CREJ

Page 38

April 5-18, 2017

www.crej.com

olorado

eal

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ournal

Taxes

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or the past 30 years,

since the passage of the

1986 Tax Act, the rules

for the taxation of commercial

real estate are aligned with the

economics and fundamentals

of the industry. That could all

change with legislation that is

being considered by the House

of Representatives. The current

proposal includes three compo-

nents that will have a significant

impact on the industry. These

include:

1. The elimination of the inter-

est deduction;

2. The elimination of the 1031

exchange; and

3. Full expensing of the cost of

the asset in the year of acquisi-

tion.

Elimination of interest

expense.

Nearly all investors in

commercial real estate borrow

heavily to acquire their assets.

Generally, 65 to 80 percent or

more of the cost of the asset is

paid for with debt. Along with

this debt is the associated interest

expense. Current tax laws allow

the owner to deduct the interest

expense from taxable income.

The new rules would eliminate

that deduction from the owner’s

taxable income. Once the cost of

the asset has been fully recouped

under full expensing (discussed

below), the owner now will have

a significant cash expense for

interest, which he will not be able

to deduct. Since interest expense

frequently accounts for nearly 50

percent or more of the operating

cash flow from commercial real

estate, elimination of this deduc-

tion will effectively double the

owner’s tax liability as a percent-

age of his net cash flow.

This will alter the traditional

capital stack used in the pur-

chase of commercial real estate.

Loans will effectively become

much more expensive and there-

fore less desirable to the owner.

Lenders will find it more difficult

to originate loans at the same

loan-to-value percentages used

historically. With the typical risk/

reward equation in the present

capital stack destroyed, cap rates

could increase to compensate.

Elimination of the 1031

exchange.

For years, the 1031

exchange has provided liquid-

ity to an industry that is oth-

erwise very illiquid. The 1031

exchange allows investors to sell

their investment property and

defer the gain on the sale if they

reinvest the

p r o c e e d s

into a new

investment

p r o p e r t y.

This tool is

valuable to

t h e i n d u s -

t r y s i n c e ,

without it,

it frequently

would not

be practical

for owners

to sell assets

s i n c e t h e

t a x l i a b i l -

i t y w o u l d

destroy too much equity.

If the 1031 exchange is elimi-

nated, it is very likely that the

volume of transactions in the

industry would decrease sig-

nificantly. Note that in Canada

there is no similar exchange

rule, subsequently properties

trade at roughly 25 percent of

the rate they do in the U.S.

Full expensing.

Current-

ly owners are allowed to take

a deduction for depreciation

against their taxable income

to recover their investment in

the asset. This deduction typi-

cally will decrease their taxable

income and associated annual

tax liability by roughly 35 to 50

percent. Full expensing would

allow the owner to deduct the

entire cost of the asset in the year

of the acquisition and carry over

any loss until the entire loss was

absorbed. This would mean that

the owner would pay no tax at

all for, in most cases, at least the

first 10 years of ownership and,

in some cases, 20 years or more.

Although in the short term this

is a huge windfall to owners of

commercial real estate, it is con-

trary to public policy with the

need for the federal government

to collect taxes. It could also dis-

tort the market for commercial

real estate as investors will be

drawn by the tax benefits rather

than sound fundamentals.

There is no good way to esti-

mate the net impact of the pro-

posed rules. Full expensing will

put upward pressure on pric-

ing as the tax benefits of own-

ing commercial real estate will

drive further investment into

an already active and possibly

overheated industry. Likewise,

eliminating the 1031 exchange

will decrease the ability of sellers

to sell, which will put upward

pressure on

pricing as

buyers will

have fewer

investment

o p t i o n s .

Meanwhile,

eliminating

the interest

deduc t i on

will funda-

m e n t a l l y

change the

e c o n o m -

ics of the

i n d u s t r y

o n c e t h e

acquisition cost of the assethas

beenfully absorbed.

These changes will not only

impact the values of commer-

cial real estate but also will

have negative effects on a num-

ber of other businesses that are

reliant on the industry. Cer-

tain businesses will cease to

be relevant completely, such

as 1031 qualified intermediar-

ies and companies that per-

form cost-segregation studies.

Other industries that will be

negatively impacted if there

is a decrease in transactions

include brokers, title compa-

nies, law firms and inspectors,

to name a few. Finally, lenders

will not only see a decrease

in volume, but also may see

a decrease in borrowing as a

percentage of the purchase

price when interest is no longer

deductible as an expense.

The 1981 Tax Act created sig-

nificant tax incentives to invest

in commercial real estate. This

led to a boom in real estate

investing and increases in the

prices of commercial real estate.

Five years later, when the 1986

Tax Act eliminated these incen-

tives, the artificially high values

dropped back to more appropri-

ate values based upon sound

economics. There is a risk that

the currently proposed rules

could pose the same threat.

We encourage all readers to

contact their elected officials

and to join the efforts of the

National Multifamily Housing

Council, National Apartment

Association, Mortgage Bankers

Association, American Bankers

Association, American Institute

of Certified Public Accountants

and others to help defeat this bill

that is presently being crafted

in the House Ways and Means

Committee.

Proposed tax rules impact CRE

Bob Nicolls

Owner and

president, Monarch

Investment and

Management Group,

Franktown

Andy Newell

Chief financial officer

and CEO, Monarch

Investment and

Management Group,

Franktown