What better way to kick off the new year than to discuss the new tax law and the gift we all just received as real estate investors? The new tax legislation will impact investors and their investment strategies as we all continue to search for yield and source opportunities within the alternative investment landscape. As equities and bonds continue to demand outsized liquidity premiums we believe certain real estate investments will have enhanced after-tax yields in 2018.
Points to consider:
1) The tax law changed the treatment for income from pass-through vehicles, including REITs and other vehicles that own real estate. The new law allows for a 20 percent pass-through deduction, which when coupled with a top tax rate adjustment from 39.6 percent to 37 percent yields a new top marginal tax rate of 29.6 percent on real estate investments.
2) These benefits could, however, have certain limitations subject to individual investors’ total taxable income, resulting in additional hurdles involving wages paid by an entity and the depreciable basis of the underlying property.
3) Capital gains treatment for developer/sponsor promotes/profits participations were left alone, with the exception that any long-term capital gain allocable to their carried interest now requires assets to be held for more than three years rather than the previous one year. While individual investors (non-sponsors) will still realize long-term capital gains treatment after one year, they might question the alignment with their developer/operating sponsor depending on the business plan and risk profile of a particular investment.
4) 1031 exchanges have remained largely intact, creating a further advantage for real estate and its tax deferral benefits, save for certain personal property that no longer qualifies for tax deferred treatment.
There are other general considerations activated by the tax change which might impact the broader real estate investment climate within the housing sector. The adjustment of the standard deduction for married couples filing jointly moved from $12,000 to $24,000, making it more enticing to rent vs. own when compared to the prior law’s treatment regarding property tax and mortgage interest deductions. This certainly will prompt many to forego or reconsider renting vs. buying, potentially buoying an increase in demand for rental housing.
REITs may become a preferred investment vehicle due to their eligibility for a 20 percent deduction without any limitations, enhancing the appeal of REITs relative to other yield-oriented investments. It is important to remember that publicly-traded REITs don’t necessarily trade based on real estate fundamentals as they are non-correlated to the less-efficient private investment market place.
One might project that this legislation could help to break the impasse between buyers and sellers on pricing, a dynamic that kept a lid on transaction volumes in 2017, but now might create an increase in new investment opportunities.
Further, corporate tax reductions may fuel increased demand for commercial property as companies grow existing businesses or start new ones, providing for improved occupancy and income from real estate investments.
We believe these changes broadly suggest that real estate investing will continue to look attractive vs. other asset classes, the latter of which are unsheltered by depreciation and interest expense with its ordinary income taxed at the top rate of 37 percent. That said, happy continued hunting for your real estate investments and congratulations on your raise.
Robert Brunswick is the co-founder and CEO of Buchanan Street Partners, a real estate investment management firm that focuses on real estate investing through direct acquisition of commercial and multifamily properties in addition to originating and funding debt for third-party owners of real estate.