CALABASAS, CA—The passage of the long-anticipated tax reform legislation will take effect next year, leading many investors to the arduous task of recalibrating their strategies and assessing how the changes will affect their assets. As John Chang, first VP of research services for Marcus & Millichap, explains, “The new tax law is generally benign for the commercial real estate sector, but there are many nuances that will affect real estate and the after-tax returns of investors.”
Before considering some of the specific provisions, it is worth noting that the simple act of passing tax reform legislation itself could significantly benefit the sector. The clarity on tax reform will reduce the uncertainty that has weighed on the marketplace. As Chang states in a Special Report issued by the company, commercial real estate investors who may have been hesitant to move previously, will now have a much better understanding of the investment real estate landscape and can formulate a plan under the new rules.
“Over the last year, a more cautious outlook pervaded the industry as investors awaited clarity on taxes, fiscal policy and a change in Federal Reserve leadership, causing many investors to move to the sidelines,” says Chang. “That guarded approach to investment planning and underwriting could begin to ease as the implications of the new tax rules are better understood, and investors are able to assess their investment strategies with a new tax perspective.”
(Please click here for the Special Report and details of the tax changes. Highlights follow.)
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For the commercial real estate industry, a notable concern over tax reform was the fate of 1031 like-kind exchanges. However, as Marcus & Millichap reports, the final version of the bill passed by Congress is expected to have no major impact on this area of commercial real estate investment. Other risk factors at the top of investors’ minds were the ability to deduct mortgage interest, how investment real estate depreciation would be handled and potential changes to carried interest. Though each of these very important considerations face some change, they were largely maintained in-tact.
From an asset performance standpoint, several changes by the new tax laws will affect specific property types. The elimination of the individual mandate requirement in the Affordable Care Act could hold ripple effects for healthcare real estate. According to Chang, “The elimination of the personal mandate is anticipated to reduce the number of insured by an estimated 13 million people by 2027.” That said, although having fewer insured could reduce demand for medical services by an estimated 5 percent, the actual impact on medical office space and seniors housing over the next decade should not be too impactful. Chang notes that “the direct effect on healthcare real estate performance should be nominal.”
Other changes to the tax laws that could impact asset performance are centered on owner-occupied real estate. The changes will likely bolster long-term demand for multifamily housing, stemming from provisions that increase the standard deduction and cap the deduction of combined property taxes and mortgage interest deductions.
“Increasing the standard deduction to $24,000 for married couples and $12,000 for individuals and capping the deduction on combined property, sales and state income taxes to $10,000 lowers the incentive to itemize deductions,” says Chang. “This shift could diminish some of the allure of homeownership for first-time buyers, and prompt additional demand for apartments.”
Finally, reduced taxes on pass-through entities may also have an enormous impact on commercial real estate investment. For current real estate investors who are not already using an LLC or other pass through business form, the new tax laws could spark an entire portfolio reevaluation as they restructure their business model. For investors who are not already in commercial real estate, the new tax rules offer prospects of higher after-tax yields than other investment options. This change could entice significant additional capital to the CRE marketplace.
In all, the clarity the new tax law provides will position investors to make more informed decisions and leverage new mechanisms to optimize their investment strategy. With the enactment of the law, it is important for investors to reevaluate their strategies now so they are poised to maximize value when the law goes into effect.