How the Tax Cuts and Jobs Act impact private lending and construction.

President Trump signed the Tax Cuts and Jobs Act of 2017 (TCJA) on Dec. 22, 2017, ushering in major changes to the Internal Revenue Code of 1986, effective Jan. 1, 2018.These changes should have a significant positive impact on the private lending and construction sectors, including boosting demand for more deals and the supply of capital.

Some of the earlier incarnations of the legislation included provisions and changes that would have been worrisome for both industries. However, the final bill that was signed should help drive both the private lending and construction industries because it provides modest tax relief to consumers, maintains the nation’s fiscal commitment to affordable housing and reduces the tax burden on pass-through companies. It’s fair to say that, on balance, the policy changes will lead to higher after-tax returns, increased investment and lower capital costs. The core Republican contention that this massive amount of tax relief will boost gross domestic product remains to be seen, but overall it should provide a steady tailwind for our corner of the economy.

Let’s first look at the TCJA’s impact on issues specific to our industry and then widen to the larger, macroeconomic picture.

Lower Pass-Through Rates

By now, even the casual news reader is aware that the TCJA restructures individual and corporate tax rates, with particular benefit both for C corporations, where the top bracket is reduced to 21 percent, and for pass-through entities like limited liability companies (LLCs) and S corporations.

The TCJA effectively lowers the tax rate for individual and trust owners of certain “qualified” S corporations, LLCs, partnerships and sole proprietorships by providing a 20 percent deduction on qualified business income. The deduction is limited to 50 percent of the W-2 wages with respect to such business; or if greater, the sum of 25 percent of the W-2 wages plus 2.5 percent of the cost of qualified property acquired during the year. This is one of the most significant impacts on our industries. The benefit of these lower tax rates should make it possible for investors and developers alike to create new, more efficient ownership vehicles.

This benefit though is somewhat limited by a distinction for owners of “specified service businesses,” where the principal asset of the business is the reputation or skill of one or more of its employees or owners, such as businesses in the fields of health, law, consulting and financial services, as these pass-through entities are generally not eligible for the 20 percent deduction. There is a small taxpayer exception to both the wage limitation and the “specified service business” exclusion: Both generally do not begin phasing in until owners have adjusted taxable income of more than $157,500 ($315,000 for joint filers).

Overall, for the lending, real estate and construction industries, the new legislation should be highly beneficial. Before the TCJA, investors seeking the advantages associated with C-corporation status had to become a real estate investment trust (REIT); otherwise, they would be treated with high entity-level taxation. Under the new law, investors may enjoy some of the tax advantages previously enjoyed by an REIT, while gaining the ability to build capital through earnings retention and to engage in a variety of operating businesses that previously were not permissible for trusts.

In addition, investors will now have more flexibility to match depreciation schedules with real property economic value. This will reduce or eliminate the need to participate in “like-kind” exchanges to preserve their basis when they decide to sell. In this way, an owner would be free to reinvest the proceeds from a sale in any assets they want at the time, without facing the adverse tax consequences they used to contend with.

Impact on Housing Market

Overall, the TCJA should continue the nation’s longstanding fiscal support of individual homeownership and strengthen opportunities for homebuilders to add much-needed housing inventory to the market. There’s an argument that some downside effects may be felt for luxury housing with price tags above $1 million. This is particularly in the high-state tax areas like the Northeast and California, but this is subject to debate due to changes in the alternative minimum tax and other factors.

The housing industry could use the help. Even after eight consecutive years of growth, new residential construction in 2017 was well below the 1.4 to 1.5 million-unit annual rates averaged in the 1980s and 1990s, according to a study by the Joint Center for Housing Studies at Harvard University. In fact, even with the bounce-back from the effects of the Great Recession, housing completions in the past 10 years still just totaled 9 million units—4 million units fewer than in the next-worst 10-year period that began after the “stagflation” 1970s era, and despite today’s much larger population. Together with steady increases in demand, the low rate of new construction has kept the overall market tight, depressing the gross vacancy rate to its lowest point since 2000.

Compared to earlier versions of the legislation in the House—which proposed to eliminate the mortgage interest deduction—the TCJA should keep consumer demand stoked. It maintains most of the tax deductions most homeowners benefit from. Specifically, the new law:

• Maintains the mortgage interest deduction for new home purchases and the deduction for second homes, although it reduces the mortgage interest cap from $1 million to $750,000.
• Retains, for existing housing indebtedness incurred before Dec. 15, 2017, the current-law limitations of $1,000,000 ($500,000 in the case of married taxpayers filing separately). However, no interest deduction is allowed for interest on home equity debt after 2017.
• Limits deductions for state and local income tax, including property tax and the choice of income or sales tax, to $10,000 per filer.
• Maintains the existing rule allowing homeowners to exclude up to $250,000 (or $500,000 for married couples) in capital gains on the profit from the sale of a home if they have lived in the house for two of the last five years. Earlier, the House and Senate each proposed to make this rule stricter, but neither provision made it through the final committee, to the relief of participants in the lending and construction industries.
• Retains the present maximum rates on net long-term capital gains and qualified dividends: 15 percent and 20 percent, depending on income levels.

