Tax Overhaul Bills Keep '1031 Exchange' and Add Other Commercial Property Perks

The residential real-estate industry might be panicking about the Republican-backed tax overhaul making its way through Congress, but many in the commercial real-estate industry are delighted with what they see so far.

Owners of office buildings, malls, warehouses and other commercial property would benefit from lower taxes on their profits and would be able to avoid a 30% limit on deductions for interest expense that would be imposed on other businesses, based on two separate bills originating in the House and the Senate, respectively.

The Senate bill, unveiled last week, also would shorten the depreciation period for commercial property to 25 years from 39 years.

Just as important, none of the provisions that commercial real estate owners feared most were included in either proposal. For example, both the House and Senate bills would preserve the much-loved "1031 exchange" provision that enables sellers of real estate to defer capital-gains taxes by reinvesting the proceeds in "like-kind" properties.

Industry executives and lobbyists are cheering.

"If the bill comes together as envisioned it will be a positive for the underlying economy and that's what America needs," said Jeffrey DeBoer, chief executive of the Real Estate Roundtable, a trade group. He pointed out a number of provisions remain unclear.

Critics of the tax bills are using other descriptions. "The House and Senate bills are both windfalls for commercial real estate that boggle my mind," said Steven Rosenthal, a senior fellow with the Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution.

The commercial property industry's favorable reaction contrasts markedly with the dismayed voices in the residential real-estate world. Realtors, home builders and other parties are upset by provisions they say would eliminate the tax incentives of homeownership, such as the provision in the House bill that would reduce the cap the on the deduction for residential mortgage debt to $500,000 from $1 million.

"This bill is a serious step in the wrong direction," said Elizabeth Mendenhall, the incoming president of the National Association of Realtors in a letter last week to House members.

Much could change in the weeks between now and the end of the year, when the GOP hopes to complete the biggest overhaul of the tax code since the Reagan administration. The House and Senate bills vary in many respects, including some provisions that would affect the commercial real-estate industry.

Property owners in some states might benefit more than others if proposed limitations on deducting state and local taxes are enacted, according to a report by Green Street Advisors. Such a change could result in weaker economies in high-tax states like New York and California, reducing demand for space.

Still, the comparatively favorable treatment of commercial property over residential reflects a sea change in the political and economic priorities of the Republican Party. Proponents of the House and Senate bills say the main priority of tax overhaul is to stoke job creation by all businesses including commercial real estate, that any pain homeowners might suffer would be made up for by economic growth, and that unfair tax breaks are being removed.

At the same time, the preferential treatment of commercial property helps rectify what many in the industry considered a major affront delivered by the Tax Reform Act of 1986. That law outraged many in the industry partly by limiting the use of so-called passive losses, like those coming from investments in real estate by doctors and dentists.

Many in the industry blamed the recession of the early 1990s partly on those changes -- particularly much stricter rules when it came to applying passive losses to other income. In 1991, when Mr. Trump was 45 years old, he testified before the House Budget Committee that the real-estate industry was in "an absolute depression" and that "one of the reasons we're there is what happened in 1986."

That change eliminated important incentives to invest in real estate, Mr. Trump said.

"If something isn't done to put the incentive back we're no different from the Soviet Union," he said. "They have no incentive and we have no incentive."

Both bills would make investing in real estate businesses more attractive, regardless of how the businesses are structured. Many private real estate businesses are taxed under the so-called pass-through provisions of the tax law. In other words, there is no tax on corporate income. Rather, income is passed through to the personal tax returns of the property owner. Currently the top rate on pass-through income generally is the personal rate maximum of 39.6%.

Under the House bill, the pass-through rate for real estate income would drop to 35.2%, but the rate would go down to roughly 25% if it is passive income, which rent often is. Under the Senate bill, the maximum pass through for real estate would drop to 32.7%, according to Mr. Rosenthal.

The House bill would tax dividends paid by real-estate investment trusts at a reduced 25% rate, according to Nareit, the industry trade association. Under the Senate bill, REIT dividends would be taxed effectively at a maximum 31.8% rate, Nareit said.

"The pendulum is swinging the other way," said Mr. Rosenthal, referring to the pain inflicted to the industry by the 1986 tax law.

The full House and a Senate committee are expected to vote this week on the different plans. It is far from clear that a final bill will reach the White House. "Feels like a coin flip," Green Street said in its report.

--Richard Rubin contributed to this article.

Write to Peter Grant at peter.grant@wsj.com

(END) Dow Jones Newswires

November 14, 2017 07:14 ET (12:14 GMT)