Part 4 in the Realized Series "2017 Tax Reform Impact on Real Estate"
Much of the recent news coming from President Donald Trump’s administration has been focused on healthcare and the wall. Though Trump tax reform has been on the back burner, there are indications that Congress and the President will begin the process of tax overhaul in fall 2017. It’s uncertain how tax reform will impact the overall economy. However, based on the limited information we have, tax reform could have a profound change on how you invest, and what type of capital might make the most sense.
The Blueprints – An Overview
In June 2016, the GOP issued a blueprint entitled “A Better Way: A Pro-Growth Tax Code for All Americans” (the “Blueprint”). And, less than a year later, in April 2017, President Trump released a one-page document, “2017 Tax Reform for Economic Growth and American Jobs.” Both documents promise to slash corporate taxes and consolidate tax brackets, making the process of filing a tax return much easier. And, both propose huge changes to the accounting treatment of debt, which many consider the life blood of investments.
Homeownership Mortgage Interest Deduction
The Potential Change: Right now, when you buy a property used as your primary residence, and finance it with a bank loan or other debt source, you can claim the interest portion of your payments (up to certain limits) as an expense against your taxable income. But under the GOP blueprint, that deduction goes away1.
The Potential Impact: According to the Blueprint, historical data indicates that the strength of the US housing market is more closely correlated with the strength of the US economy than to specific tax policies2. Following that line of logic, Americans will continue to buy homes based on their stage of life and outlook on the stability of their jobs and general economy.
Our Take: At Realized, we feel this potential change would have a minimal impact on the housing market. I have yet to meet a single person who considered the mortgage interest deduction as a major factor in purchasing their primary residence and would be very surprised if potential homeowners did not go through with a purchase if it were eliminated.
Investment Mortgage Interest Deduction
The Potential Change: Now, let’s assume you buy a property, but this time as an investor and you decide to use debt to finance its acquisition or capital expenditures. As it stands today, you can deduct the interest portion of your debt payments. These deductions generally can only be used to offset passive income (above certain allowances for actively managed real estate). Under the proposed terms of the Blueprint, again you might be out of luck taking those interest deductions3.
The Potential Impact: For a tax-exempt investor, such as a pension fund, this may have very little direct impact. However, for everyone else, as a stand-alone change, the elimination of mortgage interest deduction potentially changes the landscape of real estate investing. Generally, commercial real estate investors and developers prefer debt, rather than equity, to finance projects for very good reasons. Equity payments can’t be deducted from taxable income. And, if syndicating the equity, the investor/developer likely will give up at least partial ownership of a real estate project.
In a world without mortgage deductions, debt might not be quite so attractive. The investor is left with the same pre-tax expense but without the income tax shelter component they are accustomed to. If desired investor after-tax returns remain unchanged, this could potentially lead to flattening or decreasing real estate prices as investors need to achieve greater pre-tax returns in order to result in the same after-tax returns.
Our Take: What is the developer/investor’s alternative? Real estate investments often carry relatively high dollar amounts, and simply contributing additional equity may not be feasible for many investors. Additionally, equity is typically more expensive than debt, and the use of leverage potentially enhances appreciation without giving up more of the upside as discussed above.
If we isolate the elimination of mortgage interest deduction as the only major tax change to the real estate industry, we may see a pricing adjustment in the near term as sophisticated investors seek the same after-tax returns. However, holding all else equal, real estate still benefits from two attractive tax shelters - depreciation and the 1031 exchange - meaning, even with the elimination of mortgage interest deductions, real estate may still be a more tax-efficient investment. It won’t take too long before investors adjust to the new system and will either need to take more risk to achieve the same after-tax returns, or accept lower (after-tax) yields within their risk parameters.
Offsetting Forces: Other Elements of the Blueprint
The above analysis assumes that the elimination of the mortgage interest deduction is the only major tax code change to the real estate industry. However, the Blueprint actually proposes two other potentially major changes: immediate expensing and carry forward of net operating losses (NOLs)4.
The Potential Change: The Blueprint proposes “immediate expensing” or (aka “direct expensing”) of capital equipment or other investments, including real estate in the year of the purchase or improvement. Under the proposal, this treatment would eliminate and replace the depreciation. Instead of accounting for a physical asset’s loss in value over time, as is currently the case, investors could instead claim the full amount as an expense at the time of its purchase. By way of example, rather than depreciating $1,000,000 of basis in an apartment building over 27.5 years, the full $1,000,000 would be treated as an expense in the first year.
The Potential Impact: Paired with traditional operating expenses, this almost certainly results in taxable losses in the early years. Losses would be magnified through the use of debt, potentially resulting in many years of taxable losses. This brings us to carry forward of NOLs.
Carry Forward of NOLs
The Potential Change: The Blueprint proposes the carry forward of NOLs indefinitely, until exhausted. Keeping with the example above, the taxable losses incurred could be carried forward and used to offset future income, reducing tax liability on future earnings.
The Potential Impact: As NOLs are exhausted, the investor’s income statement suddenly shifts from excess taxable losses to no income tax shelters at all. This is potentially a drastic change from the more gradual “burn off” in income tax shelters currently typically exhibiting in real estate investments. The potential solution? Sell the asset and buy a new one in order to “restart the clock” on losses. This potentially leads to a much higher transaction volume and “churning” of assets for tax shelters.
Our Take: Immediate expensing and carry forward of NOLs have the potential to be “game changers” in the real estate industry. Far more so than the elimination of mortgage interest deduction. In Part 5 of our series we will address these proposed changes in greater detail.
Conclusion: Too Soon to Tell
In truth, it is too soon to determine the impact of tax reform. We simply don’t know enough at this time. As with any major government bill, the proposals within the Blueprint are subject to change and it’s impossible to tell what the final result will be. But, if reform is based on what’s already released, it could vastly change the way in which individuals and companies invest in commercial real estate.
1,2 “A Better Way: A Pro-Growth Tax Code for All Americans.” Page 20
3,4 “A Better Way: A Pro-Growth Tax Code for All Americans.” Pages 25-27
What is a 1031 Exchange?
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