As hard as it is to believe, summer is over, and we are now chugging toward the holidays and the end of the year. With this comes the very important public policy discussion that will take place around tax reform. Tax reform could be extremely good for commercial real estate or could be devastating.
The three components of tax reform that could profoundly impact commercial real estate capital markets are expensing, or being able to depreciate 100 percent of a capital investment in the year it is made; the elimination of the deductibility of interest on business debt (all businesses, but particularly commercial real estate, rely on debt); and modifications to 1031 tax-deferred exchanges.
Through the first half of 2017, we have already seen significant reductions in volume within the investment sales market in New York City. The number of properties sold is on pace for 3,756 sales—32 percent below 2014’s all-time record of 5,534 sales. The dollar volume of sales is on pace for $32.9 billion, a whopping 57 percent below the $77.1 billion of sales seen in 2015.
With the sales market suffering the way it is, the last thing we need is the modification or elimination of 1031 tax deferred exchanges. We estimate that about 70 percent of sellers purchase another asset within 180 days of selling their property, providing them with the ability to defer their capital gains tax exposure. Additionally, it is estimated by The Real Estate Roundtable in Washington, D.C., that one third of all property transfers pay some type of tax, even if a 1031 exchange is used.
In addition to deferring capital gains tax exposure, 1031 exchanges have three distinct benefits for the market and the economy: The additional capital investors are left with 1.) creates more investment—as investors typically “trade up,” purchasing a more valuable property then the one they sold—2.) creates more jobs—as new properties are purchased they’re also upgraded, creating construction jobs—and 3.) adds additional liquidity to the market.
While these are three very compelling benefits of 1031 exchange transactions, the scorekeepers of tax reform look at things differently. They make the assumption that all transactions that happened previously would happen again, just with different tax ramifications. This is a dangerous and faulty assumption. The fact is that without the tax deferral mechanism available via the 1031 exchange, many sellers simply would not sell. Economics 101 teaches us that if an activity gets more expensive, you get less of that activity. If 1031 exchanges were eliminated, the volume of sales would fall even further, creating the ability for sales brokers like me to take a year long vacation without missing very much.
If expensing is allowed, it would over-juice the market to the point where we would probably have excessive speculative construction the way we had in the early 1980s when depreciation schedules were just 15 years.
Today, depreciation schedules are 27.5 years for multifamily assets and 39 years for other commercial properties. One-hundred percent depreciation in year one would lead to construction of buildings that were not needed, bringing back the “see-through” buildings that were so plentiful in the early 80s that led to a significant crash in the early 90s. It would also significantly disadvantage owners of existing properties and would force them to make trades, or sell, to take advantage of these new expensing rules.
While this would create artificial business for sales brokers, and additional activity market wide, it is activity created based on wanting to take advantage of the rules, not based on solid decision making. The real estate industry believes that tax reform should reward you for what you have done, or would normally do, not create incentives to do stuff you wouldn’t ordinarily do. Our industry just wants to be taxed fairly, not have policy driving decision-making.
The real roundhouse punch to the industry of tax reform could be the elimination of the deductibility of interest on business debt. As stated earlier, all businesses, but especially commercial real estate, rely on debt and not being able to deduct that interest would drastically and profoundly change the underpinnings of the commercial real estate industry.
We are all waiting for granular details of the administration’s plan to modify our tax system. It would appear that most participants in the market are hoping for minor tax reform and not sweeping tax reform as the administration has pledged. Cuts in personal tax rates and corporate tax rates are good for everyone. However, the key question is, What are the trade-offs that will come at the expense of these reductions in other rates? We should have these answers within the next month or two, but the world could look a whole lot different based on what those details reveal.