For the past 30 years, since the passage of the 1986 Tax Act, the rules for the taxation of commercial real estate are aligned with the economics and fundamentals of the industry. That could all change with legislation that is being considered by the House of Representatives. The current proposal includes three components that will have a significant impact on the industry. These include:
- The elimination of the interest deduction;
- The elimination of the 1031 exchange; and
- Full expensing of the cost of the asset in the year of acquisition.
Elimination of interest expense. Nearly all investors in commercial real estate borrow heavily to acquire their assets. Generally, 65 to 80 percent or more of the cost of the asset is paid for with debt. Along with this debt is the associated interest expense. Current tax laws allow the owner to deduct the interest expense from taxable income.
The new rules would eliminate that deduction from the owner’s taxable income. Once the cost of the asset has been fully recouped under full expensing (discussed below), the owner now will have a significant cash expense for interest, which he will not be able to deduct. Since interest expense frequently accounts for nearly 50 percent or more of the operating cash flow from commercial real estate, elimination of this deduction will effectively double the owner’s tax liability as a percentage of his net cash flow.
This will alter the traditional capital stack used in the purchase of commercial real estate. Loans will effectively become much more expensive and therefore less desirable to the owner. Lenders will find it more difficult to originate loans at the same loan-to-value percentages used historically. With the typical risk/reward equation in the present capital stack destroyed, cap rates could increase to compensate.
Elimination of the 1031 exchange. For years, the 1031 exchange has provided liquidity to an industry that is otherwise very illiquid. The 1031 exchange allows investors to sell their investment property and defer the gain on the sale if they reinvest the proceeds into a new investment property. This tool is valuable to the industry since, without it, it frequently would not be practical for owners to sell assets since the tax liability would destroy too much equity.
If the 1031 exchange is eliminated, it is very likely that the volume of transactions in the industry would decrease significantly. Note that in Canada there is no similar exchange rule, subsequently properties trade at roughly 25 percent of the rate they do in the U.S.
Full expensing. Currently owners are allowed to take a deduction for depreciation against their taxable income to recover their investment in the asset. This deduction typically will decrease their taxable income and associated annual tax liability by roughly 35 to 50 percent. Full expensing would allow the owner to deduct the entire cost of the asset in the year of the acquisition and carry over any loss until the entire loss was absorbed. This would mean that the owner would pay no tax at all for, in most cases, at least the first 10 years of ownership and, in some cases, 20 years or more.
Although in the short term this is a huge windfall to owners of commercial real estate, it is contrary to public policy with the need for the federal government to collect taxes. It could also distort the market for commercial real estate as investors will be drawn by the tax benefits rather than sound fundamentals.
There is no good way to estimate the net impact of the proposed rules. Full expensing will put upward pressure on pricing as the tax benefits of owning commercial real estate will drive further investment into an already active and possibly overheated industry. Likewise, eliminating the 1031 exchange will decrease the ability of sellers to sell, which will put upward pressure on pricing as buyers will have fewer investment options. Meanwhile, eliminating the interest deduction will fundamentally change the economics of the industry once the acquisition cost of the asset has been fully absorbed.
These changes will not only impact the values of commercial real estate but also will have negative effects on a number of other businesses that are reliant on the industry. Certain businesses will cease to be relevant completely, such as 1031 qualified intermediaries and companies that perform cost-segregation studies. Other industries that will be negatively impacted if there is a decrease in transactions include brokers, title companies, law firms and inspectors, to name a few. Finally, lenders will not only see a decrease in volume, but also may see a decrease in borrowing as a percentage of the purchase price when interest is no longer deductible as an expense.
The 1981 Tax Act created significant tax incentives to invest in commercial real estate. This led to a boom in real estate investing and increases in the prices of commercial real estate. Five years later, when the 1986 Tax Act eliminated these incentives, the artificially high values dropped back to more appropriate values based upon sound economics. There is a risk that the currently proposed rules could pose the same threat.
We encourage all readers to contact their elected officials and to join the efforts of the National Multifamily Housing Council, National Apartment Association, Mortgage Bankers Association, American Bankers Association, American Institute of Certified Public Accountants and others to help defeat this bill that is presently being crafted in the House Ways and Means Committee.