The Impact of Tax Reform
- May 02, 2018
Sweeping tax reform legislation, originally known as The Tax Cuts and Jobs Act (TCJA), signals a key shift in economic policy focus from “redistribution” to “growth,” with the difference in these priorities being about 1 percent per annum, or 17.25 percent of GDP lost over the last 16 years. For the most part, the tax reform legislation is neutral to positive for commercial real estate and very positive for the economy in general. Because the changes to commercial real estate are not dramatic, most investors should feel fairly confident.
The most important change in the TCJA is the lowering of the corporate tax rate from 35 percent to 21 percent, which is a “permanent” change—unlike the cuts to individuals, which sunset at the end of 2025. At 21 percent, the new U.S. corporate tax rate shifts from being the highest among large developed nations to one of the lowest. This reduced corporate tax burden will increase our international competitiveness and promote the U.S. as a place to grow a business.
With new corporate and consumer demand spurred by tax savings and incentives that expire within the next five to 10 years, businesses will invest in production and expansion in the coming years, including in real estate. As a result, we expect growth to accelerate by an additional 80 basis points per annum over the next two years, returning real growth to its historic norm of about 3 percent per year.
For commercial real estate, one of the biggest changes will be the tax treatment of pass-through entities. Owners, partners or shareholders in such entities—which include S-corporations, LLCs and partnerships—are now entitled to a 20 percent deduction on pass-through income. The pass-through deduction is limited, however, to the greater of either 50 percent of W-2 wages paid or 25 percent of wages plus 2.5 percent of capital assets for owners who have an individual income exceeding $157,500, or $315,000 for joint filers. The pass-through deduction ends after 2025.
REITs will benefit from this pass-through deduction, but REIT dividend deductions are excluded from the wage restriction. As a result, a REIT shareholder who had been paying the top income tax rate of 39.6 percent on dividends will now pay just 29.6 percent of dividends in taxes. This is 7.2 percent lower than the new maximum tax rate of 36.8 percent for C-corporation dividends. However, that differential represents a 120-basis-point decrease from the tax differential between REITs and C corporations under previous law.
The positive tax differential will only last through 2025 because the new maximum individual rate of 37 percent and the 20 percent deduction on pass-through income will then expire, while the corporate tax rate cut is permanent. Beginning in 2026, REIT dividends will be taxed at a slightly higher rate (39.6 percent) than those from C-corporations (36.8 percent).
Real estate also gets special treatment with regard to business interest deductions. Under the new law, business interest deductions are capped at 30 percent of adjusted taxable income. The cap does not apply for businesses with gross receipts of less than $25 million over the last three years, nor to the real estate industry. Notably, the business interest deduction limitation does not apply to interest incurred by any “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
Appreciation for Depreciation
For those real estate companies that elect to deduct business interest expenses greater than 30 percent of adjusted taxable income, the TCJA requires that they use the Alternative Depreciation System (ADS) for depreciable real property as modified by the act. This would require that commercial properties are depreciated over 40 years and residential properties over 30 years. For companies with a lot of mortgage debt, the longer depreciation schedule will likely be well worth it. Those companies that do not opt out of the 30 percent limit will continue to depreciate their properties under the previous tax law standards.
The TCJA additionally allows for the immediate 100 percent expensing of qualified depreciable personal property placed into service after Sep. 27, 2017, and before 2023. Beginning in 2023, the allowable expensing steps down 20 percent each year: to 80 percent in 2023, 60 percent in 2024, 40 percent in 2025, 20 percent in 2026 and 0 percent in 2027. The catch is that property being expensed using the ADS method is not eligible for 100 percent expensing. This is important for those real estate companies that elect to deduct business/mortgage interest in excess of 30 percent of adjusted taxable income. This will not affect residential or nonresidential rental properties, as they were never qualified for any amount of extra expensing under the old law because their depreciable lives were greater than the 20-year limit.
The act additionally retains the 1031 exchange for real property. While the act eliminates 1031 exchanges for other types of assets, real estate investors will still be able to forestall capital gains taxes via like-kind exchanges. And finally, commercial landlords need not worry about the limitation on mortgage interest deductions affecting personal income taxes, as those deductions will remain fully deductible for commercial property.
Dr. Peter Linneman is a principal & founder of Linneman Associates and Professor Emeritus at the Wharton School of Business, University of Pennsylvania. www.linnemanassociates.com
Follow Dr. Linneman on Twitter: @P_Linneman
You’ll find more on this topic in the May 2018 issue of CPE.