Tax Reform Effects on Real Estate Investors and Home Owners

Anthony Guerriero, Jan 17, 2018 2:09:43 PM

Now that tax reform has been passed by the US Congress, we know for sure that some people stand to gain significant wealth from the new tax rules that will be implemented in 2018. As a general matter, the new law is expected to be very favorable to investors of real estate and the wealthy, regardless of whether one is in a high-tax state or not.

Of course, there are winners and losers from every new tax plan. And, it’s apparent that Republicans targeted Democratic states in dispensing punishment, in terms of capping state and local tax deductions and reducing the allowable amount of mortgage interest deduction.  However, many of the tax breaks people are complaining losing under the GOP plan, they would have lost anyway under the old AMT rules.  For marginal middle-income buyers, however, there are parts of the law that could be disincentives to buy and instead rent.

In total, however, the effect of the tax plan mostly will be positive. It instantly makes US businesses very globally competitive and should help stimulate economic growth, which is the biggest driver of wealth. 2018 will be a transition year and an opportunity for buyers (in terms of sellers willing to negotiate), given the uncertainty around the tax law changes. However, once 2019 begins, we expect to see strong economic growth and strong Miami and Manhattan real estate markets.

In this article, we will explain in broad strokes a) the highlights of tax changes affecting the commercial and residential real estate markets; b) how we believe they will affect Miami and Manhattan real estate, our homeowners and investors in the short-term and long-term; and c) what other changes might be coming to mitigate the effects of negative changes to the code. 

 

Tax Reform Changes that Will Affect Miami and Manhattan Real Estate

 

  • Corporate Federal Tax Rate Declines to 21% from 35%
  • Pass-Through Entities Receive 20% Deduction
  • 1031 Exchange Capital Gains Tax Rules Retained
  • Mortgage Interest Deduction Changes
  • SALT and Property Tax Deduction Capped at $10,000
  • Capital Gains Treatment for the sale of a primary residence remains unchanged.
  • No Changes to Capital Gains Tax for Investors
  • Changes to U.S. Estate Tax
  • Doubling of the Standard Deduction
  • Interest Deductibility and Depreciation Changes
  • Net Operating Loss Deductions Limited to 80% Income
  • Carried Interest Holding Period Extended to 3 Years
  • Reduction to 37% from 39.6% as the top rate

 

Corporate Federal Tax Rate Declines to 21% from 35%

The biggest winner from Tax Reform is the Corporation, which will see Federal tax rates plummet to 21% down from a very high rate of 35%, one of the highest in the world. At 21%, the United States economy will become more competitive globally, substantially lowering the after-tax cost of capital which should boost capital investment and ultimately jobs and wages.  It is expected that businesses from overseas will look more favorably in relocating operations to or establishing business in the United States, the largest market in the world. It is also expected to discourage domestic businesses from moving operations overseas. 

Undoubtedly, however, much of the tax cut will go to shareholders in terms of higher dividends and stock prices – the Dow Jones Industrial Average at close to 26,000 has already priced in some of the expected gains from tax reform and, as a result, people’s investment holdings and 401K’s have been enriched and provided much needed confidence in the future economy. We expect this to continue as companies and, ultimately, individuals feel first-hand the effects of the tax cut. Whether this lifts workers’ wages across the board remains to be seen, but certainly with very low unemployment (4%),  future wage growth should be substantial.

The reduction in the corporate rate is perhaps the most important change in the tax code, which we expect will have a positive long-term effect on luxury property prices in both Manhattan and Miami and be a boon for real estate investors.

Pass-Through Entities Receive 20% Deduction

Individuals that use pass-through entities such as Limited Liability Companies (LLCs), partnerships, S-Corporations and sole proprietors now receive a special deduction of up to 20% of their ordinary income. Ultimately, this would, in effect, reduce the effective maximum federal tax rate to 29.6%. The full 20% deduction is allowed if the business has income less than $157,500 ($315,000 if married), but the deduction phases out depending upon the income level, W-2 payable to employees and/or sufficient depreciable property, as the 20% special deduction is capped by the higher of:

  1. 50% of the W-2 wages paid by the business to employees or
  2. 25% of the W-2 wages paid by the business to employees plus 2.5% of the acquisition cost of depreciable property used in the business that has not been fully depreciated.

Since real estate investors can use 2.5% of the acquisition cost of the property, which is signficiant in Manhattan and the luxury segment in Miami, investors in these locales will likely be able to use this special deduction in its entirety, even if they don’t pay any W-2 wages.

We expect the addition of the special 20% pass-through deduction will have a positive effect on our real estate investors, with most being able to take the entire 20% deduction. In addition, small businesses, the bulk of business that are structured as pass through entities, will benefit greatly from this deduction.

