The highly anticipated tax reform recently signed into law by President Trump retained numerous key commercial real estate provisions.
This consistency in tax law will enable investors to move forward with most of their existing investment strategies. That said, there are many provisions in the new tax law that will have a more nuanced effect on the sector, and these more subtle adjustments could create significant new opportunities for investors.
Apartment demand likely to rise
Previous tax rules created an economic incentive to purchase a home through itemized deductions. If the mortgage interest and property taxes exceeded the old standard deduction of $12,700 for married couples ($6,350 for individuals), then taxpayers received a reduction to their taxable income that effectively offset a portion of the housing payment. The threshold home price to receive this benefit naturally depended on interest rates and local property tax rates, but was in the $200,000 range for married couples. Under the new tax law, the standard deduction has been raised to $24,000 for married couples ($12,000 for individuals) and, as a result, the threshold home price to benefit from itemized deduc- tions has increased to the $400,000 range for married couples. Because the threshold has increased well above the median home price in most metros, there likely will be a modest reduction of first-time homebuyers, lifting apartment demand.
Market liquidity could rise
The newly introduced 20 percent deduction on income from pass-through entities could invigorate investment in real estate. On an after-tax basis, the yields offered by the sector will be even more compelling than under previous tax structures. New capital could enter commercial real estate through syndicators and investment funds that are structured to capitalize on the pass-through advantages, but some new investors will enter the market with direct acquisitions. The additional capital will undoubtedly flow across a variety of property types, including apartments.
Expanded expensing rules benefit niche real estate
Changes to the Section 179 depreciation rules will favor several niche real estate investments. Under the revisions, business owners will be able to fully expense up to $1 million of depreciable tangible personal property used to furnish lodgings. This change will allow investors with investments such as hospitality, student housing and senior housing to deduct the full cost of furniture placed in service at their properties rather than depreciating them over multiple years. The rules also extend to roofs, heating, ventilation and security systems in the non-residential property. This provision is largely targeted toward small businesses, so the deduction phases out as business investment purchases exceed $2.5 million.
Housing market slowdown could offset growth
The restructuring of the tax rules will likely weigh on the owner-occupied housing market, particularly in states with elevated home prices and property taxes. The new tax law affects home sales in several ways: The increased standard deduction will modestly restrain first-time homebuyers, while limitations on the deduction of state and local property taxes will weigh on upper echelon housing, particularly in California and states in the Northeast.
- 1031-Exchange: Tax-deferred exchanges have been retained for real estate.
- Business Interest Deduction: Interest on real estate loans remains deductible for real estate investments, but using this deduction will lengthen the depreciation period for real estate assets.
- Depreciation: Real estate continues to be depreciable in 27.5 years if the mortgage interest deduction is not taken. If the mortgage interest deduction is used, then the depreciation timeline for commercial properties increases to 40 years and for residential properties, it rises to 30 years.
- Carried Interest: The hold time of assets increases from one year to three years to treat earnings as capital gains.
- Pass-Through Income: Business owners receive a 20 percent deduction on qualified income generated by pass-through entities such as LLCs, but there are some restrictions. For taxpayers earning over $157,500 (single filers) and $315,000 (married couples), the deduction is limited to greater of 50 percent of the taxpayer’s share of aggregate W-2 wages paid by the business or 25 percent of the taxpayer’s share of aggregate W-2 wages paid by the business plus 2.5 percent of the unadjusted basis of all qualified property (structures but not land).
- Corporate Tax Rate: Maximum tax rate reduced from 35 percent to 21 percent. Generous expensing and depreciation rules on capital expenditures over the short-term.
- Individual Tax Rate: Significant restructuring of personal taxes. Still uses seven tax brackets, but the income span of each bracket has changed and the marginal rates have generally been lowered. Standard deduction has been increased and several deductions have been eliminated or restricted.
- Estate Tax: Doubles exclusion to $11 million for single filers and $22 million for married couples.
Prepared and edited by John Chang First Vice President, National Director, Marcus & Millichap Research Services. He can be reached via email or at 602-707-9700.