The Impact of Trump’s Tax Plan on Commercial Real Estate
Sep. 7, 2017 Whitepaper

The Impact of Trump’s Tax Plan on Commercial Real Estate

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The theme of President Trump’s tax plan is to reduce overall tax rates. He believes in making U.S businesses globally competitive, which he thinks can be accomplished by a lower corporate tax rate. He also aims to create wealth for the average American by simplifying the tax code. Since the president made his multibillion-dollar fortune from real estate, it’s not uncommon to wonder what effects his proposed tax changes will have on like-kind exchanges, changes in tax structure, real estate investment trusts, full expensing and carried interest.

Why Tax Reform?

In an attempt to simplify a complicated and confusing tax system, Trump has proposed reducing the tax bracket system from the current seven brackets down to three, and cutting taxes in each of the remaining brackets. 

Trump believes the corporate tax rate is too high and is impeding economic growth by driving American businesses overseas. To address that, he has proposed dropping the corporate tax rate to 15 percent, which will be one of the lowest rates in the world. President Trump believes a simplified tax system and lower corporate tax rate will make the U.S economy a powerhouse once again.

Repeal Of Section 1031 Of The IRC

Section 1031, also known as the like-kind exchange, has been a tool used by real estate owners and investors for nearly 100 years. Congress has been trying to reform it for approximately five years. Normally, when an investor sells land or property, they have to pay a tax on the gains. Section 1031 allows investors to defer that tax if they reinvest their money within 180 days in a property similar to the one they sold.

For example, if an investor sells a rental house and then purchases vacant land, it could qualify as a like-kind exchange because the vacant land could be turned into another rental property. Property must be in the United States. Swapping a piece of land in the United States for a piece of land in Italy would not allow the investor to defer the capital gains tax. After selling the property, the investor has 45 days to notify a qualified intermediary of interest in a new property and 180 days to purchase the like-kind property.

President Trump’s tax plan may lead to major changes, or the repeal of section 1031, which could negatively impact investors and the market if future transactions fell within different tax years. Investors would no longer get a tax break for deferring capital gains. This could lead investors to consider other investment opportunities outside of the real estate market. Without section 1031, it will lengthen the holding period of property. This could make the market less desirable for new investors, as well as limit growth. However, section 1031 can be offset by immediate expensing.

Immediate Expensing

With the prospect for repeal of section 1031 looming in the future, President Trump has developed a plan to offset it. His plan calls for immediate expensing of an asset instead of it being depreciated over the normal 27 years. Immediate expensing will allow investors to buy a property to avoid being taxed on their earnings.

Change In Tax Structure for Landlords of Small Rental Properties

Most landlords of small rental properties own their properties through limited liability companies and partnerships. However, the income generated from these companies is usually reported on the individual’s tax return which could be taxed as high as 39.6 percent if the owner falls into the top tax bracket. President Trump’s plan would allow these entities to receive the corporate tax of 15 percent. This change would make the market for owning rental properties very attractive to new owners and very profitable to existing owners. Utilizing the 15 percent corporate tax rate is President Trump’s goal, but Congress, who has the final decision, is leaning towards 22 percent.

Impact on Real Estate Investment Trusts

Real Estate Investment Trusts (REIT) are companies that own and operate income generating commercial real estate. They usually consist of office, retail, apartments and industrial properties. Most REITs are publicly traded and operate very similar to a normal stock with regard to buying and selling shares. However, REITs are different from normal stocks in two ways:

  • Retained earnings
  • Payments of dividends to shareholders

REITs are required to pay a 90 percent dividend to shareholders. With President Trump wanting to lower the corporate tax rate to 15 percent, a higher dividend yield from other sectors could compete with REITs. Currently, according to Fidelity Investments, REITs annual average dividend yield is 3.89 percent. This is .84 percent higher than the average of all sectors. This means if a corporation, in a lower corporate tax rate, will have more income to distribute to shareholders. This will, in turn, make REITs less desirable and only a necessity for diversification in an investor’s portfolio. Also, real estate corporations may offer better returns over REITs in years to come if a lower corporate tax rate is implemented.

Carried Interest

Reforming carried interest will play a major role in the future of commercial real estate. Currently, carried interest is taxed as capital gains. Changes may be made to where it is taxed as ordinary income. The argument is that all labor should be taxed the same and since carried interest is created by labor, it should not receive a capital gains tax. This could present a problem for the real estate sector because carried interest is common in joint ventures and partnerships. The majority of profit comes from the sale of a property, which receives the 20 percent capital gains tax. With the proposed change, the sale of property may be seen as ordinary income instead of a capital gain and receive an interest tax which currently could be as high as 39.6 percent, if it is ordinary income, for those in the highest tax bracket. Although under President Trump’s plan it could be reduced to 33 percent. This would impact investors who compensate partners or others who provide services. It would cause investors who provide the majority of equity to ask for a higher percentage of the returns in an effort to make up for the potential 13 – 19.6 percent tax increase they will pay once the venture is over.

Sources:

www.wsj.com/articles/trump-tax-plan-likely-to-help-real-estate-sector-1493245692
www.nreionline.com/finance-investment/how-looming-tax-reforms-might-impact-cre-industry
assets.donaldjtrump.com/trump-tax-reform.pdf
www.wsj.com/articles/how-trump-wants-to-change-your-tax-deductions-1493380423
www.forbes.com/sites/bisnow/2017/03/07/cre-experts-give-forecast-on-1031-exchanges-under-trump-administration/#61b74ce52f53
www.forbes.com/sites/bradthomas/2017/03/13/trumps-corporate-tax-plan-could-be-a-game-changer/#26e8223f2a7d

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