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CRACKING THE CODE: How proposed tax reform might affect the valuation profession and the real estate industry.

House and Senate Republicans in December were putting the final touches on a $1.5 trillion tax reform plan that represents the most sweeping overhaul of the federal tax code in three decades. The House on Nov. 16 approved HR 1, the Tax Cuts and Jobs Act; the Senate passed its version of the tax plan on Dec. 2. Since Congressional leaders were still working on the final package as Valuation magazine went to print, any plan enacted by the 115th Congress might differ from what's addressed in this article.

The House bill includes several priority items that were included in the White House and Republican leadership's "Unified Framework for Fixing Our Broken Tax Code," which was released in September and broadly outlines ideas around tax simplification and economic growth.

Reaction from the residential real estate community so far has been negative, as battle lines have been drawn around eliminations or reductions in deductions that are treasured by real estate agents and home builders. However, other business interests stand to benefit from some of the proposed changes, especially some "pass-through" entities such as partnerships, limited liability companies, real estate investment trusts and subchapter S corporations, which are common structures within the real estate industry. Other real estate-related tax credits are on the chopping block, and advocates likely won't let those go without a fight, as both the House and the Senate attempt to reconcile a bill to send to the president for signature.

Here's a look at provisions in HR 1 that appraisers should pay close attention to because of their impact on the real estate industry.

On an individual level

For individuals and families, HR 1 would fold seven tax brackets into four: 12 percent, 25 percent, 35 percent and 39.6 percent. The mortgage interest deduction for newly purchased homes would be available on mortgage debt up to $500,000, down from the $1 million currently allowed. The deduction for interest paid on home equity debt of up to $100,000 would be repealed for new debt incurred. Refinancing debt incurred also would be limited to $500,000, and deductions for second homes would be disallowed. Meanwhile, state and local income and sales tax deductions would be eliminated, and property tax deductions capped at $10,000 per year. Expect compromises around this area in the final version.

The standard deductions for single and married filers would be doubled.

The capital gains tax exclusion on the sale of a primary residence would exempt up to $500,000 in profits for married couples and $250,000 for individuals, and would be eligible for use once every five years rather than the two years currently allowed. It would be phased out by one dollar for each dollar of adjusted gross income above $500,000 for married couples and $250,000 for individuals, and in order for owners to benefit, the property would have to have been owner-occupied for five of the past eight years, up from two of the past five years under current law.

Beyond mortgage-related deductions, charitable deductions would be preserved, maintaining certain noncash charitable contributions, such as donations for conservation easements. The estate tax would be eliminated after six years, but the existing $5.6 million exemption per spouse immediately would double, with the current 40 percent tax rate unchanged through 2022. Gift tax eligibility would not be changed, but the tax rate would be reduced to 35 percent. No changes would be made to capital gains or "carried interests," and fund managers would still be able to claim preferential capital gains treatment resulting from growth in their clients' investment portfolios.

For businesses

HR 1 would provide significant business tax relief, immediately and permanently making the tax rate 20 percent--a drop of 15 percentage points. The bill also would establish a new 25 percent rate on pass-through business income. Business owners could choose to apply the lower rate to 30 percent of their net business income, or claim a higher portion of income subject to the pass-through rate based on the firm's level of capital investments. Personal services firms (lawyers, accountants and architects, among others) would be ineligible for the lower rate unless they made capital investments. The implications for valuation firms are addressed at the end of this article. Expect changes in this area as the final bill is worked on by the conference committee.

Tangible personal property could be expensed under HR 1 for property placed in service between Sept. 27, 2017, and Jan. 1, 2023. However, cost recovery for structures (including buildings) would remain unchanged with a 27.5-year straight line depreciation for residential buildings and 39-year straight line depreciation for nonresidential buildings.

The bill would limit the business interest deduction for all businesses to 30 percent of adjusted taxable income, effective 2018. Real estate trades and regulated utilities would be exempt from this rule since they do not benefit from the full expensing provided to tangible personal property. However, businesses with average annual gross receipts of $25 million or less would be exempt from this rule.

The bill would end the use of Section 1031 Like Kind Exchange starting in 2018 for all assets other than real estate.

Multiple tax credits would be repealed or modified, including the following:

* The Investment Tax Credit would be extended to qualified fuel cell, geothermal and other energy properties with the same phase-out schedule as solar energy property; the 10 percent ITC available for solar installations after 2022 is repealed for property placed in service after 2027.

* Credit for residential energy-efficient property, which expired at the end of 2016, would be reinstated and extend through 2022, subject to a phase-out beginning in 2020.

* Credits for the rehabilitation of historic buildings and the New Markets Tax Credit for investing in community development projects in low-income areas would be repealed.

* Interest on private activity bonds and advance refunding bonds issued after 2017 would be subject to tax. These bonds typically are used by such nonprofits as hospitals and universities for development activity.

Several changes would address global competitiveness, including a move to a "territorial" tax system that would exempt most foreign income from U.S. corporate tax. However, a 10 percent tax would be levied on "high returns" of foreign subsidiaries, defined as greater than 7 percent plus the federal short-term rate.

