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Commercial real estate investors have a lot to cheer about in the new tax law relating to changes in pass through entity deductions, depreciation schedules, and an increase in expensing capital expenditures. This article will describe how the new Tax Cuts and Jobs Act will impact the commercial real estate industry and why it will extend the ongoing strength in commercial real estate investing.
Owners of pass through entities such as LLCs will be allowed to deduct 20% of "qualified business income" until 2025. While this deduction does not apply to most businesses, it does specifically apply to real estate income. The net effect on individuals will be a maximum tax rate on LLC income of 30% and much lower if it is long term gain. This is an important benefit to real estate investors as their after tax income will be higher than previous years. The intent of the 20% rule is to provide smaller businesses a corporate-like tax break by mitigating the tax disparity between the new corporate tax rate of 21% and the individual tax rate used by pass-through entities. By the way, this 20% deduction is limited to 20% of your taxable income excluding capital gains.
Since most real estate investment entities operate as LLCs, the opportunity to take a 20% tax deduction is a gift to real estate investors. Although this new law limits the full 20-percent deduction to $315,000 for married couples and $157,500 for individuals, a key clause of the new law increases the deduction amounts by including a "capital element" in the equation. Tax experts agree the "capital element" clause expands these limits to provide a huge tax break for commercial real estate pass through entities because these entities are heavy in property and light in employees. This favorable tax benefit should encourage investors to compare investments on an after tax basis. On an after tax basis, real estate will offer much more attractive after tax returns than dividend stocks or bonds.
Section 179 of the United States Internal Revenue Code provides taxpayers a choice to deduct the cost of certain types of property on their income taxes as an expense, rather than capitalizing and depreciating the cost of the property. One change in the new tax law doubles the amount that can be expensed from $500,000 to $1 million. Secondly, the 2018 tax bill expands the types of property defined in Section 179 to include “depreciable tangible personal property used to furnish lodging ”. This provision also expands types of value add property improvements such as roofs, HVAC, security and alarm systems. Specific real estate niches that will benefit include: hospitality, student housing and senior housing.
Under the new law, certain commercial real estate property capital expenditures can be 100% written off in the year incurred as opposed to being depreciated over time. This provision can effectively be used to offset an individual’s non-real estate related income from taxes up to a $1 million. In addition, the expansion of Section 179 will certainly make real estate funds consider value-add strategies to be more appealing because of the tax benefits. Since value add strategies have the potential to increase rents and profits from sales, those investing in commercial real estate will see an immediate benefit from this change.
The Tax Law limits the deductibility of interest on mortgages up to $750,000. However, the new law also allows real estate investors to opt out of that limitation on the deductibility on interest. If an investor takes full advantage of the interest expense deduction on a mortgage greater than $750,000, then they are required to utilize an alternative depreciation system with the recovery periods for nonresidential property at 40 years(up form 39 years), residential property at 30 years(up from 27.5 years) and qualified improvements at 20 years(up from 15 years). So the depreciable period has been increased a small amount.
The carried interest extension of the holding period of partnership stakes by investment fund managers, from one to three years or more, will undoubtedly push some investment fund managers away from short term strategies such as fix and flip funds. Private equity real estate funds typically hold their assets longer than 3 years so there should be little or no impact on the investment. Additionally, when investors pull out of other funds they will very likely look at commercial real estate opportunities more favorably as the tax benefits serve their investment goals and timelines.
Historically, a change in tax law is accompanied by at least two principles: it takes about a year to see the unpacking of any new changes, and there are always certain industries that benefit. Real estate investors will benefit multiple ways including: the pass-through tax deduction benefits and the increase in the amount of capital expenditures that can be expensed . Tax experts have made it crystal clear that commercial real estate and private equity real estate funds are the big winner of the newly passed 2018 "Tax Cuts and Jobs Act".
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