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Date: January 22, 2018
Category: Real Estate

How Tax Reform May Impact Real Estate

Tax reform impact on real estate marketsFor nearly 30 years, Washington bemoaned the current tax system, while intermittently passing modest tax cuts to help stimulate a slowing economy. Each cut was more of a short-term fix than part of a long-term plan. This time is different.

Not only is the Tax Cuts and Jobs Act the signature legislative achievement of President Donald Trump’s first year in office, but it’s true tax reform not seen since Ronald Reagan was in office.
So, as you look at your business’ bottom line, survey online tax calculators, or attempt to decipher what these changes mean for the economy, understand that tax reform’s success may be dependent on the answer to one question: what will everyone do with these savings?

Corporate tax cut: jolting an economy in transition

Our economy crosses oceans – and competition is driven in part by the race to provide the most business-friendly environment. In 2017 alone, eight countries reduced their corporate tax rates, with Hungary slashing its rate to a mere nine percent.1 According to the Organization for Economic Cooperation and Development (OECD), corporate tax rates in OECD countries fell on average from 32.2 percent in 2000 to 24.7 percent in 2016.1

America’s 39.1 percent statutory corporate tax rate, which included state levies, was the highest among the 34 OECD countries. However, a recent report found that most U.S. companies paid roughly 27 percent in 2016 after accounting for deductions.2

Companies minimize their tax burden generally through transfer pricing strategies, including setting up headquarters overseas to offshore profits.1 The Joint Committee on Taxation reports that corporations have roughly $2.6 trillion in profits parked offshore to avoid higher tax rates.1

This law lowers the top corporate tax rate from 35 percent to 21 percent and offers a one-time, across-the-board tax break for companies to move those offshore profits back home. Businesses will either pay a 15.5 percent tax on cash or eight percent on illiquid assets, potentially bringing $339 billion back to the U.S. Treasury.3

The hope is that leveling the global economy’s playing field will incentivize corporations to re-invest in U.S. expansion. As President Trump noted at the White House following the bill’s passing, “We’re getting rid of all the knots and all the ties, and ultimately what does it mean? It means jobs, jobs, jobs.”

Whether that’s what it means is uncertain. Tax reform is being thrown into an economy in transition. The recovery out of the Great Recession has been steady, but slow. If the markets are your measure, you believe the economy is thriving. Equity markets continue to set new records during a nine-year bull market, but success has been concentrated at the top. The top 20 percent of investors own 90 percent of U.S. equities.4 And as we’ve been reminded time and again, the markets are not the economy.

Job growth has been more methodical, but the unemployment rate has worked its way down to its lowest level since 2000.5 Yet, stagnant wage growth continues to weigh down economic optimism.6 Tax reform proponents believe lower corporate rates will spur hiring, competition for talent, and higher wages.

Current unemployment and wage growth percentage

However, other corporate leaders point out that many U.S. companies are sitting on piles of cash, and historically low interest rates are leaving few hurdles to increased investment.7 Either companies aren’t seeing investment opportunities or they believe their money is best spent elsewhere, perhaps through share buybacks passed off to shareholders as dividends. This would benefit those same equity investors, but wouldn’t solve the economy’s wage issue.

Individual tax cut: increasing consumer spending

While corporate tax cuts are getting a lot of press, roughly 80 percent of individuals will also see a tax cut in 2018.8 Seven tax brackets will remain, with slight modifications to most, including a drop in the highest tax bracket from 39.6 to 37 percent. The tax law also repeals the Affordable Care Act’s individual mandate in 2019, and roughly doubles the standard deduction from $6,350 to $12,000. These provisions are aimed at giving Americans back more of their money in hopes of propping up consumer spending.

While the corporate tax cuts are permanent, the individual tax cuts are slated to sunset after 2025 due to a regulation known as the Byrd Rule that says any legislation can’t raise deficits beyond a 10-year window. This comes on top of fears that this $1.5 trillion package may increase deficits and temper long-term economic performance.

The potential impact on real estate

So, with the table set, what’s tax reform mean for real estate and real estate investments?

Owning and renting on equal footing

Doubling the standard deduction may reduce the number of filers who itemize their deductions, limiting the advantage of the mortgage-interest deduction. While, on its own, the mortgage-interest deduction has shown to have no impact on the homeownership rate, taken together with the $10,000 cap on the deduction of state and local taxes, it’s a clear blow to homeownership’s tax benefits.

At least 23 million fewer potential U.S. homeowners may look to buy a home under these new rules.9 And studies estimate that home prices may fall by 10 percent due to lower demand.10 While this is troubling news for the housing market, the multifamily market stands to potentially benefit.

There’s no longer a difference between renting and owning in the tax code, which may benefit suburban rental markets in areas with the highest share of residents that itemize their deductions. Without these benefits, residents in high-tax areas may look to more affordable housing options.

Traditional retail may be a big winner

As an industry that generates most of its profits from U.S.-based operations, retail companies paid an average tax rate of 30.6 percent in 2016, the highest of any industry in data tracked by PwC.11

As traditional retail adapts to changing consumer demands, a lower corporate tax rate may help level the playing field in its tug-of-war with ecommerce giants like Amazon, which can often utilize offshore intellectual property in countries with lower rates.10

U.S.-focused retailers may use the increased profits to enhance in-store experiences, add ecommerce capabilities, raise wages, and buy back shares to support their investors. Retailers also believe that doubling the standard deduction will increase discretionary spending on many of the “wants” consumers have sacrificed over the last decade.

Real estate investment trusts

Investors of real estate investment trusts (REITs) also received welcomed news. Starting this year, owners and shareholders of pass-through businesses will be able to deduct 20 percent of business-related income, including investment income passed to REIT investors through dividends. Investors who earn real estate rental income outside of REITs could still be subject to taxes at the top new marginal rate of 37 percent, while REIT investors would pay just 29.6 percent at the top marginal rate. The distribution of capital gains from REITs will continue to be taxed at 20 percent, according to Nareit.12

The Bottom Line:

Will the economy expand? Will wages grow? What industries will profit most? All answers may hinge on how companies and investors spend their tax savings.

1The Hill. Too early to call the winners and losers of major corporate tax cut. 12/16/17.
2 Wallet Hub. Corporate Tax Rate Report. 11/1/17.
3 Investors.com. GOP Takes Bigger Bit From Apple, Microsoft, Google to Seal Trump Tax Cuts. 12/15/17.
4 NPR. While Trump Touts Stock Market, Many Americans Are Left Out of the Conversation. 3/1/17.
5 Bloomberg. US Unemployment Rate. 9/30/07 – 9/30/17.
6 Bloomberg. Atlanta Fed Wage Growth Tracker Overall. 9/30/07 – 9/30/17.
7 LinkedIn. Chief Economic Advisor to Trump: “The most excited group out there are big CEOs, about our tax plan.” A CEO’s Perspective. 11/10/17.
8 Tax Policy Center. Distributional Analysis of the Conference Agreement for the Tax Cuts and Jobs Act. 12/18/17.
9 The Wall Street Journal. GOP Tax Overhaul Makes Homeownership Less Appealing. 12/20/17.
10 REIS. The Tax Cuts and Jobs Act: REIS Looks at its Impact on Commercial Real Estate. 2017.
11 The Wall Street Journal. How the Tax Plan Affects Business: Everything You Need to Know. 12/19/17.
12 The Wall Street Journal. REIT Investors to Gain From Tax Legislation. 12/19/17.
 
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