Since New Year’s Day of 2018, the most sweeping federal tax law seen in decades took effect—and many commercial real estate investors and owners are poised to profit. Although not all real estate holdings will be advanced (or even affected) by tax reform, analysts agree that the structure of many of the tax relief provisions recently signed into law can provide tangible benefits to commercial property owners.
With many tax advisors still analyzing exactly how the new law will affect their clients’ bottom lines, it’s important for real estate owners and investors to dive more deeply into the ins and outs of the newest tax reform law to avoid leaving earnings and profits on the table.
Read on for more how this new law is projected to affect commercial property owners, as well as some specific steps you’ll want to take to optimize your federal tax obligation.
New Deduction for Partnerships, LLCs, S Corporations, and Other Pass-Throughs
Many real estate investors hold their property in pass-through corporate structures like partnerships, S Corps, and limited liability companies (LLCs). These types of companies don’t pay corporate tax themselves, passing through any gains (or losses) to their individual partners or shareholders, who pay taxes on the funds received.
Beginning in 2018, investors and shareholders will be able to utilize a 20 percent tax deduction on partnership, LLC, and other pass-through income. Combining this deduction with the ability to carry over certain losses can significantly trim your tax bill.
There are some exceptions to this 20 percent deduction. Individual business owners who earn more than $157,500 in taxable income per year and joint filers who make more than $315,000 may be ineligible. If you’re on the cusp of one of these thresholds, it can be worthwhile to meet with your tax advisor to see what other deductions may be available to knock your income below this line.
Preservation of 1031 Exchanges
Many investors breathed a sigh of relief to see that the final tax bill preserved the mechanics of the 1031 exchange. This provision allows real estate sellers to defer the imposition of capital gains taxes on the sale proceeds as long as they re-invest these proceeds in another property.
For those who own commercial or industrial real estate in hot markets like Seattle, San Francisco, and Denver, the 1031 exchange can help you leverage your assets while deferring capital gains taxes or even avoiding them entirely. By “trading up” to more and more valuable real estate while sheltering the profits, you’ll be able to generate significantly more revenue.
Expanding Your Expensing Options
Section 179 of the Internal Revenue Code covers depreciation deductions for commercial real estate owners. This section allows taxpayers to deduct as expenses the cost of certain property rather than capitalizing these costs. In years when a piece of property has generated quite a bit of extra income, deducting expenses under Section 179 can result in a far greater reduction to that property’s tax bill.
While the limit on Section 179 expensing was previously capped at $500,000, the new tax law doubled this threshold to $1,000,000. This significant increase was designed to encourage business owners to invest and expand their holdings instead of preserving capital for a rainy day.
Longer-Term Real Estate Tax Trends
Not all the effects of this tax law will be felt so immediately. For many real estate owners, the longer-term trends spurred by tax reform will actually have a greater tangible benefit on real estate holdings than the deductions and exchange provisions already in place.
For example, many homeowners, particularly those in high-tax cities and states, just lost their ability to deduct the total amount of property taxes paid. The tax law limits the amount of state and local (SALT) taxes that can be deducted from one’s federal tax bill to a mere $10,000.
Because of this, some experts predict that homeowners who are already on the edge of being able to afford their high housing costs may sell these homes and move into multi-family housing units like duplexes, condominiums, and apartments. This projected migration can be a boon for apartment owners and those who hold vacant residential or mixed-use lots in high-traffic areas.
Those who hold hard-to-fill commercial properties like shopping malls may want to consider converting these facilities to residential housing, if zoning restrictions permit. Combining the lower corporate tax burden with an increase in single-family housing costs can allow you to provide an in-demand housing arrangement at a competitive cost.
Holders of industrial real estate could also find their property values skyrocketing if an infrastructure bill is passed. Government investment in highways, bridges, and other important pieces of American infrastructure can provide a steady stream of income to shipping companies, warehouses, factories and manufacturing plants, and storage facilities.
What Sectors May Not Benefit From Tax Reform?
Although most commercial real estate investors are poised to see gains in 2018, not all real estate sectors are as likely to benefit. If you hold one or more pieces of property targeted toward college students or healthcare facilities, it may be worth re-evaluating your holdings in light of the new tax law.
In addition to the tweaks it made to individual income tax rates and deductions, the tax bill originally proposed to eliminate the student loan interest deduction and assess income taxes on graduate student waivers. While neither provision made it into the final tax law, the discussion of such cuts (and ensuing outcry) may have a negative impact on college enrollment, and therefore, student housing.
Medical Providers And Retailers
Hospitals and health-care facilities are also experiencing a slight decline in real estate value as government officials continue to chip away at the Affordable Care Act (ACA). With the future of the ACA in jeopardy, medical facilities are finding it difficult to accurately project either revenue or costs, and are reluctant to expand or make improvements to their properties.
However, strip malls with medical tenants could find themselves thriving amid this uncertainty. As the medical industry moves away from larger edifices into “med-tail” as a way to cut costs, property owners can benefit from the increased foot traffic generated by physical therapists, full-service pharmacies, chiropractors, and dialysis facilities.
Optimizing Your Federal Tax Obligation
Some real estate owners may not need to make any changes to their current strategy or holdings in order to reap the benefits of tax reform.
But for others, taking a holistic look at your investments can ensure you’re in the best position to continue to benefit from these changes for years to come.
Evaluate your business structure
In the vast majority of cases, it makes the most financial and legal sense to hold your real estate investments in a pass-through corporation rather than owning them as an individual. Not only can direct ownership of real estate increase the scope of your legal liability in a slip-and-fall accident, it prevents you from benefiting from the new 20 percent deduction for pass-through income.
If you haven’t already established an LLC, partnership, or S Corporation to hold your real estate assets, there’s no better time than the present. This is even truer if you’re in a part of the country currently seeing rapid appreciation in real estate values; placing your holdings in a pass-through entity now can help you shield more of your impending gains from taxes.
Divest yourself of underperforming holdings
Diversification in the real estate industry can be a double-edged sword. Too much diversification among the types of real estate you hold can leave you spread too thin while managing a range of assets, while too little diversification can render you vulnerable to market fluctuations that target your specific segment of real estate.
But if you’re invested in a building or business that’s been struggling for some time and isn’t likely to see gains under the new tax law, it may be better to sell this asset soon instead of waiting for its value to rebound. Doing so will free up additional assets or cash flow that you can invest in a business that is poised to see specific benefits in 2018 and beyond.
Some analysts have pointed to this tax reform law as a once-in-a-generation opportunity for real estate investors to grow their businesses while preserving their existing assets. But in order to derive the maximum benefit available under these new provisions, you need to structure your holdings in such a way as to reap all tax deductions possible.
And even if you’re already holding your real estate investments in a pass-through entity and taking full advantage of 1031 exchanges and capital expense deductions when available, it’s never a bad idea to give your real estate holdings a holistic examination once every year or two. Doing so can help you jettison your underperforming assets or make the changes needed to turn them around while focusing your efforts on the assets that are most likely to see rapid appreciation in the near future.