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April 17, 2018

Making CRE Sense of Tax Reform and Rising Interest Rates

Considerable attention and uncertainty surrounds the sweeping tax reform and recent actions to raise interest rates by the Federal Reserve. Yet, the most intriguing question being asked by those in the commercial real estate business is will the changes knock the current cycle off kilter?

The answer to that question won’t likely be clear for some time. In the meantime, an examination of what is known reveals the tax law changes are significant steps forward for the country, and a big win for the economy.

JPMorgan Chase CEO, James Dimon noted the changes in the tax code could improve “American competitive growth in the global economy”, as companies bring back talent and capital from overseas over time. “It's the cumulative effect of retained capital and increasing competitive American companies that will drive jobs and wages in the long run,” said Dimon.

Examining the rising interest rates side, while it is a factor to watch, commercial real estate experts don’t believe it will have a significant detrimental effect immediately or be the big blow that causes the current growth cycle to reverse.

The Federal Reserve does plan to continue gradually increasing interest rates in 2018. The money policy body is staying to its charted course toward normalization because it sees the economy strengthening, and it wants to maintain a smooth functioning economy, while keeping inflation at bay. To be sure, multiple interest rate increases could start to have a material adverse impact on the commercial real estate market over time.

On the other hand, the newly-minted Tax Cuts and Jobs Act of 2017 (TCJA) presents a host of intriguing impacts that will play out in the commercial real estate sector over the coming months. The first big re-write of the U.S. tax code in more than three decades is expected to boost economic growth by reducing tax rates and simplifying the tax code.

Before the complexities of the code get deciphered and any unintended consequences show up, let’s examine what is known. There are a number of positive aspects to consider on the commercial real estate side. Benefits for CRE owners include:

  • Property owners can deduct mortgage interest on commercial properties in full and an owners’ net income will be taxed at 21%, which is a significant decrease from the 35% rate at which it was previously taxed.
  • CRE owners can take a full, 100% property deduction in the same year in which an asset was acquired. Currently, owners can only deduct 50% of a qualified property’s cost in the first year, then continuing depreciation in the years following.
  • The government will continue taxing real estate carried interests held for three years as capital gains. This entitles developers to a greater split of the profits, disproportionate to the capital contributed by the developer, after the preferred return is achieved.
  • Investors and residential owners relying on the 1031 Exchange program to defer capital gains taxes can still do so under the new code.
  • Entities organized as “pass-through’s” (PTE), such as partnerships and limited liability companies, are now subject to a top individual rate of 37%. Additionally, the pass-through business income is now eligible for a 20% deduction.
  • Developers willing to renovate older structures catch a unique break under the new code. The 20% credit for certified historic structures is still in place, though it must be claimed over a five-year period. However, the 10% credit for non-certified structures built before 1936 has been eliminated.

The net result of the tax law changes is largely expected to continue fueling the current business cycle up until the 2020 Presidential election. The certainty and clarity the changes provide may free up business spending and boost economic growth.

Corporate leaders, especially at firms that’ve accumulated massive war chests of wealth, could be filled with an extra measure of confidence, too. Moody’s reports that U.S. non-financial firms cash and liquid investments holdings rose by 5% in 2017 to $1.9 trillion. Cash holdings by Google’s parent company Alphabet reached $103 billion by the end of last year, while Apple’s cash reserves were projected to hit $265 billion.

That could result in significant piles of cash coming back home because the new U.S. tax laws now allow companies to repatriate offshore wealth at a lower tax rate for a limited time. Set against a backdrop of low interest rates, real estate investments appear to be an attractive alternative. This is already driving investment in new offices, facilities and plants across the U.S., and is a trend expected to continue as corporations move funds from overseas.

Both the tax reform and overall economic health of the country support continued strong commercial real estate fundamentals. Despite the rising Federal funds interest rates, and the myriad variations of the new tax law to work through, the CRE sector appears positively positioned with more runway.

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