5 Ways New Tax Legislation Will Impact CRE Professionals
Commercial real estate, the network of industries in which President Donald Trump first amassed and now holds much of his wealth, is expected to immediately benefit from the new tax plan. CRE investors and companies, regardless of size, structure or specialty, will be largely exempt from the loophole closings aimed at offsetting reduced rates.
Provisions for interest rate deductions and deferred taxes in the plan Trump championed will generally help CRE firms, especially pass-through businesses and REITs based on a potentially favorable treatment of rental income. Here are five key ways the new tax plan will affect CRE.
1. Tax Rates Slashed For Top-Bracket Investors
Based on prior law, passive investors in the highest income bracket had their net income from rents taxed at 39.6%, plus a 3.8% Affordable Care Act tax. Under the tax bill, investors qualifying for the new 20% deduction will have their net income from rents taxed at 29.6%, plus the unchanged 3.8% ACA tax starting in 2018.
This is a substantial tax decrease that could benefit many real estate investors, according to RSM principal Don Susswein. Income that does not qualify, such as rental income on land in many cases, will be taxed at the top marginal income tax rate of 37%, plus the 3.8% ACA tax.
“In order to qualify for the full 20% deduction, the business must either pay a minimum amount of wages, typically twice the desired deduction, or have a minimum investment in tangible, depreciable property used in the trade or business, such as a building, but not including such items as land or inventory property,” Susswein said.
2. REITs Are Big Winners
The wage or asset requirements would not apply to shareholders receiving income through REITs as dividends. REIT ordinary dividends will be taxed at an all-in rate of 33.4%, rather than the 43.4% maximum tax rate on ordinary REIT dividends under previous law. This treatment should apply to mortgage REITs that pool and collect interest from real estate mortgages, according to RSM Senior Manager Andrew Cohen.
3. Interest Expense Still Deductible, But Depreciation May Change
Most real estate investments are heavily debt-financed, and under prior law interest payments would be fully deductible. The final bill imposes new limits on interest deductions for corporations and pass-through businesses. But real estate trades or business can irrevocably elect to be exempt from those rules in exchange for more restrictive depreciation timetables.
For real estate trades or businesses that do not meet a small taxpayer exception or opt out of the business-interest limitations, the rules would prevent many taxpayers from being able to deduct their entire amount of interest in the year incurred. Unused interest deductions can be carried forward indefinitely and be used to offset future items of income.
4. Like-Kind Exchanges Preserved
Although the fate of the like-kind exchange appeared to hang in the balance with this new tax legislation, the key section 1031 provision remains. It allows investors to defer capital gains taxes on the sale of a property if they reinvest the proceeds in a new qualifying property.
“The allowance of tax-free like-kind exchanges of rental real estate is preserved under section 1031 of the tax code, but it is not clear how such exchanges would interact with the asset test used in the new pass-through income deduction,” Cohen said.
5. Changes To Carried Interest
Under the final bill, carried interest in certain activities, like private equity, real estate private equity and hedge funds, would only receive capital gains treatment if the assets generating the gain were held for three years. This is longer than the prior one-year holding period.
“It appears that this rule applies to the asset generating the gain, whether it be a partnership interest or the underlying assets,” Susswein said. “It may be appropriate to consider possible structural or deal modifications to maximize after-tax benefits under this rule.”
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