When it comes to policymaking, tax reform has been the most prominent topic of discussion in the past few weeks in the nation’s capital, with President Donald Trump calling for lawmakers to put a bill on his Oval Office desk by Thanksgiving.
Trump met with Senate Republicans Tuesday, as the details of the proposed plan were being ironed out before they’re unveiled to the public, potentially next week.
The implications, or benefits, tax reform may have for the multifamily industry remain to be seen.
“I wish I could tell you where things were, but we’re all looking at our crystal balls anticipating next week, when we actually see something in writing,” National Apartment Association (NAA) president and CEO Robert Pinnegar told MFE Wednesday.
In May, NAA launched the “Protect the Lease” campaign, using a grassroots approach that seeks to ensure the “Trump administration and Congress understand what’s at stake for the national apartment housing industry and, ultimately, the U.S. economy,” as they discuss changing the U.S. tax code.
To date, Pinnegar says, nearly 33,000 industry professionals have sent out communications to their members of Congress expressing their hopes and concerns with respect to tax reform. The campaign has been successful, he adds, because members of Congress are hearing from their constituents on this issue as opposed to a blanket information dump.
John Isakson, chief capital officer at Preferred Apartment Communities, has been keeping a close eye on the developments out of Washington, D.C., as well. His father is Johnny Isakson, a U.S. senator from Georgia who sits on the Senate Committee on Finance. The younger Isakson has been outlining the potential risks and “the things that we should be advocating for” to his colleagues in the multifamily industry in recent months.
According to Isakson, doing away with the carried interest and 1031 exchange provisions would have the most pervasive impact on the real estate business.
Carried interest, as the Tax Policy Center explains, is “a contractual right that entitles the general partner of a private investment fund (often a private equity fund) to share in the fund’s profits.” As it stands now, that income is treated as capital gains, which means it’s eligible to be taxed at a lower rate (23.8%—20% tax on net capital gains plus a 3.8% investment tax). If it’s taxed as ordinary income, the rate could rise to as much as 39.6%.
Carried interest is unpopular with some because of the hedge-fund compensation structure that’s in place, Isakson says. But real estate investors who have carried interest take far more risk than hedge funds because of their obligation under the debt.
“We haven’t actually seen how the policy will be written, but one of the risks—and I think this could be a the real risks—is you could have a phantom income issue where somebody’s getting carried interest calculated on a year-to-year basis and they’re being taxed on that as ordinary income, but they’re not receiving it until the end of the investment’s life,” Isakson says. “Now, the less-damaging position to take would be if they taxed carried interest it when it was received at ordinary income levels, versus taxing it as capital gains, which would still be a big blow, but obviously wouldn’t cause as big a problem as if you were trying to tax money that hadn’t actually been received yet.”
On a call with MFE Monday, Isakson noted, “The framework doesn’t lay out any of these details or specifics; I’m just outlining the potential risks.”
At the Multifamily Executive Conference in Las Vegas last month, Isakson moderated a panel and asked industry professionals about their biggest concerns when it comes to tax reform. The two executives on the panel who run private companies both said carried interest was their top worry.
“We only do a few deals a year, so the tax treatment on our carried interest is a big deal,” said David Hanchrow, CIO, Bristol Development Group, at the conference. “Treating us like the hedge-fund guys who don’t take the same risks is simply not fair.”
Kirk Motsenbocker, CFO, JPI, added that if carried interest were eliminated, his company’s “taxes would double.”
If like-kind exchanges, or 1031 exchanges, were to be eliminated, Isakson says, the multifamily transactional market could dry up to some degree.
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Here’s how the Internal Revenue Service explains 1031 exchanges:
Whenever you sell business or investment property and you have a gain, you generally have to pay tax on the gain at the time of sale. IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange.
The exchange “was created as a way for real estate–driven businesses to continue as operating businesses and to defer paying taxes on transactions they were using to grow their business,” Isakson explains. If the exchange were to be eliminated, some owners might receive a much higher tax bill.
“Basically, what it’s going to do is dry up the transactional market to some degree,” Isakson says. “What that does is slow down the re-investment in those assets. Assets are going to stay on the books with owners for longer; there’s probably going to be less capital investment; and renters are going to see less money going into the assets and fewer improvements in the assets in the long term.”
According to Pinnegar, key members of Congress were already “a little sensitive to protecting the 1031 like-kind exchanges.”
“So I think for now, that’s off the table,” he adds.
Also off the table, Pinnegar says, are changes to the low-income housing tax credit (LIHTC) program.
When major tax reform was passed in 1986, Pinnegar says, the multifamily industry was greatly hurt. It’s a result the NAA is working to avoid this time around.
“We want to protect against decisions being made in a vacuum without really understanding the full impact of what’s happening,” he says. “And that’s especially a challenge in an environment like this where there’s a lot of pressure to get something done as quickly as possible.”
The NAA and its members are continuing to reach out to Congress and will ramp up their efforts once more when a bill is unveiled.
“There’s a lot of conversations that are going on right now with key members to try and convey the last-minute concerns,” Pinnegar says. “We’re really waiting to see what happens next week when the bill does become public. At that point … we’ll re-engage our grassroots network with information as to what’s going on and have them recontact their members of Congress.”