While the special pass through deduction doesn’t apply to highly paid professional service workers, such as attorneys, we expect many of these businesses will choose a different structure to run their businesses, such as becoming a corporation or divide the business into two or more companies, to take advantage of tax reform . For instance, dividing a law firm into one that purely provides professional legal services and one that provides other services, such as administrative and paralegal work. In this example, the attorneys would pay higher tax rates on income received from purely professional services and lower tax rates on administrative type of work that they also perform, such document review or some paralegal work. By identifying different characteristics of law firm income and restructuring wages and guaranteed payments, a law firm will be able to enhance its ability to benfit from the new tax law. 

1031 Exchange Capital Gains Tax Deferral Rules Retained

Section 1031 rules for real estate have been retained. Under Section 1031, a business can swap one property for another, without triggering a taxable event (as long as it is located in the United States). It allows your new investment to grow tax deferred. The many rules around the process of “like-kind” exchanges for real estate will stay intact can be found here.

The retention of 1031 rules is a big win for real estate investors who have always greatly benefit from 1031 exchanges.

Mortgage Interest Deduction Changes

Landlords of commercial and residential property retain their ability to deduct the full amount of their mortgage interest. Homeowners, however, are now limited to deducting mortgage interest on loans of $750,000, down from $1,000,000, for new mortgages on both primary and second homes. Existing mortgages are not affected. Starting in 2026, the limit will revert to $1,000,000 mortgage. As in the previous policy, the limit is not indexed for inflation. Also, the deduction for interest paid on home equity lines of credit (HELOC) will no longer be eligible for the home mortgage interest deduction (previously, interest on up to $100,000 was deductible).

The psychological effects of capping the mortgage interest deduction on loans of up to $750,000 for primary homeowners may be greater than the actual effects in the Miami and Manhattan real estate markets, since the real cost of the change in policy translates into a maximum of net $3,700 less tax savings per year or $308 per month (for the 1st year), assuming the new top rate of 37% and would be only $2,500 per year or $208 per month for someone who happens to be in the 25% tax bracket. [For our examples, we calculated interest on $250,000 at 4% interest which is approximately $10,000 of interest per year at 37% and 25%, respectively, would be $3,700 and $2,500 less tax savings.]

We think this change will have a slight negative impact on property prices in New York City and the Miami Beach luxury real estate market, where property prices are generally higher than the rest of the country. While we have read sensational reports that this could lead to lower prices, we expect that economic growth, higher wages, and lower tax rates will offset or at least lessen the impact.

In addition, we expect that many current property owners with mortgages of $1,000,000 or more will be less likely to trade up or move, as the new mortgage would have a cap at $750,000. This could have the effect of putting a further squeeze on the supply of inventory, especially at lower price points, say under $2 million, which has been under pressure already in Manhattan, ultimately putting upward pressure on prices. This change is a blow to mobility and not the most logical economic policy choice when trying to stimulate economic growth. This illogical change demonstrates that this was intended by Republicans to inflict damage on Democratic voters in big cities where property prices are highest.

SALT and Property Tax Deduction Capped at $10,000

Landlords of commercial and residential property retain their ability to deduct state and local property taxes. The new tax law, however, places a $10,000 cap on the amount of state and local property taxes, income taxes and sales taxes an individual can deduct. The cap is not indexed for inflation. This change is perhaps the most egregious change in the tax law and a punishment to Democratic voters.

Under the Alternative Minimum Tax ("AMT"), however, those who make between $200,000 and $500,000 have already lost the benefit of the SALT deduction because they’ve been hit by the Alternative Minimum Tax. Under AMT, SALT deductions are already capped, as AMT rules reduce or eliminate the SALT deduction. AMT requires many tax payers to calculate their liability twice – once under the rules of the regular income tax and once under the rules of AMT – and then pay the higher amount. In 2017, approximately 5 million households were required to pay the AMT. Despite the SALT cap, high-income households generally will do well under the new tax law, which cuts corporate, individual, and pass-through effective tax rates and scales back AMT, which will have a higher threshold under the new law, significantly decreasing the number of individuals required to pay AMT tax beginning in 2018.

Overall, we expect this change will have negative effects on high tax states like New York and will benefit low tax states like Florida. High-tax states like New York, California and New Jersey, however, are reevaluating how they collect state income tax and will likely seek to mitigate the effects of the law by replacing income tax with a payroll tax system levied on employers or reclassifying certain tax payments as charitable deductions. While the charitable deduction idea is dubious and likely a non-starter, the employer paid payroll tax idea has some legs. The idea is that if employers pay the payroll tax and reduce employee’s salaries by the same amount, workers would not have to deduct anything from their taxes and would wind up being paid the same amount. This would allow states to collect the same revenue while preserving individuals’ deductions for federal tax purposes. There is a concerted effort by Governor Cuomo and other governors to get this done quickly, so we expect to see this change in 2018.  Such a change would significantly mitigate the negative affects of the $10,000 cap in the new law and potentially be a windfall for NYC taxpayers.

