Tax reform has become a central focus on the “what’s ahead” discussions swirling around President-elect Trump’s agenda. That topic has moved to the forefront for good reason. The commercial real estate industry, and the country, could be on the verge of the first substantive tax reform since 1986.
Commercial real estate did not come out as a big winner in the Tax Reform Act of 1986, and reforms have been on the agenda for years with no tangible changes to the tax code. That could very well change under a Trump administration with Republicans in control of the House, Senate and White House for the first time in a decade.
“I think there is definitely rational reason for optimism on tax reform,” says John Gimigliano, head of the federal tax legislative group at the audit, tax and advisory firm of KPMG LLP. The cautionary note is that even with those planets aligned there are a million ways that tax reform could fall apart, says Gimigliano.
The overarching theme behind current tax reform is a desire to reduce overall tax rates. There is an especially keen focus on reducing the corporate tax rate from its current level of 35 percent down to 20 percent or even 15 percent. “That is largely driven by a goal of making U.S. businesses more globally competitive,” says Gimigliano. On the individual side, another goal is to dramatically simplify the process of complying with the tax code.
“The Treasury Department after President-elect Trump takes office will have the opportunity to significantly impact a number of areas important to the real estate industry,” adds Tanya Thomas, a tax managing director with BDO USA. Current proposals include reforms that could both negatively and positively impact commercial real estate investors. Some of the key proposals that the industry is watching relate to changes in carried interest, property expense deductions and pass-through income.
Carried interest
One reform that could have a big negative impact on commercial real estate investors is a proposal to tax carried interest as ordinary income rather than as a capital gain. Carried interest structures are common in real estate partnerships and joint ventures and this is getting a lot of attention for good reason. It would significantly increase the tax liability for investors that receive carried interest from a real estate partnership.
In many cases, a substantial portion of the gain from a partnership comes from the sale of the property, which currently is taxed at the capital gains rate of 20.0 percent. However, there is a proposal to tax that carried interest as ordinary income at a current rate of 39.6 percent for those in the highest tax bracket. Although that rate could drop to 33 percent under Trump’s proposed rate reduction, it would still represent a substantial increase in the tax rate by either 19.6 percent or 13.0 percent.
The higher tax rate could be a big sticking point for those sponsors or general partners that depend on the carried interest as part of their compensation. If that carried interest legislation comes into play, it would become much more expensive for equity investors in real estate to compensate their joint venture partners or other executives who provide services.
In other words, the higher tax rate may cause some of those providing the “sweat equity” to ask for a higher percentage of the transaction to compensate them for the fact that their share is now being taxed at a higher rate, says Mark Van Deusen, a principal with Deloitte Tax LLP. So it could change the economics of real estate investment structures that include a bigger carve-out for sponsors and a lower net return to investors or limited partners.
“From an industry perspective, treating capital gains as ordinary income would likely have an impact on the structuring of joint ventures rather than individual passive investors,” adds Thomas. “However, it’s important to note that application of the carried interest rules is likely going to be targeted to particular areas, such as hedge funds.”
Property depreciation
Another sea change for real estate is a proposal as part of the House GOP plan that calls for immediate, full expensing on the purchase price of a building. Instead of taking depreciation deductions on building cost over many years, an investor could take a full expense write-off immediately in year one. On a related note, proposals also call for introducing limited or no ability to deduct net interest expense. So if someone bought a building and put a lot of leverage or debt on the building, the investor would not be able to deduct the interest expense.
Under today’s model, the depreciation deduction is taken over many years and there is a benefit of the interest deduction on taxable income over the life of an investment. Switching to a full expensing model allows for a huge deduction in the first year that will create a net operating loss that can be carried over into future years. “But at some point, there is going to be a cliff where you run out of the net operating loss and you are not going to be able to deduct interest,” says Van Deusen.
Essentially, an investor could jump from having really no tax on the investment as a result of not having any taxable income to having a significant amount of taxable income all at once, says Van Deusen. Although it is too soon to say what the potential impact could be on the real estate market, it certainly could influence investor hold periods and decisions to sell assets once the operating loss has burned off.
Pass-through income
Currently, income from partnerships, such as LLPs and LLCs flows through to partners and is taxed at 20.0 percent if it is a capital gain and 39.6 percent for ordinary income. Both the Trump plan and the House GOP plan have a proposal that would create a single rate (15.0 percent from Trump and 20.0 percent under the House GOP plan) for pass-through income. That would significantly change the economics for the better for investors who hold real estate through partnerships. “It is not exactly clear how that is going to play out, but it is definitely something that the real estate industry should keep an eye on,” says Van Deusen.
These tax reform proposals could see any numbers of changes and modifications as they move through the legislative process. In addition, there could be additional proposals that emerge that would directly impact the commercial real estate industry. For example, the 1031 tax code is one likely target that has not been addressed specifically by the Trump administration or the House GOP plan, but limiting or repealing 1031 exchanges has been discussed in Congress during the Obama administration. Another potential target for tax reforms are special investment vehicles, such as REITs.
“At this point, it is hard to say exactly what is going to happen. But I think there is a lot for the industry to pay attention to and be vocal about their views on as the legislative process unfolds,” says Van Deusen.