trump was and is pro-business, and he made his billions in the commercial real estate sector. This, real estate pro’s thought, is a guy who has the industry’s back.

But not every real estate specialist views the Trump presidency as a net positive.

Take Tommy Sowers, from GoldenKey, a real estate technology platform with locations in San Francisco and Durham, N.C.

Sowers holds a “strong belief” that President Donald Trump will actually be detrimental for the real estate industry, making it less affordable for Americans to buy homes.

“During the campaign, Donald Trump spoke about home ownership numbers being the lowest they have ever been since 1965 at 62.9%,” says Sowers. In a nation where homeownership is seen as synonymous with the American dream, it’s no surprise that he wanted to highlight this low rate and suggest ways to increase it, he says. “The reality is that his policies and actions indicate the opposite,” he says.

Sowers lists several reasons why Trump may not be the industry savior some real estate professionals might have counted on:

Rising interest rates – “While this responsibility sits with the Federal Reserve, which has kept interest rates low in recent years, Trump has blasted them for doing this stating that they are ‘creating a false economy,'” Sowers explains. “Most economists predict that interest rates will now rise in 2017.”

Dismantling Government Sponsored Enterprises (GSEs) – “During the 2008 financial crisis, the taxpayer bought out Fannie Mae and Freddie Mac and now under government control they play a greater role than before the crisis in sustaining real estate sales and providing liquidity to the housing market,” Sowers says. “Trump wants to privatize them – a shake up to this arrangement could mean that banks stop offering the lower cost 30-year fixed rate mortgages.”

Cutting FHA home insurance – This was one of Trump’s first acts in office, making it more expensive for borrowers to insure their homes, Sowers notes. “His pick for Treasury Secretary, Steve Mnuchin, wants to limit the mortgage interest deduction,” he adds. “This may not impact the average US homebuyer but in many areas across the country the average home is above the threshold of $500,000.”

Immigrant confidence – “We are a nation of immigrants and many are here legally with green cards,” Sowers states. “His latest immigration policy has sent shock waves to foreign investors and will likely stunt confidence in immigrants that are here legally from buying a home.” President Trump has said he hopes to encourage further building with the National Association of Home Builders, he adds. “However, with so many immigrants working in the construction industry, his policies are likely decrease the speed of development,” Sowers says. “With less new homes being built, people are likely to wait and not move or buy a new house.”

There are other areas of concern, experts say. For example, reducing government regulations may thrill real estate professionals, along with buyers and sellers, but industry experts say that will actually hurt the U.S. housing market.

“Trump’s commitment to weakening the Consumer Financial Protection Bureau and the consumer protection provisions of the Dodd-Frank Act will have a harmful impact on the housing market in the long run,” predicts David Reiss, a law professor at the Brooklyn Law School, in Brooklyn, N.Y.

Reiss says Trump and his allies argue that Dodd-Frank has cut off credit, but the numbers don’t bear that out. “Mortgage rates are near their all-time lows,” he says. “Dodd-Frank, which created the CFPB and mandated the Qualified Mortgage and Ability-to-Repay rules, put a brake on most of the predatory behavior that characterized the mortgage market before the financial crisis. Getting rid of Dodd-Frank and the CFPB may loosen mortgage lending a bit in the short term, but in the long term it will allow predatory lenders to return to the mortgage market, big-time.”

“We will the see bigger booms followed by bigger busts,” he adds. “That kind of volatility is not good for the housing market in the long term.”