With Republicans controlling the White House and both houses of Congress, there’s been a lot of discussion among political and business leaders about the possibility of meaningful tax reform. This prospect often causes many multifamily executives who were in business in the 1980s to shudder, as the multifamily industry lost big in 1986, the last time the tax system was overhauled.
However, few proposals have been released for consideration. So, for now, focus is mostly on the House Republicans’ Blueprint for Tax Reform, which was released in June 2016. The blueprint aims to both modernize and simplify the tax code for the benefit of individual households, businesses and the economy at large.
Given that changes to the tax structure can affect both demand for apartments as well as our industry’s ability to build, own and trade properties, the 2017 NMHC Research Forum featured a session outlining the multifamily-specific ramifications of the blueprint. Researchers approached the topic in two distinct ways: first, by asking how the nation’s apartment residents would fare under the reformed system and, second, how the industry stands to gain or lose should the blueprint go into effect.
New Rules Support Residents
The House Blueprint includes a number of key changes that would affect renters’ after-tax incomes. Chief among them are:
- Elimination of personal exemptions;
- A larger standard deduction / elimination of additional standard deduction for those 65 and older;
- Elimination of itemized deductions, with the exception of charitable contributions and mortgage interest deduction;
- 50% deductibility of investment income;
- Elimination of the Alternative Minimum Tax;
- Condensed marginal tax brackets; and
- Expansion of the Child Tax Credit
Using microdata from the 2015 American Community Survey, NMHC Senior Research Analyst Chris Bruen looked at renters’ personal incomes, deductions and tax credit information and applied three potential scenarios to get a robust picture of how a change in the tax rules could affect renters:
- In scenario 1, renters took a standard deduction
- In scenario 2, renters maxed out their itemizations (assumes that renters itemize at the same rate and in the same amount as homeowners)
- In scenario 3, some renters did some itemization (assumes that about half the renters in each income bracket itemized and that they itemized 25 percent less than homeowners)
After crunching the numbers, it would appear that the majority of renters win in all of the scenarios, netting income gains. (Chart below shows scenario 1.) However, households with children are likely to gain less than other household types mostly because their deductions for dependents and child-care credits would decline. Similarly, the analysis showed varying effects for different income brackets such that the renter households with higher incomes had larger average net gains.
It’s a Mixed Bag for Multifamily
However, the effects of tax reform, as currently outlined, are less clear cut for multifamily businesses. David Barker, a partner with Barker Apartments and visiting scholar at the University of Iowa, offered some alternative analysis of the effects of the House blueprint, as well some points of President Trump’s tax plan.
Of importance to multifamily firms, the plans call for:
- Lower marginal rates
- Immediate expensing of investment (House blueprint excludes land while the Trump plan makes this an election available only for manufacturing businesses)
- No deductibility of net interest expense (House blueprint includes interest on all investmenst while the Trump plan makes this an election for manufacturing businesses)
- Possible end to 1031 Like-Kind Exchanges
Other potential changes could include cost segregation (which can accelerate depreciation), estate tax repeal, qualifications for real estate professional status (as it relates to active versus passive income), new tax structure for pass-through entities and changes to the Alternative Minimum Tax.
Because after-tax cash-on-cash rates of return drive real estate prices, Barker’s analysis focused on how the main parts of the blueprint could affect returns. Under this lens, Barker’s analysis suggested that the potential loss of interest deductibility would cause much less heartburn than, say, a combination of both accelerated depreciation and the ability to take losses.
Also concerning is the loss of 1031 like-kind exchanges, which would likely result in a 10 percent decrease in commercial real estate prices, affecting properties in high-tax states even more significantly, according to academic research, Barker said.
Given how much the proposal and its components are in flux, Barker developed a matrix that examined the various options, the likelihood of each moving forward and the potential impact on multifamily. The spreadsheet sets up a property scenario using some basic financing and tax assumptions and then allows users to play around with how changes to things like depreciation schedules, deductibility of business interest and new distinctions between active versus passive income can affect, either singularly or in concert with each other, the property’s net present value. (Below is a snapshot of analysis done through the spreadsheet matrix.)
In addition, Barker created a simple spreadsheet calculator that illustrates how tweaking some basic financial and performance metrics can quickly erode property price and even put an owner underwater on a loan without much effort .