Capital Gains Treatment for the Sale of a Primary Residence Remains Unchanged

A primary homeowner may exclude the capital gain from the sale of property of up to $250,000 on a home for a single tax payer or $500,000 for a couple filing jointly. As long as the homeowner occupies the home as a principal residence for two out of the past five years, the homeowner is eligible for these capital gains tax exclusions.

No Changes to Capital Gains Tax for Investors

The maximum long-term capital gains tax rate for individuals remains at 20% plus 3.8% Obamacare surcharge for gains greater than $250,000. To qualify, the property must be held for at least one year such as under the current law.  If Obamacare is completely eliminated, then the 3.8% surcharge may go away, but not until then.

Changes to U.S. Estate Tax

Beginning in 2018 thru 2025, the US estate tax exemption is increased to $11.2 million for single filers or $22.4 million per couple for those domiciled in the United States.  For non-US individuals, there will be no change to US Estate tax exposure, therefore, they will remain subject to the US estate tax upon death and be exempt of $60,000. Accordingly, non-US individuals will need to plan to avoid the estate tax or hedge against it. With the corporate rate converging with individual rates, by going down to 21% (vs. 35% previously), the a foreign buyer of US property should consider structuring the purchase using a Foreign Corporation, which is now a much more attractive vehicle to hold the US property. Using this type of vehicle to hold the property allows the purchaser to avoid exposure to the US estate tax.  Learn more in our Foreign Buyer Guide

Doubling of the Standard Deduction

The standard deduction is doubled to $12,000 for single filers and $24,000 for married filers. While this simplifies a lot of things for most middle-income taxpayers, the doubling of the standard deduction effectively wipes out the distinction between owning and renting in the tax code for middle-income taxpayers, removing a tax incentive to own.  This change could possibly affect first time home buyers the most who may not see concrete financial benefits (via tax breaks) from owning. However, the benefits of owning a home are much more than receiving a small tax break, so we don’t think this will significanly affect Manhattan real estate or Miami luxury real estate.

Interest Deductibility and Depreciation Changes

A real estate company can continue to deduct net interest expense and applies to existing and new debt. The taxpayer must elect out of the new interest disallowance rules, which limits the deductibility of interest to the extent that net interest expense exceeds 30% of EBITDA (EBIT beginning in 2022).

In addition to electing out of the new interest disallowance rules, such taxpayers are required to depreciate property over slightly longer recovery periods: residential property over 30 years, commercial property over 40 years and interior improvements by 20 years. Otherwise, the new tax law continues current depreciation rules for real estate.

Net Operating Loss Deductions Limited to 80% Income

The amount of net operating losses (NOLs) that are deductible from income is limited to 80% of the taxable income of the corporation for such year. Under the new law, NOLs are no longer allowed to be carried back to the previous two years, but can be carried forward indefinitely, in contrast to the 15 year carryforward provision in the prior law.

Carried Interest Holding Period Extended to 3 Years

Carried Interest preferential long-term capital gain tax rate not eliminated but requires a more than three-year holding period. 

We expect that the increase in the holding period to 3 years from 1 year will have little impact on our investors, since most of them hold commercial property for greater than three years anyway. Those that want to flip properties, however, are out of luck.

Other Highlights:

  • The individual top tax rate has been lowered to 37% from 39.6%, for income in excess of $500,000 if single and $600,000 married
  • Corporate AMT is repealed

 

Conclusion:

Tax reform is going to significantly benefit real estate investors and, ultimately, homeowners when all is said and done. The economic stimulus created from dropping the corporate rate to 21% from 35% will be huge, as the after-tax cost of capital drops significantly, encouraging capital invesment domestically. In addition, the special pass-through deduction of 20% will immensely help small businesses, the backbone of the economy, and, in particular, real estate investors.  While disincentives have been added to the code for more middle-income buyers, the benefits of these two changes alone will be greater than any tax benefits lost by the new changes to the law.

In 2018, we will start seeing companies change company structures to take advantage of all the good things in the law and avoid all the bad. With such egregious changes directed at Democratic states, there is a full concerted effort to minimize negative affects by of the SALT caps by recharacterizing income tax to payroll tax and charitable deductions.  In the meantime, Miami will significantly benefit by this legislation, as some people shift from high tax states to low tax states. 

While 2018 will be a year of uncertainty, it will also be a year of opportunity for buyers in the Manhattan and Miami luxury real estate markets who take advantage of the uncertainty surrounding the law. Seller’s, on the other hand, won’t likely benefit in the short-term, but starting in 2019, we expect they will do very well, especially in Manhattan and Miami, as economic growth takes hold. Ultimately, tax cuts will benefit the rich and ultra-rich, which will be music to the ears of luxury property developers and ultimately homeowners in NYC and Miami.

 

References:

https://www.hklaw.com/publications/main-effects-of-us-tax-reform-on-foreign-taxpayers-01-02-2018/

https://www.hklaw.com/publications/us-tax-reforms-main-effects-on-real-property-investors-and-developers-12-28-2017/

 

 

 

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