A lot has been written about the new Tax Cuts and Jobs Act (TCJA) and its potential implications for the real estate investment industry since the law was passed on Dec. 22 of last year. I’m not a tax expert by any stretch, or a prognosticator of market dynamics; however, as an owner of one of the most active real estate investment brokerage firms in Chicago, I can speak somewhat to the legislation’s tax benefits to, and potential implications for, our clientele. In general, the new tax act’s changes, and lack thereof, appear to be beneficial to the industry.
Several primary tax laws have a direct impact on investors’ economic interests: capital gains, the 1031 exchange, the step-up in basis rule, depreciation, operating-expense deductions, pass-through entities, and carried interest. The loss of any one of these could influence the decision to complete a transaction. In addition, changes to individual income taxes and mortgage interest deductions could have a significant, albeit indirect, effect on the housing industry.
Let’s look at how each of these tax laws individually will be affected, if at all, by the TCJA.
Capital Gains Rate
Long-term capital gain is defined as the increased value of assets held more than one year. Short-term capital gains are taxed as ordinary income and are defined as gains made on assets held for one year or less. Since 1922, the maximum long-term capital gains tax rate has ranged from 12.5% (1922–33) to 35% (1972–77 and 1979). The lowest in recent history was 15% (2003–12), and currently it’s 20% (since 2013).
Since the installation of the new administration, there’s been speculation about reducing the rate again to encourage investment. The TCJA, however, left the long-term capital gains rate unchanged, at 20%, and also didn’t change how short-term capital gains are taxed. Although lower ordinary income taxes improve the economics for assets held less than one year, the overall tax benefit of holding longer is much greater.
The 1031 Exchange
Prior to the new tax act, Section 1031 of the tax code allowed for real and personal property held for business or investment to be exchanged for “like-kind” property without recognizing a gain. Instead, the gain was deferred for tax purposes. It’s estimated that real estate accounts for 36% of all 1031 exchanges and that approximately 10% to 20% of real estate transactions utilize the 1031.
Upon sale, an investor would be subject to capital gains and depreciation recapture. Thus, the 1031 exchange effectively enables an investor to defer these taxes. The TCJA eliminated the 1031 exchange for personal property, but, the good news is, the law left it intact for real property.
Step-Up in Basis
Closely related to the tax benefits discussed above is the step-up in basis tax rule. Upon death, beneficiaries receive a “step-up” in basis. In other words, the cost basis for beneficiaries becomes the current fair market value at the time of inheritance. This eliminates taxable appreciable gain between the original cost and the current value. The new tax act did not repeal or modify this rule. Essentially, those “lucky” enough to have died having always exchanged, or never selling, successfully avoided paying taxes on these assets.
Tax law allows for a reduction in taxes resulting from the gradual obsolescence of various investment assets. The deduction, referred to as depreciation expense, can be applied to buildings, improvements, and personal property but not land. Real property depreciation is calculated instead using a straight-line accounting basis. The tax law, before and after the TCJA, allows for multifamily property to be depreciated over 27.5 years. Therefore, a property acquired for $30 million with land value of $2.5 million can provide a depreciation expense of $1 million per year.
The new law temporarily increased the allowance for what is called “bonus” depreciation, which includes personal property and improvements. The new tax act increased the bonus depreciation to 100% from 50%, all of which can be immediately expensed the year of purchase or when the work is performed. This includes appliances, carpet, mechanical equipment, and the like (“personal property”) as well as roofs, landscaping, parking lots, and so on (“improvements”). This is a substantial added incentive and should spur the improvement and rehabilitation of investment properties.
Mortgage interest, property taxes, property insurance, repairs, and maintenance are all common expenses necessary for the operation of investment properties and constitute some of the largest expenses of ownership. The cost and expense associated with them have been and apparently will continue to be deductible against the income of the property.
Pass-Through Tax Entities
Most of our clients hold their real estate investments in a limited liability company (LLC). In addition to the legal protection they provide, LLCs aren’t taxed, but, rather, the income flows through to the owners at the ordinary income tax rate. Effective Jan. 1, 2018, the new tax act reduced the maximum corporate income tax rate to 21% from 35%. In order to provide similar benefit, owners of pass-through entities, subject to certain limitations, receive a 20% reduction in their taxable income. This has the potential to provide substantial savings to investors and developers.
The change in taxation to carried interest will negatively affect real estate professionals who utilize it.
Carried interest primarily affects managers of investment partnerships and is treated as a capital gain. It’s defined as the profit such managers make in excess of the return on their contribution, if any (also known as a “promote” or “profits interest”). The old law required investments to be held for over one year to qualify. The new law requires that these assets be held for at least three years; otherwise, they’ll be taxed at the ordinary income tax level.
Many investment managers base their performance on an internal rate of return (IRR). The more quickly their objectives are met, the higher the IRR. The result of this tax change will likely reduce some managers’ pursuit of assets that can be quickly flipped for a profit.
In addition to the above, the tax reform act lowered individual income taxes, reduced the mortgage interest deduction, and removed the interest deduction for home equity loans. Lower income taxes may put more money in consumers’ pockets, but the change in interest deductions could motivate would-be home buyers to rent instead. The combination of these changes could be an additional boon to the multifamily investment industry.
Note: This article isn’t meant to be exhaustive, as there are many nuances to the above tax laws. Nor is it meant to be definitive in terms of the information provided. It is only one, fairly active real estate investment practitioner’s understanding. Investors should always consult their respective tax counsels before making investment decisions.