The new $1.5 trillion tax bill represents the most drastic changes to the U.S. tax code since 1986, and the commercial real estate market could be among the sectors most impacted. As an investor, this could spell big savings to your earnings and new investment opportunities in markets affected by job creation.
To get a sense of this impact, I spoke with Mitch Roschelle, a partner at PwC with over 30 years of experience serving a wide array of real estate investors, foreign and domestic. Roschelle is a regular on Fox Business and Bloomberg TV, where he speaks about real estate, housing, business trends, capital markets, the retail industry, and the economy. He is also the co-publisher of Emerging Trends in Real Estate, a widely-circulated global annual market forecast that many investors rely on.
The New Tax Bill Hits a Thriving Economy
On December 22, 2017, President Trump signed the new tax reform bill into law. The Tax Cuts and Jobs Act (TCJA), as it is formally known, took effect at the start of this year and affects both individual income and business taxes. Before we deep-dive into the specific tax changes that affect investors, let’s take a moment to put these changes into perspective.
Roschelle says what makes this new tax reform stand apart from its predecessors is the economic environment it is being introduced into. On the day the bill was signed, the Dow Jones Industrial Average had climbed nearly 5000 points in one year and as of today, sits near the 25,000 mark.
“The 1986 Tax Reform Act passed by the Reagan administration was all about tax cuts, but it was trying to stimulate the economy,” Roschelle says. “ The chances for success of this tax bill, in terms of further growing the economy, are greatly enhanced by the fact that we are moving in the right direction already.”
Investors should take note that there are risks when a market overheats too quickly. “The thing that the Fed is super focused on is going to be inflation—monetary policy has to step in to try and prevent the economy from overheating,” Roschelle says.
Indicators of an Overheated Market
In real estate, when commodity prices go up, so does the cost of construction. “Lumber prices have gone up for a variety of reasons including scarcity of the resource and trade issues across the northern border with Canada,” Roschelle says. While this presents challenges for new construction, existing multifamily buildings may see a rise in demand.
Higher prices for lumber is one thing, but when labor for construction goes up as well, it becomes difficult to add new housing starts. “Construction labor costs are astronomical, and that’s purely a function of supply and demand for that skilled portion of labor—a demand driven by hurricane rebuilds and not new housing starts necessarily,” Roschelle says, referring to the reconstruction efforts following hurricanes Harvey and Irma.
These are all dynamic drivers that contribute to the inflation problem. And if you consider the basket of goods that form part of the core Consumer Price Index—such as U.S. crude oil prices going as high as $60 per barrel—investors will start to paint a compelling narrative of the economic situation at hand.
Roschelle says that the simplest indicator is at the checkout line. “Think about going to the supermarket and filling your cart up with stuff, it starts to become expensive because the economy is overheating—if this continues, that’s when the Feds will intervene.” This may result in higher interest rates, fewer loans, and as a result, a slowdown in the market.
How Will the Tax Bill Affect Passive Real Estate Investments?
According to Roschelle, there are two things in the tax bill that are truly transformative—one is the new categorization of income and the other is the shift from a worldwide tax system on the corporate side to a territorial one.
New categorization for “pass-through” business income
If you’re a passive real estate investor, you’re likely an accredited high net worth individual participating as a limited partner in a limited liability company (LLC). Roschelle highlights that LLC partnerships—set up as passthrough entities—can now receive a deduction of up to 20% of qualified business income (QBI).
QBI means simply the net amount of income, gain, deduction, and loss that are effectively connected with the conduct of a trade or business. The Motley Fool does a great job of explaining the exceptions that aim to prevent abuse of the new TCJA provision.
Roschelle provides a simple example for an investor who makes 10% from their $100K investment. ”That’s 10,000 dollars worth of income in a passthrough, and if you’re passive in your investment in that passthrough, you get a deduction of 2,000 dollars to apply against the 10,000 dollar income, so you pay tax on 8,000 as opposed to 10,000,” he says.
While it’s important to seek professional tax advice to make sense of your personal position in the partnership and actual tax rates, it is generally understood that the investment activity of a member of an LLC that’s investing in a real estate with a third party manager should qualify for the pass-through benefits.
The corporate tax system goes territorial and competes worldwide
Back in 2012, the intent of the Jobs Act signed by Obama was to create jobs and increase capital for small businesses. Consequently, real estate crowdfunding grew rapidly and now, we might see even more jobs moving to the U.S. and impacting the commercial side.
Under the new tax law, companies that make a one-time repatriation of cash will be taxed at a rate of 15.5% on cash holdings and 8% on non-liquid assets. Several multinational giants that have kept a total of roughly $3 trillion in global profits off their domestic books to sidestep the previous 35% federal corporate tax rate have already announced plans to bring billions in cash back to the U.S.
Roschelle considers his own client base at PwC, representing the top multinationals around the world, and he admits repatriation has been discussed. “Our clients are trying to figure out where it makes most sense to fill out their supply chain—not where is the most tax efficient. We’ve taken that tax efficiency out in many respects, and that is likely going to translate to jobs at home,” he says.
“If we’re globally competitive in our tax rate, and we have a territorial system not a worldwide system, and you’re running a business that manufactures something, or you’re running a business that sells a consumer product, there is an incentive now through the tax law to start shifting that supply chain closer to home,” Roschelle says.
Investors should pay close attention to where these jobs are being created. “Let’s remember what the demand drivers are for real estate, its businesses that pay rent for commercial real estate, and it’s the employees that work for those businesses that can afford more rent or a bigger house if they’re in the home buying market,” Roschelle says.
“Years ago coming out of the financial crisis I said we need to stop saying location, location, location—those used to be the three most important words in real estate—Now it’s jobs, jobs, jobs,” Roschelle says. “At the time we were not creating jobs at the 200,000 monthly rate that we’re creating right now,” he adds.
Roschelle makes one thing clear—the effects of the new tax bill cannot be isolated from broader economic forces. Real estate investors must step back and consider all relevant drivers when considering new opportunities while appreciating that this tax bill is hitting the marketplace and the economy in the face of tailwinds as opposed to headwinds.
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Tyler Stewart is VP of Investor Relations at RealCrowd. All opinions expressed by Tyler and interviewees are solely their own opinions and do not reflect the opinion of RealCrowd. This article is for informational purposes only and should not be relied upon as a basis for investment decisions.