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Real Estate Sector Girds for Tax Reform Debate

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Real Estate Sector Girds for Tax Reform Debate

With Congress tied up in an overhaul of healthcare, the timeline for tax reform, originally part of President Donald Trump's agenda for his first 100 days in office, has stretched out significantly. The president has said in recent interviews that he wants tax reform passed by the end of the year.

The moving timeline, and the uncertainty about the precise shape tax reform will take, has not diminished real estate players' angst about the potential impact on their industry of the first major overhaul of the tax code in 30 years.

In interviews, tax professionals noted that there has been a ramp-up in preparedness planning. Real estate players are undertaking a variety of modeling exercises to see how projects pencil out under various tax-change scenarios. Others are getting involved in lobbying efforts in an attempt to steer the tax reform dialogue.

"I think people believe the chances of something actually happening are better than they have been in a long time," Jim Sowell, principal with KPMG's Washington National Tax Practice, said.

The last time the Grand Old Party controlled the White House and both the House and Senate was 1928.

To be sure, the tax reform process is still in the formative stages, and observers have only the broad brushstrokes of a blueprint, a document dubbed "Better Way for Tax Reform" unveiled by House Republicans in mid-2016, with which to speculate about the shape of reform to come. Trump has said he wants to slash corporate and individual tax rates, but observers point out that the revenue lost from such cuts will have to be made up somewhere. Even Republicans disagree about where sacrifices should be made.

There is some concern among commercial real estate industry observers that certain long-standing provisions from which the sector has benefited — mortgage interest deductability and carried interest, the provision that allows real estate funds managers to pay a lower capital gains tax rate on their income from investments, to name two — may wind up on the chopping block.

Chatter in recent months has focused on "like kind" exchanges under Section 1031 of the tax code, the decades-old provision that allows property owners to sell an asset and acquire a replacement property, via a qualified intermediary, without generating a tax liability on any capital gain. The House blueprint does not explicitly mention 1031 exchanges, but legislators have targeted the provision in earlier pushes for reform, as former House Ways and Means Chair Dave Camp did in the Tax Reform Act of 2014.

However, David Ling, a professor of real estate at the University of Florida's graduate school of business, said in an interview that real estate is not the glaring problem point in 2017 that it was perceived to be in the lead-up to the last major overhaul of the tax code in 1986.

"Tax reform then was driven a lot by perceived abuses, if you will, in the commercial real estate industry," Ling said, citing the industry's use of "liberal" depreciation benefits in the early and mid-1980s. "Although they were just using the depreciation available to them by law."

Property owners of all stripes, corporations as well as individual taxpayers, including farm owners, use 1031 exchanges. Mark Hansen, co-chair of the government affairs committee of the Federation of Exchange Accommodators, the trade group for qualified intermediaries, said the hit to the economy from the loss of 1031 exchanges would outstrip the tax revenue gained from rolling back the provision. Because most 1031 exchanges are "exchanges up" the property-quality spectrum, requiring leverage, banks and other lenders would lose business. Construction firms, surveyors, landscape architects and many other real estate-related businesses would also suffer.

The FEA asserts that 1031 exchanges are complementary to the tax reform priorities of streamlining and driving economic activity for a host of real estate-related businesses.

"Any potential revenue raise effected by repeal [of 1031 exchanges] would be totally negated by the contraction in GDP," Hansen said.

Another big unknown is how significantly the "border adjustment" provision outlined in the Republican blueprint, which proposes to eliminate taxes on U.S. exports and tax all imports, would negatively impact real estate businesses. Trump has expressed disapproval of the boarder adjustment tax proposal.

In other corners, real estate leaders worry that the REIT asset class will be less attractive — in terms of the tax "efficiencies" the model provides — in a field where corporate taxes in general are significantly lower. REITs do not pay corporate income tax provided that they pay out 90% of their taxable income to shareholders in the form of dividends. Shareholders pay taxes on those dividends as if they were ordinary income, unless they are deemed "qualified dividends," in which case the dividends are taxed at a lower capital gains rate.

REITs' continued appeal as an investment vehicle will depend on how REIT dividends are taxed in the new framework, Mark Van Deusen, principal with Deloitte Tax's Washington National Tax Group, said.

"It's entirely possible that tax reform could make the REIT template less attractive than it was before," Van Deusen said. "It's likely still going to be attractive relative to a C corporation. But it may not be as attractive."