How Recent Tax Proposals May Affect RealtyShares Investors

The commercial real estate industry in which RealtyShares investors participate remained largely unscathed by the recent House proposal of changes to the Internal Revenue Code. Investors may actually benefit from some of the proposals, and changes to the individual mortgage interest deduction and other changes may actually end up benefitting the market for value-add multifamily projects that RealtyShares often features.

No Changes to 1031 Like-Kind Exchange Tax Deferrals for Real Estate

Investors that re-invest the sales proceeds from investment properties into replacement investment properties have long benefitted from the tax deferrals on gains that qualify for “like-kind” exchanges under Section 1031 of the tax code.  While the House proposal eliminates such tax deferrals for personal property, it leaves the tax provision unchanged for real estate investments.

Limitations on Sponsor Business Interest Deductions Are Also Avoided

The original GOP House blueprint for tax reform proposed eliminating the corporate interest deduction in exchange for allowing companies to expense capital expenditures right away. Because property loans make up a significant portion of a real estate project’s overall capitalization, such a deduction elimination could have been very problematic for real estate companies.

Under the revised proposal, most business will still be able to deduct interest, but the deduction would be limited to 30% of their earnings before interest, taxes, depreciation, and amortization (EBITDA). But that limit will not apply to commercial real estate.

No Changes to Carried Interest Taxation

Real estate developers make much of their money from taking a “promote” interest in their projects – a portion of the profits beyond those otherwise attributable to their invested capital – which is treated similarly under the tax code as “carried interest,” a similar compensation mechanism used by hedge fund and private equity managers. This compensation has typically been taxed at a lower rate than ordinary income, and some observers (including, earlier, President Trump) had called for the elimination of that disparity.

The House proposal does not address carried interest.  The issue may become moot anyway if the proposed new tax rate for pass-through business income (discussed below) is enacted.

Lowered Business Income Rates for Investors in Pass-Through Entities

The change that might affect investors and sponsoring real estate companies most directly is the proposed reduction of the tax rate applicable to business income received from pass-through entities, such as the limited liability companies and partnerships utilized by RealtyShares and most project companies formed by sponsoring real estate companies.  This rate on pass-through business income would be dropped from 39.6% to 25%.

For many investors in real estate projects, the lower rate for pass-through business income could be a boon.  This is because the proposal aims to encourage investment by small businesses through a formula that targets tax revenue that is applied to capital expenditures.  Real estate projects should benefit from that “capital expenditure” test.  And the current proposal allows “passive” owners in such pass-through entities to benefit from 25% top rate as well, according to the legislation. The provision would thus likely work to the advantage of RealtyShares investors who invest in real estate projects

The proposal faces much criticism, however.  The bill would make it very difficult for lawyers, engineers, doctors, consultants and other personal services providers, who make up a good share of small businesses, to qualify for the 25% rate since their services do not involve capital expenditures. And since the change only effectively lowers taxes for persons whose income tax rate is above 25%, the change wouldn’t help everyone. Couples earning less than $260,000 and singles earning less than $200,000 wouldn’t be able to take advantage of it. And some observers claim that about 86% of these pass-through business owners aren’t paying individual rates greater than 25% anyway.  Critics thus argue that the “small-business tax cut” label that the House is applying to this proposed change mischaracterizes the situation.

Additionally, the change’s applicability to persons who are “passive” owners, while potentially beneficial to investors in real estate projects, strikes many as counter to previous IRS rules that generally try to avoid providing special tax breaks to non-active investors, which earlier efforts aimed (for example) at preventing people from falsely claiming to be active in order to claim tax losses.

Individual Mortgage Deductions May Be Capped

The tax plan would reduce the maximum available interest deduction available on owner-occupied mortgage debt from the current $1 million cap to a $500,000 amount.  And it would make that deduction less relevant, too, by implementing a big increase in the standard deduction (the amount that can be earned before paying tax), which would greatly reduce the incentive to take advantage of itemized deductions in the first place (Americans must pick one or the other).

For most of America, the impact will be minimal, since the $500,000 figure is still more than double the median home price in the United States of roughly $200,000Fewer than three percent of home mortgages involve principal balances of more than $500,000, according to CoreLogic.

But more expensive areas along the coasts will feel the pinch.  While in the Houston metropolitan area only about 6.5 percent of homes are valued at more than $500,000, in San Jose, Calif., more than 90 percent are, and in San Diego, Calif., it is 63 percent, according to Zillow. The move will thus serve to raise the overall cost of buying a home in those areas, and perhaps discourage existing homeowners in those regions from moving.

For the single-family or condominium sectors of the housing market, these changes will generally not help transaction activity in the high end of the market.  The U.S. homeownership rate has already fallen to about 64 percent from its pre-recession peak of around 69 percent, and the whittling away of the mortgage interest deduction gives homeowners one more reason to stay put, said Svenja Gudell, chief economist at Zillow.

The House plan would also cap the deductibility of property taxes at $10,000, another provision that could weigh on the construction and resale of more expensive homes. Moreover, the proposed elimination of deductions for state and local income taxes would adversely affect itemizing households in high-tax states like California and New York.

But if the changes do continue or accelerate the shift from home owners to renters, the commercial property sector that focuses on rental units may well benefit. The market for value-add multifamily apartment complex projects often featured by RealtyShares, for example, may actually see increased interest if the proposed changes are enacted into law.

Things Are Moving Fast

The residential real estate industry, including mortgage bankers, will be pushing back hard on Congress in the weeks to come with respect to the new limits on the mortgage interest deduction and other proposals considered damaging to the single-family housing industry.  The House seems intent on speeding the plan to a vote, though – Republicans are attempting to get the plan to President Trump’s desk by Christmas – so lobbying efforts may be less effectual than in the past.

Neither RealtyShares, Inc. nor North Capital Private Securities Corporation, as institutions, advise on any personal income tax requirements or issues. Use of any information from this article is for general information only and does not represent personal tax advice, either express or implied.  Readers are encouraged to seek professional tax advice for personal income tax questions and assistance.

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.
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