Will Tax Reform Slam Real Estate?
This April, we turn our attention to tax reform and its effect on the real estate industry. A variety of real estate associations, including the Real Estate Roundtable, the International Council of Shopping Centers, and the National Association of Realtors are educating their members and Congress about the likely consequences of various tax reform proposals for the real estate industry. Here's our take on two of them:
Border Adjustment Tax
A border adjustment tax would impose taxes on goods manufactured outside the U.S. that are imported and sold here, while rebating taxes on goods manufactured in the U.S. exported and sold abroad. This would shift taxes away from domestic production and toward domestic consumption. Proponents claim this would incentivize American job creation and strengthen the dollar, while opponents argue that this is a regressive tax that would chill the domestic retail industry.
Between 95% (apparel) and 15% (food) of all goods sold in the U.S., whether in brick-and-mortar stores or online, is imported. So for the real estate industry, while retail real estate would be hardest hit, we expect that industrial real estate (used for warehousing and distribution) will also be negatively impacted. Some retail real estate owners are already feeling the pinch, as retailers put plans to open new locations and renew existing leases on hold until they have a better understanding of whether a border adjustment tax will be enacted.
Carried Interest Taxation
A carried real estate interest is a financial interest in the long-term profitability of a real estate investment given to the developer by investors to compensate the developer for sweat equity and risk assumption. The income flowing from the carried interest is currently taxed at the lower capital gains rate of 20%, rather than the personal income tax rate, in the upper 30% range for high earners.
Proponents of taxing this income at the higher rates view the current taxation as unfair. Opponents point out that this income results from a long-term, inherently risky ownership stake in real estate that should not be treated as if it were a guaranteed salary.
IRS figures show that 3.2 M partnerships (46% of which are real estate related) and more than 22 M business partners would be adversely affected by such an increase. The likely impact of taxing carried interest income at a higher rate would be to reduce the profitability of real estate investments as there will be less after-tax income to go around.
The uncertainties that tax reform presents make it all the more compelling to minimize the time, cost and risk of getting your leases over the finish line.