Are you going to capitalize on the latest 20% real estate pass-through deduction?
Written By Forbes Contributor
Through a late provision added to the GOP tax plan over the weekend, real estate investors may be on course for a multimillion-dollar tax break.
The change would allow real estate investors to take advantage of a new break that provides a 20 percent deduction on taxable income for pass-through companies. A pass-through is a special type of corporate structure, popular among small business owners. These firms avoid the double taxation of paying corporate and individual taxes. Instead, taxes are applied solely at the individual level.
Ultra-wealthy real estate investors are the first beneficiaries of the tax provision, but anyone who invests in rental real estate may also stand to benefit. This includes President Donald Trump, and other policymakers like Senator Bob Corker of Tennessee, who voted against an earlier version of the legislation and on Friday said he’d support the revision.
While the tax cut is a boon for private real estate investors, it will likely make the inventory shortage worse–the most pressing issue in housing.
“Lack of inventory was a major problem for American home buyers before tax-reform. Unfortunately, this bill does nothing to improve it, and will likely result in even fewer homes for sale,” said Redfin chief economist Nela Richardson. “Pass-through tax cuts, combined with changes in the ability to deduct state and local taxes will continue to drive American migration, where people from coastal cities strike out for affordable places to live.”
Here are three ways that tax cut could limit the supply of homes on the market next year:
1. More profits means landlords are less likely to sell.
The bill makes it more profitable to own income-generating property like apartment rentals. Now, instead of paying the regular income tax rate (as much as 37%), a landlord could simply create a limited-liability corporation for their rental and pay the pass-through rate (20%). This also means that landlords are incentivized to hold on to their properties longer. That’s a tough break for housing, which remains starved for inventory, especially in the starter-home segment, where investors have scooped up housing and turned it into rentals. More competition in the rental market might have a silver lining for renters, but could lead to lower demand in the housing market if there’s less incentive to become a buyer.
2. Construction may lean toward apartments for investors, away from homes for buyers.
The one bright spot for homebuyers in 2017 was a substantial pick up in single-family construction. After the housing recession, builders were reluctant to construct new for-sale homes and focused on developing apartment buildings because they were a less risky and more lucrative. Multifamily new construction has slowed significantly this year, as single-family building has finally started to regain its footing. The tax change may encourage builders to build apartments again since there could be more demand from investors looking for income-generating rental properties.
3. More office buildings means fewer homes.
Under the tax change, all commercial properties qualify for the lower pass-through rate—everything from hotels, to casinos to office buildings. Anything that is leased and produces income counts. Premium apartment buildings owned by investors (such as corporations, REITs or pension funds) will not benefit
because they don’t pass-through profits to personal income taxes. Smaller, cheaper and privately-owned office buildings located away from city centers may compete with housing development directly, as those locations are often where housing is built.
Real estate investment is clearly important for the future of housing. But tax reform that makes it more profitable for investors to rent out properties won’t solve one of the biggest problems facing homebuyers next year, the lack of affordable homes for sale.