The passage of tax reform —the Tax Cuts and Jobs Act of 2017—will undoubtedly reduce the uncertainty that has weighed on commercial real estate investors as major tax proposals have been contemplated, which in and of itself is a benefit. Now that the final provisions are known, the Act has been lauded by many as a great boon for commercial property owners. Some analysts have predicted the newly amended tax code should specifically strengthen demand in the multifamily sector and incentivize corporations into putting more capital into real estate assets and new development. Of course, it is difficult for us at this time to determine exactly how the effects of tax reform will play out long term for the alternative investment industry—what expected benefits will actually be realized, and what the unintended consequences will prove to be. In the meantime, we can still make some relatively confident predictions. Let’s review how tax reform will likely affect different segments of real estate investment.
Listed below are a few of the highlights to be gleaned from the Act as it relates to commercial real estate investment:
These changes will affect real estate investors differently, depending on their individual tax rate and their chosen mode of real estate investing.
One of the most beneficial features is the deduction for pass-through entities. Pass-through businesses do not pay entity-level income tax, but instead owners/shareholders pay personal taxes on income generated at the business level. By law, REITs must pass through at least 90% of their taxable income to shareholders. This includes income that flows to REIT investors through ordinary dividend distributions, mainly from rent or mortgage interest.
The Act allows an investor to deduct 20% of the dividend income, with the remainder of the income taxed at the investor’s marginal rate. This benefit is available even if the investor does not itemize deductions. The effect will be to lower the overall tax rate for investors who invest in REITs. According to the chart put together by Annaly Capital Management, REIT investors who currently pay the top income-tax rate of 39.6% on dividends, for instance, will see that rate effectively drop to 29.6% on REIT dividends. In fact, effective tax rates are down at every marginal rate, making REITs a more attractive vehicle for real estate investors by increasing the after-tax rate of return. (It should be noted that capital gain distributions from REITs realized when properties are sold will continue to be taxed at 20%.) This change has the potential to increase overall demand for REIT shares, both traded and non-traded.
This deduction for pass-through businesses applies to taxpayers who have some or all of their business income taxed on their individual return. Such "pass-through" income also includes S corporations, LLCs, partnerships and sole proprietorships. Investors in such entities will now be taxed at their individual tax rate less the 20% deduction for qualified business-related income. For example, if a partnership owns a warehouse property that provides $100,000 in annual income to its investors, those individuals could avoid paying taxes on $20,000 of that income if they are eligible for the full deduction.
There are limitations to the 20% deduction. As always, it is best to discuss these kinds of things with a tax professional. Overall, however, the impact of tax reform on the real estate sector should be positive. There are no transformative changes, but investors will no doubt be taking note. According to a white paper produced by research firm Reis Inc., commercial property owners in general “are easily the biggest beneficiaries of this tax bill.” For investors who are not already in commercial real estate, the Act offers the potential of higher after-tax yields when compared to some other investment options. This change could entice significant additional capital to the commercial real estate marketplace. There is some concern, however, that the tax rules might prove to be too much of a good thing for an industry whose pitfalls are over-borrowing and over-building. This is what we will need to watch as the future unfolds.
Kemp Hanley, CFA, is vice president of financial analysis for FactRight, a Minneapolis-based due diligence and consulting firm that helps financial advisors best advise their clients on alternative investments.
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