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Tax reform should attract new capital to commercial real estate

The commercial real estate industry clearly came out on top in the tax law overhaul.

In addition to preserving most of the existing tax benefits for investors, the Tax Cuts and Jobs Act provides a few new perks as well.

Early drafts of the legislation limited the deductibility of interest — of key importance to a market that relies heavily on debt to fund purchases. Legislators were also looking at eliminating so-called like-kind exchanges, which allow sellers of commercial property to postpone paying tax on any capital gain if they reinvest the proceeds in a similar property.

The exceptions for real property and businesses in the final bill President Trump signed into law at the end of December were lauded as a triumph at the Commercial Real Estate Finance Council’s annual conference in January, according to participants.

The CRE Finance Council and numerous other real estate-oriented organizations had lobbied Congress intensively, warning that losing either provision would damage valuations and capital availability, this slowing overall economic activity.

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The Internal Revenue Service (IRS) headquarters stands in Washington, D.C., U.S., on Friday, Oct. 20, 2017. President Donald Trump's top legislative priority took a major step forward as the Senate narrowly approved a budget vehicle for tax cuts -- but sharp divides over an array of non-binding amendments revealed the towering challenge he faces from here. Photographer: Andrew Harrer/Bloomberg

“What’s important is the continued ability for commercial and multifamily real estate transactions to act as major drivers of U.S. economic growth,” Lisa Pendergast, the trade group’s executive director, said in a November statement.

Now, the in addition to benefiting from a lower corporate tax rate, business can continue to deduct all of their interest, with an important condition. They may elect instead to depreciate their assets at an accelerated rate. And the taxes for so-called pass-through businesses — a common real estate investment vehicle — were also reduced. So instead of restricting investment, the new tax code is likely to attract more capital to commercial real estate.

Interest Deduction

The Tax Cuts and Jobs Act limits the deduction for net business interest expense to 30% of adjusted taxable income, but real property trades or businesses are eligible to elect out of the limitation. The exception is defined broadly to include any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. “The congressional report describing the law makes clear that the exception is not limited to rental businesses and that it applies to the management of real estate,” the tax practice group of law firm King & Spalding said in a Jan. 12 client alert.

There’s a catch, however.

Businesses that make this election are required to use the generally less-favorable alternative depreciation system for most types of real property and certain improvements. And in the case of a partnership, the net interest expense disallowance would be determined at the partnership (and not the partner) level.

And it’s unclear if so-called corporate blockers that hold nothing but a direct or indirect interest in a real estate investment trust will qualify, according to King & Spalding. To ensure that the election out of the interest deductibility limits is available, these investors will want to invest below the REIT level. Even in that case, it is somewhat unclear whether the real estate exception will allow partners to be attributed the real estate business of their partnerships.

“This is an issue where additional guidance from the Internal Revenue Service and Treasury will be needed,” the report states.

Accelerated writedown

The reason that real estate businesses may not elect out of the 30% limit for interest deduction is that they may instead choose to immediately write-off of the cost of many asset purchases — generally tangible property that has a depreciation recovery period of 20 years or less under current law.

So there is a big trade-off.

“You have to make a calculation, based on whether you are a low leveraged or highly leveraged business, what’s worth more,” said Jonathan Talansky, a partner in the tax, real estate and mergers and acquisitions practices at King & Spalding.

The accelerated depreciation is available for property acquired or placed in service after Sept. 27, 2017 and before Jan. 1, 2023, with a gradual phase-out of expensing after that. After five years of 100% expensing, the rate will phase out at to 80%, then 60%, then 40% and then 20% rates over the ensuing four years.

(It is still unclear a whether a partner of a partnership that does not use accelerated depreciation schedule can still benefit from the exemption if the partner itself depreciates its property using the accelerated depreciation schedule, according to King & Spalding.)

REIS predicts that allowing business to immediately expense many asset purchases could spur new construction over the next few years. “There is the possibility that cash-rich corporations may choose to overinvest in real assets and development in the next five years, stimulating supply growth in moribund sectors like office and retail,” the commercial real estate data and analytics company warned in December.

REIS thinks that this could raise construction costs, which will force businesses to reassess the economic prospects of their specific industries. “With the threat of e-commerce still [damping] demand for brick and mortar retail space, for example, it seems unlikely that there will then be a rush to build or buy new malls just because businesses can now deduct asset investments in the first year,” the report states.

“However, e-commerce companies that were contemplating building their own warehouse or distribution facilities could accelerate their plans.”

Like-kind exchange

While personal property is no longer eligible for tax-free exchanges, this perk is still available to real commercial property that is not held primarily for sale — a clear win for investors who frequently use this technique to exit investments while deferring the tax gain.

Like-kind exchanges are particularly important to real estate investment trusts, which both invest directly in commercial real estate and underwrite mortgages for sale to CMBS conduits. REITs are required to distribute their taxable income in order to avoid corporate tax, so like-kind exchanges permit them to reallocate and grow their portfolios without being required to distribute capital.

Like-kind exchanges also allow REITs to manage the recognition of a capital gain under the Foreign Investment Real Property Tax Act (FIRPTA), which requires a buyer to withhold a portion of the sale price of a property acquired from a foreign holder.

Pass-through deduction

The biggest real estate developers and investors rely extensively on limited liability corporations and partnerships. These entities, which don’t pay income taxes at the corporate level, but pass them along to individual members, benefit from a new 20% deduction — another boon to the industry.

Ordinary REIT dividends qualify for the same 20% deduction, resulting in an effective maximum income tax rate of 29.6% on such dividends. What’s more, the deduction for REIT dividends is not subject to the same limitations as the deduction for pass-throughs. So while both pass-throughs and REITs are better off, REITs are still relatively better off.

In fact, the tax changes could prompt restructuring as investors convert to what is now the optimal structure for them. More owners may opt to form LLCs or other partnerships to benefit from the deduction, for example.

“It used to be prohibitively expensive for a business structured as a corporation to covert to another structure,” Talansky said. “Any deemed gain on the sale of assets by the corporation was be taxed at the 35% corporate rate.”

Now, exiting a corporate structure is less costly in light of the new, flat 21% rate, especially if the corporation has accumulated net operating losses, he said. Conversely, businesses that do not distribute earnings may wish to convert into a corporate structure as a result of the more favorable corporate tax rate.

However, hedge funds and private equity funds, also important investors in commercial real estate, can continue to treat carried interest as a capital gain, rather than income, though there is now a three-year holding period to qualify. This new rule applies to partnership interests received in exchange for services performed as part of an investment management trade or business.

No relief from FIRPTA

There’s one change the commercial real estate has been lobbying for that did not make it into the Tax Cuts and Jobs Act: relaxation of restrictions on foreign investment. FIRPTA, which was put in place in the ‘80s, made real estate investment for non-U.S. investors particularly expensive for tax purposes. It requires purchasers of a property from a foreign seller to withhold a percentage of the amount realized on the sale.

Over time, the restrictions have been relaxed, and a significant amount of commercial real estate has been purchased by foreign investors over the last 25 years for investment purposes, despite the act, providing a fillip for the market. Still, some people are hoping for more comprehensive relief.

“There’s been talk about repealing FIRPTA for a while,” Talansky said. "FIRPTA has its roots at a time when there was sensitivity about foreign investment in U.S. real estate. The market has changed, people are not only more comfortable with foreign investment in U.S. real estate, a lot of developers depend on foreign money.”

Still, “that does not mean that there is sufficient political will to completely repeal FIRPTA. Plus, various amendments to FIRPTA have been made over the past two to three years that broaden some of the exemptions and generally facilitate inbound U.S. real estate investment.”

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