The Tax Cuts and Jobs Act of 2017 (TCJA) created a sweeping overhaul of the U.S. tax landscape—the biggest set of changes in 30 years. Among the key provisions from that legislation for real estate businesses were:
- Corporate tax rates were lowered to a flat 21 percent of taxable income
- Broader tax base and a territorial tax system
- One-time tax on overseas earnings that are deemed repatriated
- Limitation on business interest deductions
- An increase of the bonus depreciation percentage from 50 percent to 100 percent for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023
- Immediate expensing of certain capital expenditures
Although TCJA was passed in 2017, significant final and proposed federal regulations and other guidance continue to be released. Then, with the current pandemic, there has been the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which contains numerous revisions to the TCJA. Ongoing change is also inevitable at the state level, as states and local jurisdictions either conform or diverge from the TCJA.
However, proposed policy changes from the Biden administration may yet again change taxes for real estate investment. The recent American Rescue Plan Act was light on tax aspects that may affect commercial real estate, which is already hard hit by the effects of the COVID-19 pandemic.
On March 31, 2021, President Biden and the White House released the $2 Trillion “American Jobs Plan” which is aimed primarily at upgrading infrastructure, electric grids, broadband capacity, and expanding affordable housing. According to a fact sheet released on March 31st, the Made in America Tax Plan was proposed alongside the American Jobs Plan. The key takeaways from the tax plan that would affect private equity investors in real estate are:
- Increase in U.S. corporate rate to 28 percent from 21 percent
- Impose a 15 percent minimum tax for very large corporations based on book income
- Increase in the effective rate on global intangible low-taxed income (GILTI) to 21 percent, calculate GILTI on country by country basis and eliminate 10 percent return on tangible assets
- Seek global agreement to encourage other countries “to adopt strong minimum taxes on corporations” and “deny deductions to foreign corporations on payments that could allow them to strip profits out of the United States if they are based in a country that does not adopt a strong minimum tax”
- Tougher rules for preventing U.S. companies from “inverting” (become foreign-domiciled)
- Eliminate the deduction for foreign-derived intangible income
If these pass, private equity investment firms will be seeking ways to minimize their tax burden. Private equity real estate investors may restructure the entities they own to work around these taxes.
The President looks forward to working with Congress and will be putting forward additional ideas in the coming weeks for reforming the tax code.
This current tax environment impacts transactions in some significant ways, whether it is tax due diligence, pricing and valuation, deal financing and structuring or any post-deal integration. Private equity investors can turn this tax uncertainty into potential opportunity by being proactive and engaging with tax advisors from the outset of the deal.
Based on what President Biden said during his presidential campaign, other tax policy proposals that may be forthcoming in the next round of tax legislation having serious considerations for private equity investors include:
- The potential repeal of 1031 like-kind exchanges will surely have a strong impact on the real estate industry. These transactions have long been in legislators’ sights, but their economic importance has always overshadowed previous attempts to eliminate them. It remains to be seen how the real estate lobbies will push back and to what effect. If the 1031 exchange is eliminated, the question remains: Will there will be an alternative available to benefit U.S. taxpayers?
- President Biden wants to increase the rate for individual long-term capital gains for taxpayers with more than $1 million a year in income. These changes would result in long-term capital gains being taxed at ordinary tax rates for taxpayers with more than $1 million in income and eliminate the carried interest loophole.
- Carried interest (which is taxed as capital gains) held for more than three years is currently taxed at preferential rates. The proposal is to raise it from 20 percent to a top rate on ordinary income for individuals, which is also proposed to be increased from 37 percent to 39.6 percent.
- If this passes, general partners of private equity funds will see a drop in their post-tax incomes.
- General partners of private equity funds are usually compensated through “carried interest,” which is usually around 20 percent of profits accrued above a specified hurdle rate. The higher tax rates may result in increased percentage of profits paid as carried interest.
- This could result in private equity funds having to revise their investment models, resulting in lower return on investment for the limited partners investing in such funds, thereby reducing valuation of these portfolios.
- During the Trump Administration, Congress and the IRS gave taxpayers the opportunity to invest in qualified opportunity zones (QOZ) via qualified opportunity funds (QOF). QOF investments are designed to invest in real estate and businesses in QOZs, which are areas designated as economically distressed. The tax incentives for these types of investments included deferring and potentially reducing taxes on capital gains. Once designated as QOF, the fund must invest at least 90 percent of its assets in QOZs to receive preferential tax treatment, and it must make substantial improvements to the property. Investors who elect to reinvest capital gains into Opportunity Funds will receive multiple capital gains tax benefits that will allow an investor to defer, reduce, and ultimately eliminate future capital gains. Private equity investors can defer tax on any prior gains invested in a QOF until the earlier of the date on which the investment in a QOF is sold or exchanged or until Dec. 31, 2026.
President Biden plans to keep the incentives for eligible projects, but include more disclosures and transparency, which will create more scrutiny for investors. Biden’s proposed increase in capital gain tax rates may also have a negative impact on QOZs as current gains are deferred and taxed at a potentially much higher rate in 2026. On the other hand, an increase in capital gain rates would make the tax-free exit from a QOZ investment more attractive, assuming the increased rates are still in place after the required 10-year holding period. Also, if Section 1031 like-kind exchanges were to go away, there may be a surge in QOZ investments to seek at least a limited tax-deferral.
Regarding cash liquidity for private equity investors in the commercial real estate sector: The bottom line is always to maintain or increase liquidity and mitigate or defer tax liability. Some private equity sponsors may choose to use traditional tax planning strategies to achieve these goals; others may use strategies that plan around the recent tax reforms to defer income, accelerate deductions, and fully utilize losses. Reclassifying and accelerating asset depreciation through a cost segregation analysis can yield significant results in terms of cash flow and tax savings. This cost segregation may be performed for various real estate asset classes.
While the Biden administration’s tax proposals are not yet on the congressional bargaining tables, investors should be aware of the potential legislative updates and how they will affect commercial real estate investment for private equity funds and investors. Higher tax rates, reduced profits, and possible liquidity issues may force some sponsors to make adjustments in their real estate portfolios to ensure more positive investor outlooks.