Industry reaction

Reaction to the proposed tax plan from real estate agents and home builders has been largely negative, particularly around the proposed reduction in allowable itemized deductions. William E. Brown, president of the National Association of Realtors, stated, "These efforts represent a tax increase on millions of middle-class homeowners." NAR expressed alarm over the proposed trade-off involving increased standard deductions and the elimination of itemized deductions, noting that the combination would make the mortgage interest deduction less practical for most taxpayers, even leading to a tax on homeownership.

"That tax increase flies in the face of a reform effort ostensibly aimed at lowering the tax burden for Americans," Brown said. "At the same time, the lost incentive to purchase a home could cause home values to fall."

The National Association of Home Builders, which had hoped to advance new tax credits for homeownership prior to the introduction of HR 1, declared its "active opposition" to the bill when homeownership credits were not included as offsets for the likely reduction in homeownership incentives.

However, many real estate firms could benefit from a reduced tax rate because they operate under LLC arrangements. The Real Estate Roundtable was bullish on the bill following its introduction.

"By reducing barriers to private sector capital formation and business investment, tax reforms in the House bill will boost economic demand and job growth," Roundtable President and CEO Jeffrey DeBoer said. "If the final bill is similar to the one introduced today, our industry will put more people to work modernizing and improving existing properties--office buildings, shopping centers, apartments, industrial properties--to meet the changing and growing needs of American businesses and consumers."

The Real Estate Roundtable signaled its intent to push for improvements to the bill, focusing on some of the concerns expressed by NAR and NAHB.

The commercial real estate news site stated in a Nov. 2 article, "The bill has largely good news for the commercial real estate industry." The article authors noted retention of the capital gains incentive and the continued use of the Section 1031 Like Kind Exchange rules for real estate. They also recognized that the cost of real estate debt is a necessary business expense, and that interest on debt used in a real estate trade or business would continue to be deductible.

What lies ahead

The Senate bill differs from the House bill in several ways, including:

For individuals

* The existing seven-bracket rate structure is retained, but with multiple rate cuts.

* The mortgage interest deduction is retained, but deductions for interest incurred on home equity loans and lines of credit are repealed.

* The estate and gift tax exemption thresholds are doubled starting in 2018, but the estate tax is not repealed after 2024.

For businesses

* A 17.4 percent deduction for qualified pass-through income earned by noncorporate businesses whose owners pay taxes on their profits as individuals is created. Income derived from "personal services," such as real property valuation, law, consulting, accounting and investment management, would qualify for the full deduction only on the first $150,000 of taxable income ($75,000 for single filers), with the benefit phasing out over the next $50,000 in income ($25,000 for single filers).

* Deductions for net operating losses by active pass-through business owners would be capped at $250,000 for individuals and $500,000 for joint filers. They would be indexed for inflation on an annual basis.

* The start date for the 20 percent corporate tax rate of 2019 differs from the House bill. Section 179 expensing allowances increase to $1 million, up from $500,000, with the limit on eligible expenses per year rising to $2.5 million, up from $2 million. The House plan sets limits at $5 million and $20 million, respectively. The type of property eligible for expensing would include lodging furnishings and nonresidential real property such as roofs, ventilation equipment, fire protection and alarm systems.

* The 39-year cost recovery period for non-residential real estate property and the 27.5year depreciation schedule for residential property are shortened to 25 years for each. The 15-year schedule for qualified leasehold, retail and restaurant improvements is reduced to 10 years.

* The historic building rehabilitation credit would drop to 10 percent from the current 20 percent, and the 10 percent credit for pre-1936 buildings is repealed.

* No changes were made to New Markets Tax Credit or private activity bonds, unlike in the House bill.

Outlook and impact

Tax reform efforts do not occur frequently, but when they do, they tend to have a sizable impact on the real estate industry. As of this writing, the House and Senate conference committee was meeting to iron out a compromise that would allow it to present a final tax package to President Trump by the end of the year.

Once a final bill becomes law, there are several items appraisers and valuation firms need to consider, including the following:

* Will your firm qualify for the pass-through entity tax deduction? How does the conference committee treat such corporations, and how much income would be sheltered from taxes prior to paying individual rates?

* Will changes to tax deductions, limits for state and local tax deductibility, and limits to mortgage interest deductions impact demand for single-family housing, rental housing or other residential construction?

* Do changes to the tax law result in greater use of such tax planning activities as cost segregation or accelerated depreciation for construction costs?

Informed and well-trained valuation professionals need to understand how the tax plan might impact the overall real estate industry. The devil is in the details, and it may take some time for tax planners to digest it and advise clients accordingly. As things stand, the impact appears significant, and there appear to be multiple targeted opportunities for the real estate industry and valuation professionals.

About the Author

Bill Garber is the Appraisal Institute's director of government and external relations and is based in AI's Washington office. He can be reached at or 202-298-6449.

Caption: Senate staffers gather inside the U.S. Capitol prior to the vote on the tax reform bill. The real estate industry's reaction to the proposed plan has been mostly negative.
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Title Annotation:Legislative Issues
Author:Garber, Bill
Publication:Valuation Magazine
Date:Sep 22, 2017
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