Tax break seen helping Trump isn’t as sweet thanks to IRS rules
The tax law gave a last-minute windfall to commercial property owners such as President Donald Trump. But regulations proposed by the Internal Revenue Service could diminish the benefit.
Under the proposals, the agency’s rules would penalize real estate investors when they make like-kind exchanges — a common practice used to defer taxes by buying a building with the profits gained from the sale of another property.
If the regulations become finalized, developers could wind up surrendering tens of millions of dollars annually that they would have saved on their tax bills.
It’s a setback for the real estate industry, whose members cheered when lawmakers added a provision days before the tax bill passed that effectively allowed owners of real estate businesses to tap a tax break created for pass-through businesses such as partnerships. The 20 percent deduction was extended to firms with large capital investments like buildings, but few employees.
Some Democrats slammed the provision as a giveaway to the wealthy and pointed out that several members of the administration, including Trump and his son-in-law Jared Kushner, whose family has extensive real estate holdings, would benefit from the change. Trump’s financial disclosures show he’s used an array of pass-through businesses, including in his real estate ventures, and many of his most lucrative businesses generate income from rents and leases.
The IRS is responsible for issuing regulations clarifying how some of the 2017 tax law’s complex provisions should be interpreted and implemented. The agency often meets with industry members to take their views into account before coming out with its proposals. In a surprise to the real estate industry, the rules the IRS published in August were far more onerous than what had been considered a worst-case scenario for like-kind exchanges.
“I don’t think anybody saw it coming,” said Steven Schneider, a tax attorney at Baker McKenzie who works with commercial real estate developers.
The rules reflect how the regulation writers interpreted the text of the law, but they’ll consider comments they’re receiving on the issue, Treasury Department attorney-adviser Audrey Ellis said at an American Bar Association panel in Atlanta last week.
A spokesman for the IRS declined to comment.
Typically, when investors sell properties for cash, they owe capital gains taxes on the increase in the value of the property. But if they quickly reinvest the money in another property, the taxes are deferred.
When calculating how much of their taxable income qualifies for the pass-through break, real estate owners can use 25 percent of wages paid plus 2.5 percent of the cost basis, or purchase price, of their tangible, depreciable property.
But Congress didn’t specify how to determine the cost basis when property owners do a like-kind exchange. The IRS rules say property owners have to use a much lower price than was expected, which effectively reduces how much they can write off.
Some in the industry hoped the IRS would hike the cost basis to the purchase price of the new property. For example, if an investor bought a property for $10 million and exchanged it for a property worth $15 million a decade later, the basis would increase to $15 million, excluding the value of the land.
More pessimistic developers figured the IRS would make them use the purchase price of the old property — so the basis would stay at $10 million.
But the IRS went even lower, saying for like-kind exchanges, developers should use the cost of the original property minus any depreciation the owner took over time. For a typical rental property held for a decade, that could mean a purchase price of $10 million is reduced to a cost basis of $6.4 million.
For a taxpayer in the top 37 percent tax bracket, taking the pass-through deduction for a property purchased for $10 million would result in $92,500 in annual tax savings, according to Brad Borden, who specializes in tax and real estate law at Brooklyn Law School. But if the owner did a like-kind exchange and had to use a cost basis of $6.4 million, the benefit would be reduced to $59,000 in tax savings every year.
Real estate owners often put properties into a partnership in exchange for a share of the company. The proposed regulations would also require those transactions to use the depreciated value for the property, said Baker McKenzie’s Schneider.
The combination of the partnership and like-kind regulations could translate to tens of millions of dollars in extra taxes a year, Schneider said. It’s especially painful since the regulations seem to pertain both to transactions going forward and to transactions that have already happened, he said.
The largest commercial real estate investors in the country include Blackstone Group LP, Prologis Inc. and CBRE Global Investors, according to data from Real Capital Analytics.
Still, the tax overhaul is ultimately a boon for real estate investors. The pass-through break is overall a win, and the law offers other carve-outs for the industry, such as preserving like-kind exchanges for real estate property and avoiding limits on deductions for interest expenses.
“The proposed regulation by itself increases the tax liability on like-kind exchanges, but taking all aspects of the new tax law into consideration, these exchanges still benefit from the tax law,” said Mark Zandi, chief economist with Moody’s Analytics.
The industry argues that the IRS rules could dissuade real estate developers from exchanging properties, since doing so would effectively raise their tax bills. According to an industry-funded study, like-kind exchanges account for nearly a third of apartment building transactions and a fifth of office transactions, though the numbers rise and fall depending on how local real estate values change.
Borden said such a hit could tip the balance against making an exchange but that for most developers, it wouldn’t be the deciding factor.
Now the industry is urging the IRS to walk back its proposed regulations. In a September letter to the agency, the National Multifamily Housing Council and National Apartment Association said if the regulations aren’t changed “we are concerned that capital could sit on the sidelines and not be fully deployed.”
Associations representing shopping center owners, real estate partnerships and others sent similar letters more recently.
The proposed regulations “will discourage like-kind exchanges and, as a consequence, real estate investment activity as a whole, completely in contravention of the intent” of the pass-through rules, the International Council of Shopping Centers said in its letter to the IRS.