While there is a lot uncertainty concerning which of the many proposed policies of the incoming administration will be pursued, some sort of tax reform is very likely. Although the potential impact of the various proposals on the real estate community is far from clear, significant rules changes could have a major impact on real estate values.
Tax Rates and the Alternative Minimum Tax
Most of the talk on tax reform starts with lowering the tax rates for individuals from 39.6% to 33%, and reducing the number of brackets from seven to three.
While the Trump plan keeps capital gains at the existing 20% rate, the House proposal gives a 50% exclusion to capital gains, dividends, and interest income, effectively taxing them at a maximum rate of 16.5%.
There is also the possible repeal of the 3.8% Net Investment Income Tax, as well as the Alternative Minimum Tax (AMT) - benefitting residents of states with the highest tax rates (NY and CA among them).
Proposed reductions in the corporate rates from 35% to either 15%-20% and rates for "business income" from pass through entities are central pillars of both tax reform proposals. The lower corporate tax rate may help foreign investors that come in through corporate blockers.
The proposed rate reduction may already be impacting the tax exempt bond market. When investors look at their municipal bond portfolio, they generally compare the rate they are getting from the bonds to after-tax return on a taxable bond. With tax rates going down, the bonds may not be as attractive as before.
As an offset to proposed rate reductions, there are proposed limitations on certain itemized deductions.
The Trump proposal appears to cap the deductibility of itemized deductions at $100,000 ($200,000 if married). The House plan, however, would only allow deductions for charity and mortgage interest, eliminating deductions for investment interest expense, medical, miscellaneous itemized deductions, gambling losses (to the extent of income), and state tax deductions among others. There is talk about possible limitations on corporate deductions as well.
The flip side to this is the impact of the proposed rate cut on the real estate related tax credit market. When a developer is looking to work on rehabilitation of a historic building or tax credits, part of the capital usually comes from finding an investor interested in the depreciation and "selling" them the credits. While the credits are a dollar for dollar reduction in the tax regardless of the rate, the present value of the tax savings from credits and depreciation deductions will change dramatically with the reduced tax rates. Investors have begun negotiating document provisions requiring automatic changes to amounts invested if there is an adverse economic impact by the rates going down.
For real estate developers and promoters with carried interest, the biggest potential impact of Trump's tax proposal deals with the tax rate applicable to carried interests.
Currently, developers and promoters typically get some type of profits interest once certain criteria are met by the investors (for example an IRR hurdle). The profit percentage increase should not be taxed upon the issuance of the additional percentage interest but is an allocation of the entity's taxable income after the hurdle is met.
This isn't the first time that the government attempted to alter the tax treatment of tax carried interests. However earlier versions of proposed legislation created more confusion by being incredibly complex and overly broad. Coupled with the lack of political will, these proposals were destined for the trash bin.
On the bright side, the proposed lower ordinary income tax rates may dampen the impact of the carried interest rules.
Over 200 years ago, Benjamin Franklin famously said, "in this world nothing can be said to be certain except death and taxes". For a lot of people in the US, both came together in the estate tax regime.
There has been a push over the last decade to limit its impact by raising exemptions. First by raising the exemption to $5 million, and then by indexing it for inflation. Both proposals call for changes to the estate tax regime.
While the proposals vary, both call for some sort of income tax on built in gains; the Trump plan calls for deemed sale on death with an exemption for the first $10 million of gain and the House calls for deferral until the heirs sell the property but is silent on any type of exemption.
With the impact only to a limited class of people (about 11,000 estate tax returns were filed in 2014), however, making changes to the current estate tax regime will likely not be the first priority. Ironically, while both the Trump and House plans call for the repeal of the estate tax, they are both silent on gift and generation skipping taxes. This can substantially limit tax efficient lifetime transfers as well as transfers that go to grandchildren.
There is also a lot of chatter about eliminating or limiting so-called "tax expenditures" - special subsidies in the form of deductions, exclusions, or credits that are delivered through the tax code in order to promote certain activities and reduce the cost of the overall bill.
Examples include energy credits, pension deductions, accelerated depreciation and deferring gains through 1031 like-kind exchanges. There is a lot of speculation that some of these benefits may be reduced in order to limit the cost of an overall bill, and the lack of any guidelines is making market participants very nervous as to which may not be available going forward. Also, given the fact that many states use the federal tax system as a starting point to impose their state taxes, it is also unknown what impact - positive or negative - any federal tax reform will have on state taxation.
With a new administration as well as Republican control of Congress, some level of "reform" is extremely likely. It is ironic how there are always more pages added to the tax code and regulations every time they try to streamline.
Albert Einstein famously said, "The hardest thing in the world to understand is the income tax." This quote should be remembered as the government looks to "simplify" the tax code.
For further clarification of the upcoming tax code changes, speak with your advisors or contact a Berdon representative to review how the proposed tax plans might impact your personal and business tax situation. This article is based on the proposals as they currently exist and care should be taken as these can be changed at any time.
Berdon LLP New York Accountants