U.S.
Special Report
The New Tax Bill
January 2018
Washington’s Holiday Gift: Implications for
the New Tax Bill on Commercial Real Estate
Andrew J. Nelson, Chief Economist | USA
After working through differences between the House and Senate
versions of the Republican tax bill, Congress passed the final bill
just before Christmas, which the President then promptly signed
into law. The bill represents not only a major tax cut for businesses
(and a modest cut for households), but also the most sweeping tax
overhaul since the Tax Reform Act of 1986 under the
Reagan Administration.
Key impacts on the property sector include:
>> Tax liabilities for most commercial property owners and investors
will decline under the new tax bill as tax rates are lowered for all
businesses and most individuals, while most prevailing special
tax benefits enjoyed by the real estate sectors have
been retained.
>> The tax bill should improve property fundamentals for commercial
real estate in the near term due to an improving economy as
well as favorable tax treatment for businesses in several key
industrial sectors that lease commercial real estate. The retail
and industrial sectors should be clear winners here. However,
the relatively minor cut for individual taxpayers will limit net
additional consumer spending, and thus the potential boon for
these sectors.
>> The multifamily sector looks to gain from tax law changes that
will reduce the benefits of homeownership in many markets, and
thereby raise the incentives for apartment rentals for
some households.
>> The office sector looks to benefit the least of the major property
sectors. Key office tenants will gain only limited to average tax
savings from the new tax code. Moreover, many corporations will
distribute much of their tax savings to shareholders instead of
investing in new facilities.
>> Impacts on real estate capital markets are less clear. Uncertainty
as to the timing and nature of the tax reform likely kept some
capital on the sidelines this year, so enactment of the tax act
could encourage more transactions now that the uncertainty has
been lifted. However, the act does not confer any new significant
benefits specifically to real estate owners, blunting any potential
capital inflow to the sector.
>> Interest rates may rise faster after the tax cut due to the greater
national debt and more aggressive fed rate hikes. Impacts for the
property sector could include lower returns on interest-sensitive
investments (like REITs), more costly acquisition costs and
slower leasing once the interest rates eventually slow economic
growth (likely in late 2019 or 2020).
Introduction
The 2017 budget reconciliation act (formerly known as the Tax
Cuts and Jobs Act) will have far-reaching impacts throughout
the economy, affecting just about every taxpayer and business in
the nation. While the full implications will not be understood for
years owing to the complexity of the legislation—and the ingenuity
of motivated tax accountants—much of the bill is clear enough to
gauge its major impacts.
By just about any measure, the commercial real estate (CRE)
sector emerged fairly well from the legislative process. (See “Key
Provisions of the 2017 Tax Act Impacting Commercial Real Estate”
below.) Most directly, many of the industry’s most important
benefits under the prior tax code—notably tax-free 1031 exchanges,
commercial mortgage interest deductibility, asset depreciation and
carried interest—saw limited material changes in the new law.
At various points over the last year, all these special benefits for
the real estate sector seemed threatened. So even if the industry
was not awarded many special new benefits under the tax law, CRE
gained just by not losing its special privileges. Combine that with
lower rates on both corporate and individual income, and it’s clear
that tax liabilities for owners of commercial property will be lower
going forward.
But the impacts of this tax law will be greater and broader than just
these direct impacts. As discussed briefly in our State of the U.S.
Market and 2018 Outlook, the primary impact for the real estate
sector may well be through improved property fundamentals. The
tax cut is likely to foster at least somewhat stronger economic and
job growth this year, though most economists expect the boost
to be both modest and short lived. Building owners can expect
stronger leasing from several industrial sectors that will benefit
disproportionately from the new tax law. And finally, the multifamily
sector looks to gain from tax law changes that will reduce the
benefits of homeownership in many markets, and thereby raise the
incentives for apartment rentals for some households.
Almost everyone gains, but some more than others
Though all businesses will enjoy lower tax rates under the
revised tax code, some industrial sectors will fare far better than
will others. The net impact for individual companies will vary
significantly depending on its source and type of income, its use
of debt financing and the extent to which its revenue depends on
investments in depreciable physical assets, among other factors.
According to the non-partisan Penn Wharton Budget Model, the
effective tax rate (ETR) averaged across all industries and weighted
by size of industry will decline this year from what would have been
21.2% to just 9.2%. The primary factor reducing the ETR is the
drop in the corporate income tax rate from 35% to 21%. In addition,
expensing and depreciation for various types of equipment and
other eligible expenses will be more generous, and the corporate
alternative minimum tax (AMT) was repealed. However, interest
and operating losses deductions will be more limited (though,
significantly, not for the property sector). Moreover, some of these
2 The New Tax Bill | Colliers International
provisions phase out over time, including the bonus depreciation
(accelerated depreciation on eligible business equipment), thereby
raising the average ETR over time to 18.9% by 2027—still below the
23% rate that would have been in effect under the old tax law, but
more than double the ETR in 2018 under the new code.
In sum, the cumulative average tax bill over the next 10 years will
be almost one-third lower than under the prevailing law, again
averaged across all industries and weighted by size of industry.
However, the decline will be much greater in asset-heavy industries
like mining, which will benefit from immediate expensing for
spending on short-lived capital equipment. On the other hand, some
industries will see their tax bills rise on average. Heavily indebted
firms, particularly those with lower credit ratings, will see the limits
on interest and operating losses wipe out the gains from the lower
tax rates.
Cumulative Tax Change by Sector
2018-2027
-60% -40% -20% +0% +20%
Utilities
Arts and entertainment
Professional services
Health care
Manufacturing
Real estate
Information
Total (all industries)
Construction
Finance and insurance
Agriculture
Retail trade
Wholesale trade
Educational services
Transport & warehousing
Other services
Hotels & food services
