Adams says, “Some great advantages that were more relevant for Californians, such as the $500,000 capital-gain exclusion for sale of principal residence, are still there.” ***Photo courtesy of www.SeniorLiving.org.

SAN DIEGO—Much has been discussed about the relatively less-favorable tax treatment for residents in high-tax states incentivizing moves to lower-tax locations, but Wells Fargo's SVP and business-banking area manager Daniel Adams tells GlobeSt.com that a lot of this has been exaggerated. Adams recently moderated a panel presented by the Commercial Real Estate Association of San Diego titled, “Changes to the Tax Code: A Boon or Bust for Commercial Real Estate?” Afterward, we got his take on how the tax code is expected to impact CRE and how the market will react to these changes.

GlobeSt.com: What changes to the tax code will affect the commercial real estate industry?

Adams: Well, first off, I need to put out the disclaimer to “consult your tax professional,” but I'll give you my somewhat-educated personal opinions, which are not necessarily the opinion of Wells Fargo Bank.

But to answer your question, commercial real estate typically tracks to the overall business cycle. And, without getting into political issues, I have yet to hear anyone argue that the new tax law is bad for business. If tax policy can spur an additional 2% to 3% GDP growth, that would certainly increase demand for office, industrial, warehouse and other commercial property.

The tax law made numerous changes that will favorably affect commercial real estate as an asset class, including indirect changes such as reductions in tax rates. But specifically, the new tax code substantially allows for an aggressive recapture of depreciable personal property that is part of a real estate transaction. In many cases, a building purchaser could immediately deduct up to $1 million in depreciation for things like HVAC or other interior improvements during the first year of ownership.

Additionally, the law provides for a 20% reduction of business income for most pass-through entities, including S corporations and LLCs, and then subjects that personal income to a lower tax rate. So, whereas in 2017 you might have $100,000 in LLC income that passes through to you personally and would be subject to, for example, a 28% marginal tax rate, in 2018 that same situation might result in just $80,000 of the LLC profit passing through and then being subjected to a 24% marginal tax rate.

I think we also need to consider changes to other areas. For example, the ability to defer taxes through a 1031 exchange is now only available with real estate, eliminating art, equipment, livestock, etc. from 1031 treatment. So, the tax code now carves out real estate as the only asset where you can defer gains through 1031. Also, you need to look at what wasn't changed, such as the continued deductibility of interest expense for real estate investments.

Additionally, if the real estate is held in a C corporation, the graduated federal tax rates (up to 38.9%) have been replaced by a flat 21% rate while retaining almost all of the income deductions.

Even the increase in estate-tax exclusion to $11 million per person should be viewed as favorable to real estate and businesses, since those are the assets that most often appreciate and are inherited by heirs.

Everywhere I looked, real estate was treated as the preferred investment vehicle for businesses and individuals.

GlobeSt.com: Will these changes ultimately be only positive for the industry?

Adams: Absolutely. More than anything, the elimination of uncertainty allows for informed planning and decision making for everyone, whereas the lack of clarity often causes people to delay.

As I mentioned, real estate is clearly the preferred asset within the tax code, but overall business investment has also been positively impacted. You can now typically take a Section 179 expense to accelerate depreciation on equipment and other qualified capital improvements, freeing up additional cash that would otherwise have gone to pay taxes.

I do think that within commercial real estate, certain property types may outperform others. For example, the doubling of the standard deduction means that 90% of taxpayers will not be itemizing their personal tax return. This effectively eliminates the tax advantage of owning a house versus renting, so many experts believe that this will increase the demand for single- and multifamily rental properties. And the provisions to encourage repatriation of foreign business profits could spur additional investment in US-based manufacturing, which would drive demand in that sector.

I don't think many people realize how significantly business decisions are impacted by tax policy, and it will be exciting to see the direct and indirect impact of these tax changes on the economy.

GlobeSt.com: How will the market react to these changes?

Adams: I expect you will see the normal impact of supply and demand, so if people shift to real estate from other, less tax-attractive investments, we should see an increase in values there.

Being in California, I know much has been discussed about the relatively less-favorable tax treatment for residents in high-tax states, and there could be some additional incentive for people to relocate to lower-tax locations. However, I think a lot of that has been exaggerated.

For example, although state and local taxes (SALT) are now capped at a $10,000 deduction, the alternative minimum tax (AMT) was already offsetting about 70% of the SALT-tax deductibility. The new law severely curtailed AMT, meaning the negative impact of SALT-deduction limits is likely not as negative as first appeared. And remember that some great advantages that were more relevant for Californians, such as the $500,000 capital-gain exclusion for sale of principal residence, are still there.

One market reaction that might offset all this positive inertia is the capital market; the increased growth could trigger a rise in interest rates associated with increased inflation. That could, in turn, make the cost of real estate financing more challenging for some borrowers. There are always balancing actions whenever you have disruption—even the positive disruption that this law provides. For example, I really don't know what impact the elimination of itemized deductions (including reducing mortgage-interest deductibility) will have on the housing sector.

GlobeSt.com: What else should our readers know about this topic and the panel discussion on it?

Adams: One significant take-away for me when interacting with the brokers was that the impact of the new tax law on them personally was just as important as the impact on the marketplace. Tax law is pretty dry, so you didn't get a lot of media attention paid to the specific changes this law made.

But everyone—and commercial real estate brokers in particular—needs to speak with their tax professional and figure out how to structure their business, their income and their investments in a way that maximizes the advantages of the new tax law. Some of the favorable treatments are lost at certain income levels, so don't think that this tax law is a “one size fits all” situation.

Instant Insights /

Tax-Related Exodus From CA May Be Overblown

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