AMERICAS GC: Taxing matters

Market participants attempting to read the tea leaves for indications of the policies of President Donald Trump have kept a close eye on his tweets – as well as on more traditional methods of presidential communication.

Throughout the campaign and following the election, Trump has remained nearly as unanalyzable as he is unconventional, but comprehensive tax reform has emerged as the issue with the greatest implications for real estate over the foreseeable future.

Comprehensive tax reform should be at the top of property investors’ minds in 2017. Details are currently very limited and a wide range of potential outcomes exists, rendering the ultimate net impact on real estate values unclear today. Nevertheless, as long as uncertainty over the outlook for taxes remains high, transaction volume is likely to thin out.

Republican control of both the House and Senate, combined with their ability to enact new legislation via budget reconciliation – which sidesteps Democrats’ ability to filibuster – make it a very real possibility that 2017 will bring the most significant overhaul to the tax code in 30 years.

The primary template for comprehensive tax reform is the Better Way Blueprint, published by House Republicans last June. The plan is endorsed by House Speaker Paul Ryan as well as House Ways and Means Committee chairman Kevin Brady.

While short on details, the blueprint lays out an ambitious plan to cut both individual and corporate tax rates, shift to a cashflow tax approach for business and move to a destination-based tax system. The latter of these would tax imports but not exports – a change that would mostly affect the retail and industrial real estate sectors. The plan was largely overlooked by many until Trump’s upset victory. House Republicans are currently working on shaping the blueprint into a legislative bill.

The push and pull of the legislative process makes it impossible to forecast which aspects of the blueprint will ultimately be enacted into law. At this point, the potential implications for real estate are unclear and range from peripheral to revolutionary. Many blueprint items appear to at least partially offset each other and the ultimate legislation will have a range of impacts depending on the structure in which real estate assets are owned. Some real estate investors are tax exempt and will therefore be relatively unaffected by tax changes. As investors await clarity on the tax front, expect real estate transaction activity to slow materially for the foreseeable future.

The implementation of a destination-based cashflow tax system would carry myriad, mind-boggling implications for real estate investors. A few of the most likely implications include: use of lower leverage; relatively unfavorable consequences for land-heavy assets; and challenges for retail landlords housing tenants dependent on imported goods. The Better Way plan does not appear to be designed to penalize real estate investors. However, given the lack of detail and wide range of potential outcomes, the ultimate net impact on real estate values is unclear.

Additionally, conversations with industry participants and tax experts indicate that like-kind exchanges, which are not addressed in the blueprint, are unlikely to survive comprehensive tax reform. Both sides of the aisle have long viewed this tax-deferral mechanism as a loophole.

If the elimination of like-kind exchanges is accompanied by a shift to the cashflow tax approach contemplated in the blueprint, the demise of 1031s becomes a minor issue, due to the full expensing of a property on a company’s balance sheet at the time of purchase. If, however, the substantial tax reforms envisioned by the blueprint are not enacted, the elimination of like-kind exchanges will have an effect.

While the new administration and Congress work on comprehensive tax reform, expect real estate transaction activity to take a breather.