New changes tax laws pertaining to commercial real estate (CRE) could threaten the way CRE investors and developers currently do business. Some in the industry feel that the elimination of so-called “1031 exchanges” will depress real estate sales and transactions as more investors attempt to avoid capital gains taxes by keeping their money into properties for longer. Another proposal that would lengthen the term of depreciation for CRE to 43 years is also expected to cause problems, because many believe real estate depreciates must faster. For more on this continue reading the following article from National Real Estate Investor.
If you’re the kind of person who calls your Congressman, it might be a good time to pick up the phone.
Legislators are negotiating the details of a huge reform of the nation’s tax code, and some ideas under consideration could prove to be toxic to the commercial real estate business. These talks are moving slowly—for now. This may be the best time for real estate to participate in the discussion, before tax reform begins to speed up.
“At some point the dam breaks and tax reform moves forward,” says Ryan McCormick, vice president and counsel for The Real Estate Roundtable. “These proposals will continue to be the building blocks of tax reform.”
In late November, SenateCommittee Chairman Max Baucus (D-MT) released an initial series of tax reform discussion drafts. Depreciation rules, capital gains tax rates would be deeply altered—and 1031 exchanges, which many real estate investors depend on, would be eliminated altogether.
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“You’ve moving towards a tax system that doesn’t encourage saving,and capital formation,” warned McCormick.
The proposals would wipe out the law—Sec. 1031 of the tax code—that allows “like-kind exchanges used by many real estate investors. Since the 1920s, investors have been able to delay paying capital gains on the sale real estate if they quickly reinvest the money from the sale by buying another, similar real estate asset.
Getting rid of like-kind exchanges will probably depress sales of real estate. Instead of selling, investors would be incentivized to keep their money in properties for longer periods, earning a yield for a longer time before getting hit with capital gains taxes.
Depreciation, capital gains, and energy
The proposals in Baucus’ discussion drafts would lengthen the depreciation period for both residential and non-residential real estate to a uniform 43 years. Depreciation allows taxpayers to count the aging and obsolescence of expensive assets as a loss of taxable income.
For many industries, depreciation periods are arguably much to short. “Assets are being depreciated faster than their useful life is being depleted,” says McCormick. But that doesn’t apply to real estate, he says. “If anything, commercial real estate should be depreciated more quickly. Buildings become obsolete more quickly.”
The proposals would also punish investors if they claim depreciation that is not apparent in the sale price of a property when the investor finally sells it. The portion of capital gains from a sale that are attributable to prior depreciation deductions would be taxed as ordinary income, a much higher rate than the capital gains rate for real estate.
Changing the rules on depreciation could raise a huge amount of new revenue for the federal government—roughly $700 billion over ten years, which could decrease the deficit or make room in the budget for a lower overall corporate tax rate. “It’s always been expected that depreciation would be the foundation of a corporate tax cut,” says McCormick. “We always thought that real estate would be considered outside of depreciation of equipment.”
This article was republished with permission from National Real Estate Investor.