Waste management
Holding companies
Mining
Sources: Penn Wharton Budget Model and Colliers International
In this context, owners of real estate will certainly benefit
significantly, though a bit below average. The Penn Wharton
model projects that taxes for the property sector will drop 30% in
aggregate over the next decade against the baseline versus 32%
for all industries. As noted previously, CRE managed to maintain
most of its special benefits from the old tax law, but won few new
additional benefits, beyond the lower individual and corporate tax
rates applicable to all sectors.
An improving economy . . .
Beyond the lower taxes owners of commercial property will pay
under the new tax code, the CRE industry will enjoy indirect
benefits from the lower taxes as well. The economy already started
growing faster in mid-2017, in part attributable to a significant
pickup in business investment, as firms bet on the tax relief that
Congress finally delivered in December. Thus, some of the boost
that a tax cut could be expected to deliver has already been
reflected in the economic pick-up last year.
Additional stimulus will come from the fact that tax cuts are largely
unfunded (that is, without offsetting spending cuts). This stimulus is
variously estimated to total between $0.5 and $1.4 trillion once the
effects of induced economic impacts of the $1.5 trillion tax cut are
considered, with most independent estimates near the upper end of
the range.
. . . but limited further upside potential
This impact is likely to be limited, however. First, the U.S. has an
annual GDP of about $19 trillion, so a 10-year stimulus of $1 trillion
amounts to only about 0.5%. Granted, some of the stimulus will be
front-loaded into the early years as some of the tax cuts are phased
out over time, so the 2018 stimulus will be a bit greater. But its net
addition to the overall economy will still be relatively modest.
Moreover, the economy is already believed to be operating close to
its full potential. Government stimulus tends to be more effective
during a recession, when there is considerable slack in the
economy. Adding fuel to an economy already at full employment
will tend to raise inflation more than output.
Also limiting the potential impact: While consumers account for
more than two-thirds of the U.S. economy, the tax cuts seem
unlikely to induce much additional spending. The tax cuts are
heavily weighted to favor businesses over consumers compared
to their shares of the economy (Congressional Budget Office).
Plus, the cuts are skewed to the upper end of the income scale
(Joint Committee on Taxation). The affluent tend to save more of
their income and spend less of their tax cuts than lower-income
households, thereby limiting net additional consumption from this
tax law.
Finally, the economic lift is likely to be short-lived, as most
economists believe the tax bill will prompt the fed to raise interest
rates more quickly to flow inflation. The greater national debt from
the unfunded tax cuts also will tend to raise interest rates. In turn,
higher interest rates would slow both business investment and
consumption, thereby slowing economic growth.
Consensus economic forecasts show the economy growing by 2.5%
in 2018, about the same as last year, but then slowing in 2019 and
especially 2020, as the cumulative effect of fed rate hikes take
full effect.
Winners in commercial real estate
In summary, landlords can expect at least a modest, short-term rise
in leasing from faster economic growth. But some sectors of CRE
should see even greater absorption as several tenant groups that
will benefit disproportionately from the new tax law are key users
of commercial real estate.
>> Retailers and restaurants look to be among the biggest winners
under the new tax law, which should benefit shopping centers in
their battle with e-commerce. Retailers and restaurants currently
3 The New Tax Bill | Colliers International
pay among the highest effective tax rates of any sector because
they cannot take advantage of many of the tax credits available
to other sectors. These sectors will benefit strongly and directly
from the drop in the corporate tax rate.
>> Similarly, warehousing and wholesale trade also pay some of
the highest effective tax rates and will benefit disproportionately
by the new lower tax rates. With stronger tenants, warehouse
owners could see even greater demand for their product, which
is already experiencing record demand due to e-commerce,
economic growth and the logistics revolution.
>> By contrast, the office sector should not expect much greater
demand from occupiers beyond that from the overall pick-up in
the economy. Some key office tenants, like tech and finance,
will gain only average tax savings from the new tax code,
while others, like health care and professional services, will
see more limited gains. (See chart above.) Moreover, many
corporations are expected to distribute much of their tax savings
to shareholders through dividends and share buy-backs, instead
of investing in new facilities.
Finally, the multifamily sector stands to gain from the partial
reduction of long-established benefits to homeownership,
particularly in pricey, higher-taxed property markets:
>> capping property tax deductions ($10,000 together with other
state and local taxes)
>> limiting mortgage interest deductions (to the first $750,000 of
mortgage debt, down from $1 million and eliminating the interest
deduction on home-equity loans)
>> doubling the standard deduction, which reduces the incentive to
itemize deductions on tax returns.
The housing sector did maintain its tax-free capital-gains exclusion
on primary residences (up to $500,000 for married couples). But
these three foregoing provisions will raise the effective, after-tax
cost of purchasing or owning a home in higher-priced markets.
Over time, the effect should be to slow or even reverse home price
appreciation in these markets, ultimately making houses more
affordable (though hurting current owners). But the more immediate
effect will be to reduce the benefits of home-buying relative to
renting, to the advantage of apartment owners and developers.
However, impacts on real estate capital markets are less clear.
Anecdotal evidence suggests that some capital remained on the
sidelines this year due to uncertainty as to the timing and nature
of the tax reform. Enactment of the tax act could encourage more
transactions now that the uncertainty has been lifted. However, the
act does not confer any new significant benefits specifically to real
estate owners, blunting any potential capital inflow to the sector.
Moreover, interest rates are likely to rise faster, reducing returns on
interest-sensitive investments and transaction volumes.
Key Provisions of the 2017 Tax Act Impacting
Commercial Real Estate
Weighing in at some 500 pages, the new tax reform act has numerous
provisions that will touch virtually all aspects of the commercial real estate
industry, including both general provisions as well as those targeted
directly at our sector. Key terms include:

