By Max Sharkansky
Uncertainty regarding the influence of the Tax Cuts and Jobs Act (TCJA) on investment strategies has proliferated both before and after the bill took effect at the beginning of the year.
That said, the consensus has generally been that this law will bolster investor opportunities in commercial real estate by offering incentives that further position real estate as an attractive alternative investment.
Following Q1, many investors still have questions regarding the impact of TCJA on their current real estate portfolios and how they should change their investment strategy going forward – if at all.
Below, we’ve highlighted some key effects that the new bill has had on the real estate investing landscape, as well as factors and strategies to consider when advising clients regarding real estate investment in light of the changes:
Reap the full benefits of the 20 percent deduction
Although it is not the only potential benefit that the new act brings to real estate investors, the 20 percent tax deduction on income generated by pass-through entities – which includes nearly all real estate private equity firms, crowdfunding endeavors, and REITs – is perhaps the most talked-about due to its direct impact on higher returns for investors.
For example, if an individual investor is paid out $1,000 in returns from a fund, they will only be taxed on $800. Essentially, qualifying investors will never pay more than 29.6 percent on pass-through income.
That said, advisors must counsel clients to help them understand exactly how they will or could benefit from this deduction, as there are some limitations on those who make over a certain amount in income – more than $207,500 if single or $315,000 if married and filing jointly.
As a general trend, we anticipate that we’ll see high-net-worth individuals working closely with advisors to identify which real estate investment strategies offer the most income-producing strength, which will depend on many factors including market, product type, and length of hold, among others.
Be prepared for potential changes in investment manager habits and trends
While commercial real estate is predicted to be boosted by recent regulatory changes, high-net-worth clients should be made aware that some investment managers may choose to change their strategy as a result, and certain sectors may not present the same investment opportunities they did previously.
For example, for investment managers to qualify for carried interest – which allows them to make a profit that is more than simply the return on their contribution to a property investment – the subject property must now be held for three years, rather than the previous requirement of one year.
Certain managers might have been bullish in the past on opportunities that would allow for a quick turnaround of 1-2 years, in order to maximize internal rates of return. These same management companies may reconsider this strategy now to avoid being taxed at their ordinary income tax level. The difference can be significant – carried interest tax is capped at 23.8 percent, while the highest income tax bracket pays a rate of nearly 37 percent.
Ultimately, this could lead to less opportunities to invest in quick-flip properties through these entities, but time will tell to what degree this investment niche will be impacted.
Another example of a change that advisors and investors should be cognizant of relates to affordable housing. While it can vary by location and other circumstances, in most cases, affordable housing investment is profitable due to the Low-Income Housing Tax Credit (LIHTC).
With the corporate tax rate dropping to 21 percent from 35 percent, the tax credits lose much of their appeal, and ultimately, their value. It is predicted that this could significantly decrease the number of affordable units delivered over the next several years.
Advisors should counsel those who are currently invested in this sector to remain aware to understand how their capital might be impacted.
Seek out value-add investments
The TCJA also includes a temporary depreciation allowance increase. This means that some businesses can immediately expense 100 percent of certain commercial property and improvement costs (up from 50 percent previously).
This can reduce taxable income without actually decreasing cashflow and applies to properties owned through certain kinds of partnerships and LLCs as well as property owned outright.
As a result, the new law should increase the frequency of real estate investments that involve the improvement and rehabilitation properties. This also creates a significant additional incentive to seek out opportunities through fund managers that are experienced in value-add renovation strategies.
The commercial real estate industry as a whole is thriving, and it will likely be bolstered further by the current pro-growth landscape. It is true that new incentives laid out in the TCJA do have a direct positive effect on the returns, further increasing the appeal to invest in the sector.
That said, the benefits of these tax laws vary greatly when factoring in an individual’s personal income and tax bracket or the classification of the businesses they invest with and properties they invest in.
As always, it is critical to evaluate every aspect of potential real estate investment opportunities when an individual is considering diversifying his or her portfolio with real estate investments – whether they are new or seasoned in the sector.
Max Sharkansky is Managing Partner at Trion Properties, a private equity investment firm that primarily acquires value-add real estate properties. Contact him at [email protected]