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Commercial real estate a likely 'winner' in tax reform, experts say

Next week, Congress is set to take a final vote on tax reform and, if the legislation is left substantially unchanged from the most recent versions, commercial real estate players will breathe a collective sigh of relief.

U.S. House and Senate Republican leaders, who behind closed doors have been negotiating a compromise between their respective versions of the bill, are expected to deliver a final version Friday. Based on available information, tax experts and others have widely deemed real estate a "winner" or at least not a "loser" in the reform process. Certain tax code provisions that industry leaders had feared might be axed to pay for the broader corporate cut are expected to remain in place, and many players will enjoy new benefits.

"For real estate investors, the final versions appear relatively benign, with only modest changes to key provisions such as the 1031 tax-deferred exchange, mortgage interest deductibility and asset depreciation," brokerage Marcus & Millichap said in a special report. The legislation could attract additional capital into commercial real estate and generate deal flow, the firm added.

In an interview, Steven Meier, partner at law firm Seyfarth Shaw LLP and co-chair of the firm's national tax practice group, characterized the proposed legislation as "benign to favorable" with respect to its potential impact on real estate.

"Meaning it is no worse, in any meaningful way, than the current status quo which I think, frankly, is a win," Meier said.

For months, industry leaders feared that legislators would finally do away with 1031 "like-kind" exchange, a frequent target for reformers looking to close perceived loopholes, but for real estate investors, that provision is expected to be unchanged. Property owners will continue to be able to sell a building and buy a replacement property without generating a tax liability on capital gains.

The tax rate on so-called pass-through entities, such as real estate investment trusts, that pass through to shareholders income generated from rents, which is then taxed at ordinary income rates, could be cut to as low as 25%. Moreover, legislators said late Wednesday that the owners of pass-through entities will be able to deduct 20% of that income before paying taxes at the marginal individual rate 39.6% at the top, under current law.

Steve Rosenthal, a tax lawyer and senior fellow at the Urban-Brookings Tax Policy Center, called the pass-through rate change the "most remarkable" aspect of the bill and a "tremendous deal" for holders of vehicles like REITs.

"Rent has always been taxed at top ordinary rates, so that's quite surprising that we would be going down that path, especially in the context of a pass-through," Rosenthal told S&P Global Market Intelligence.

Rosenthal expressed reservations about the proposed pass-through rate change. "[The proposed legislation] seems to allow arbitrage. You can borrow to buy REIT shares and effectively deduct at 39.6% to invest" at a much lower rate, he said. "That seems inappropriate."

In both the House and Senate versions of the legislation, the hold period for the carried-interest provision, which allows real estate fund managers to pay a lower capital-gains tax rate on their income from investments, is raised to three years from one year. Meier said the proposed change represents only a minor concession.

"The carried interest has got a three-year holding period, but that's not going to cause anybody significant distress since most carried interests need three years to season, in any event, just as a business matter," he said.

As of press time, Republican leaders were reportedly still looking for ways to tweak the legislation to reduce its overall costs, according to reports. There has been no indication that key real estate industry provisions will be back in the crosshairs, but anything could happen.

"The sausage-making process from this point forward could be fast and ugly," Meier said. "So we've just got to watch out. We've got to keep our eye on the ball. Things can happen quickly, and we've just got to stay focused."