Lower corporate and individual tax rates – The corporate tax rate has
been permanently reduced from 35% to 21%. The tax code reduces the
number of tax brackets and marginal tax rates (MTR) paid by individuals
and households have been reduced marginally for most filers, but raised
for some. For example, the top rate declines from 39.6% to 37% and that
rate kicks in for single filers at income above $400,000, compared to
$427,000 previously. However, the 35% rate now starts at just $200,000,
compared to $425,000 previously, effectively raising the MTR for single
filers with income between those two thresholds. In addition, the lower
MTRs expire in 2026 unless extended with new legislation.

Pass-Through Income – Individuals receiving income through pass-

through entities such as LLCs and partnerships can deduct up to 20%
of their “qualified business income,” effectively lowering their maximum
MTR from 37% to 29.6%. However, this deduction is limited by various
conditions, so many taxpayers will not be able to claim the full deduction,
raising their tax rate. This treatment of pass-through income is one of the
few in the new tax code specifically targeted to benefit owners of CRE;
many pass-through entities are excluded from this provision, including
service providers in the fields of financial services, law and accounting,
among others. Importantly, real estate brokers are also excluded. And this
provision, too, is set expire in 2026.

REIT Dividends – REITs may deduct 20% of their dividend payments,

thereby lowering their maximum MTR from 37% to 29.6% on their
dividends. This provision, too, is set expire in 2026.
FOR MORE INFORMATION
Carried Interests, 1031 Tax-Free Exchanges, Interest Expense Andrew J. Nelson
Deductions, and Asset Depreciation Provisions – All these prevailing Chief Economist | USA
provisions of the tax code survived more or less intact in the new tax +1 415 288 7864
law. Despite threats to treat carried interest as ordinary business income, andrew.nelson@colliers.com
carried interests continue to be treated as long-term capital gains at lower
tax rates, though the minimum hold period has been increased from one to
three years. 1031 exchanges were essentially unchanged, though personal
property is now excluded.

And while most businesses now face a limit on their interest expense
deductions equal to 30% of their adjusted taxable income, real estate
businesses are generally excluded from this limitation, preserving a key Copyright © 2018 Colliers International.
benefit for CRE owners. However, businesses electing this treatment faced The information contained herein has been obtained from sources
deemed reliable. While every reasonable effort has been made to
marginally slower depreciation of their real assets. ensure its accuracy, we cannot guarantee it. No responsibility is
assumed for any inaccuracies. Readers are encouraged to consult
Provisions Affecting Homeownership – Three measures may affect their professional advisors prior to acting on any of the material
the cost of owning a home, particularly in higher-taxed, pricey property contained in this report.
markets: a cap on property tax deductions ($10,000 together with other
state and local taxes), limits on mortgage interest deductions (to the
first $750,000 of mortgage debt (down from $1 million plus eliminating
the interest deduction on home-equity loans); and the doubling of the
standard deduction, which reduces the incentive to itemize deductions
on tax returns (which would normally include both mortgage interest and
property tax deductions).