Multifamily real estate investors got a beautiful holiday present when the President signed the new tax law into effect in late December. Commercial real estate investing already provided among the most powerful tax breaks available in the US, but the new rules make it even sweeter.
Wellings Capital was not completely shocked by this, given the career of our current president, but I must say that even we were surprised at the significant level of tax benefit that commercial real estate investors will realize under this new law.
This article, from National Real Estate Investor, reviews many of the reasons experts predict high net worth investors will be more focused than ever on the commercial real estate sector. Here is a quick overview:
- High net worth investors will receive a 20% deduction on income from pass-through business entities. This applies to ownership via partnership, LLCs, and investors in public and private real estate funds.
- Taxpayers can factor in 2.5% of the original purchase price of commercial real estate assets as part of their 20% deduction. The combined effect of these first two benefits could create a 25% tax reduction (10 points – from a 39.6% to 29.6% rate).
- Section 179 of the tax code has long allowed limited deductions for capital improvements in the current tax year. The new law expands this allowance significantly, which could result in significant paper losses for some capital improvements. For example, a new roof or HVAC system, which would have been depreciated over many years before, can possibly be fully deducted in the current year under the new law.
- Though the new law eliminated the tax deferred 1031 Exchange for many asset types (like airplanes and other types of personal property), it was retained for real estate. This is a wonderful benefit that we got while others lost out.
Steven Ginsberg, co-founder of the Chicago-based law firm Ginsberg Jacobs LLC, says, “All in all, real estate represents probably ‘the most accessible way’ for HNW [high net worth] investors to profit from the tax law.”
Wellings Capital doesn’t invest in, or recommend that others invest in, an opportunity solely for the tax benefit. It must first be a sound investment with solid risk-adjusted cash flow, and an opportunity for capital appreciation.
Another Less Obvious Benefit of Tax Reform
In addition to these direct benefits to multifamily syndicators and investors, a less obvious but very powerful multifamily benefit is the doubling of the standard deduction for tax filers.
“By doubling the standard deduction, Congress has greatly reduced the value of the mortgage-interest and property-tax deductions as tax incentives for homeownership,” says the National Association of Realtors. “Congressional estimates indicate that only 5% to 8% of filers will now be eligible to claim these deductions by itemizing, meaning there will be no tax differential between renting and owning for more than 90% of taxpayers.”
Sepi Ghiasvand, an attorney with Hopkins & Carley, based in Palo Alto, Calif., says this is “’another disincentive’ for people considering a home purchase.”
John Isakson, chief capital officer at Preferred Apartment Communities, says doubling the standard deduction is going to “keep people who rent renters for longer because it takes away one of the bigger incentives to own a home.”
The Dark Side of the New Tax Law
There’s got to be a downside, right?
Initially, it was hard to find one. And I don’t see a downside in this sweeping new legislation. But this law may have a side effect that will create new challenges for multifamily syndicators.
In a Bigger Pockets article that I penned late last year, I predicted that the multifamily market frenzy was nearing the top, and that we would likely see a softening of prices and competition in 2018 and beyond.
I think I was wrong.
As I speak to investors and other syndicators, I have been sensing that the tax reform act has injected new life into a market that most thought was past its peak. This short post published in National Real Estate Investor (NREI) confirms my suspicion.
Last November, only 26% of NREI readers believed the market would continue to expand. Just two months later, that number jumped to 41%, over a 50% jump (15% ÷ 26% = 57% increase). And their survey showed that the number of respondents who believe the market had peaked dropped from 59% to 45%.
Though we don’t depend only on investor sentiment, let’s face it… sentiment and widespread beliefs will drive behavior.
So what does this dark side mean for Multifamily Investors?
Just like last year (and every year), there can be a temptation among some commercial real estate syndicators to overpay for an asset. To bank on the capital appreciation more than the current cash flow. To acquire a marginal asset to pocket the fees and hope the investors won’t mind. Or to even allow the tax tail to wag the investment dog.
We find this reprehensible.
Yes, that’s a strong word, but that’s how we feel. Wellings Capital will never knowingly overpay for a multifamily asset or bank on it’s appreciation potential at the expense of its current and projected cash flow.
That’s how multitudes of single family home investors were burned in the last downturn, and we won’t play that game.
Appreciation is great, and we hope for it in every deal, but appreciation is like a bi-polar friend.
I’m studying Warren Buffett’s investing philosophies and he said something I want to mention here: “It’s better to buy a great company at a fair price, than to buy a fair company at a great price.”
For Wellings Capital, I translate this as follows: “We endeavor to acquire great multifamily assets in excellent locations for a fair price, rather than to overpay for home run properties in marginal locations and bank on their appreciation.”
We believe that time will prove that this is the path to profitable, safe returns for our investors and our families. History has proven this for centuries, and it won’t change anytime soon.