When the Tax Cuts and Jobs Act was signed into law in December, commercial real estate professionals waited to see how it would impact the industry. Talks of eliminating long-standing tax incentives like 1031 exchanges and Low Income Housing Tax Credits sent rumbles of concern among property owners and developers.

Four months into 2018, it is business as usual, according to KeyBank Senior Vice President of Real Estate Capital Chris Terlizzi. Low Income Housing Credits and Historic Tax Credits are here to stay, as are 1031 exchanges — at least for like-kind exchanges of real estate assets.

“The only real big change here is in the depreciation schedules and the cost recovery area,” Terlizzi said. “Everything else has more or less stayed the same.”

But while the Tax Cuts and Jobs Act has not done much to alter the financial side of CRE, new rules when it comes to cost recovery could sway how industry professionals go about acquiring, selling and developing assets. Slight changes to the LIHTCs and Historic Tax Credits, as well as the lowering of the corporate tax rate, could also have an indirect effect on activity within affordable development.

Low Income Housing and Historic Preservation

LIHTCs have been responsible for about 90% of all the affordable housing built in the U.S., and have led to the creation of more than 2.5 million affordable rental units. Following the lowering of the corporate tax rate from 35% to 21% under the TCJA, the credits have become less effective.

While it is still too early to tell, some experts in the multifamily sector are predicting a drop in housing production.

“The buyers of these credits tend to be corporate entities,” Terlizzi said. “When you look at the benefit that they get now under the lower corporate tax rate, it is now reduced. I don’t think anybody really knows if the lower tax rates will create a disincentive to invest in these LIHTCs.”

Historic Tax Credits also have undergone minor changes. These credits have historically offered relief from tax liabilities to developers of qualifying income-producing properties like office buildings, retail establishments and rental apartments. There is still a historic tax credit of 20% that can be taken over a five-year period in equal amounts, but the 10% deduction for buildings built prior to 1935 has been eliminated.

Historic Tax Credits have resulted in the preservation of more than 42,000 buildings and generated over $84B in economic development. Time will tell if the adjustment will disincentivize developers from using the deduction.

In major urban areas, like New York City or San Francisco, where affordable housing shortages have reached a boiling point, city officials have created local incentives to supplement federal support. Initiatives like New York’s 421-a program provide tax relief in exchange for a certain percentage of affordable units.

“Cities that are in need of affordable housing will have to look to self-help rather than rely on federal credits,” Terlizzi said.

Interest Payment Deductions 

For individual filers, the Tax Cuts and Jobs Act imposed limitations on mortgage interest deductions, capping property tax deductions at $10K for single filers. The decreased incentive to take out a mortgage could further sway taxpayers toward renting instead of buying property, which could increase demand and prove to benefit multifamily production.

At the other end of the spectrum, the luxury housing market would be negatively impacted, Terlizzi said. Whereas buyers of expensive homes could normally subsidize large loans through a tax deduction on the interest payments, that benefit has been largely diminished.

“An estimated 90% of taxpayers are probably going to see no differential between renting and buying,” Terlizzi said. “There is less of a financial incentive to buy a McMansion.”

While changes to interest deductions predominantly impact sole proprietors of assets, changes to carried interest rate deductions could affect returns on investment for project investors. Carried interest, also known as a “promoted interest,” is a financial interest provided to managers or developers as an incentive to maximize performance of a partnership’s assets or investments at a lower tax rate.

While hedge funds are the typical recipients of promoted interest, real estate partnerships also apply to developers, who receive a portion of profits from the property after investors are paid.

The carried interest requirements for capital gains treatment now have a three-year holding period. Anything under that time period would be treated as ordinary income and subject to a higher tax rate.

Qualified Improvement Properties

The most significant change to tax policy for CRE is the elimination of depreciation categories for qualified leasehold improvements, qualified restaurant property and qualified retail improvement property, unifying the categories under qualified improvement property.

QIP placed in service after 2017 is now depreciated over 15 years versus the prior 39-year life and remains eligible for bonus depreciation. The new law also provides a 20-year Alternative Depreciation System life versus the prior 40-year life.

Bonus depreciation has been increased to 100% through 2022, at which point it will decrease 20% yearly. The reform also extends and modifies bonus depreciation to allow businesses to immediately deduct 100% of eligible property placed in-service after Sept. 27, 2017, and before Jan. 1, 2023. For certain property with longer production periods, the 100% bonus depreciation is extended through Dec. 31, 2023. This creates an opportunity for investors buying property to get immediate tax benefits.

“If you buy a property, you can segregate out the QIP of that purchase and you can take bonus depreciation on that immediately,” Terlizzi said. “So you don’t have to spend money on redoing a lobby or putting in leasehold improvements.”

While the impacts of the Tax Cuts and Job Act have yet to be fully realized, CRE professionals should not look to one change over the other when assessing how tax reform will impact the industry. Terlizzi recommends a holistic approach.

“You can’t just look at individual components of the tax code, you have to look at the big picture,” Terlizzi said.

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