Impact on Luxury Housing

There’s a fair amount of concern that one downside of the TCJA on the industry may be the $750,000 cap on the Mortgage
Interest Deduction (MID), which could be felt in the luxury residential real estate market since it reduces the nominal after-tax value of pricy primary residences. According to Bloomberg, there are currently more that 2 million homes worth greater than $1 million nationwide. Looking at the top 10 highest-cost markets, inflation-adjusted median home values climbed more than 60 percent over the last seven years, so increasing amounts of housing inventory are expected to push past that $1 million threshold each year.

In those top 10 real estate markets, million-dollar residences are relatively common, according to a report by the website Trulia. They compose more than half the residential stock in cities like San Francisco and San Jose, and represent a big share of Los Angeles (16 percent), New York (12 percent), Seattle (7 percent), metro D.C. (6 percent) as well as other markets. Even among nominally lower-cost regions like Atlanta or Nashville, there are still plenty of neighborhoods where plus-$1 million housing is common.

Those arguing that the TCJA puts pressure on the luxury market point to the new rule that limits deductions for nonbusiness state and local tax expenses (SALT), including property and income taxes, to $10,000 ($5,000 for married filing separately). California, for example, has among the highest taxes in the nation in addition to its pricy real estate. Its base sales tax rate of 7.5 percent is higher than that of any other state, and its top marginal income tax rate is 13.3 percent, the highest state income tax rate in the country. Given the political and economic divide between red and blue states, the changes to MID and SALT deductions have received their fair share of negative press.

Although these arguments are politically saleable, it is fair to say that the extent of the impact on the high-end residential housing remains open for debate. Most likely this is a wait-and-see issue due to three significant, countervailing factors:

1. Because the bill also doubles the standard deduction, fewer people will claim the MID and SALT deduction overall. The weakened MID and SALT deductions could be a wash for a lot of taxpayers, given the new standard deduction.
2. For taxpayers in the coastal blue states where prices and SALT rates are high, those who can afford luxury real estate mostly have been subject to the AMT anyway, which historically wiped out a lot of their MID and SALT deductions. Under the TCJA, the AMT exemption amounts are going up, which may offset part or, for some people, all the lost benefit of the reduced MID and SALT deductions. The AMT exemption amounts will increase to $70,300 for single filers and $109,400 for joint filers, and they will phase out for those taxpayers at $500,000 and $1 million, respectively. This is significantly better than the status quo AMT exemption amount for single filers of $54,300, which begins to phase out at $120,700; and for joint filers, where it is $84,500 and begins to phase out at $160,900. Although these changes will end after 2025, the new AMT thresholds may well offset any risks to luxury real estate that the mortgage interest and SALT limitations pose, at least for the foreseeable future.
3. The luxury residential real estate market historically correlates positively with the major stock market indices, which are likely to continue to climb due to the much lower marginal tax rates for corporations. This may sound counter-intuitive at first because, according to Case Schiller and many other analysts, over the long term the overall housing market is negatively correlated to equities. When stock markets plunge, investors typically move money into real estate and REITs. However, when it comes to luxury residences, the correlation is positive historically, because bull markets supply high net worth buyers of real estate with both liquidity and consumer confidence.

Impact on Affordable Housing Programs

Many investors, builders and private lenders were relieved to see the TCJA protected various affordable housing options by protecting private activity bonds (PABs), which had been in the firing line in earlier incarnations of the bill. PABs are tax-exempt bonds issued by or on behalf of local or state government for providing special financing benefits for qualified projects. The financing is most often for projects of a private user, and the government generally does not pledge its credit.

Without PABs, economists with the National Affordable Housing Bureau trade group had estimated that the inventory of lower cost rental property would have plunged by more than 750,000 units over the next decade. Fortunately for the industry and lower income families alike, the final TCJA retains PABs so that programs that include the 4 percent Low-Income Housing Tax Credit (LIHTC) and the Historic Tax Credit (HTC) maintain their effectiveness as tools to produce affordable housing. The 4 percent LIHTC funds a third of affordable housing construction, while the HTC has been used to fund renovations to more than 40,000 historic structures since 1981.

LIHTC and HTC tax credits were created by the 1986 Tax Reform Act to incentivize private equity to fund low-income housing development. The credits, also known as Section 42 credits, are attractive because they reduce a taxpayer’s federal taxes on a dollar-for-dollar basis, much more beneficial than tax deductions that simply reduce the amount of income the tax rate is applied against. The “passive loss rules” and similar tax changes made in 1986 reduced the value of tax credits and deductions to individual taxpayers, so individual investors claim less than 10 percent of current credit expenditures.

But despite these benefits for affordable housing, the National Association of Local Housing Finance Agencies pointed to a macro issue concerning the reduction of the corporate tax rate. The concern is that the greater attractiveness of public company equity (and debt) due to the lower marginal tax rates will reduce demand for LIHTC. Because the bill also cuts the corporate tax rate from 35 percent to 21 percent, this will inherently lower the value of both credits and lead to fewer affordable housing units and renovated historic buildings.

“Unlike previous versions of the legislation, important affordable housing tools, including private activity bonds, the low-income housing tax credit, the New Markets Tax Credit and the Historic Tax Credit were fully preserved in the final bill,” NALHFA Executive Director Jonathan Paine said. “The corporate tax rate will be lowered from 35 percent to 21 percent, however, which will likely cause a reduction in housing credit equity.”

Other Provisions

Some other details in the final bill are very interesting to both industries and to their tax advisers, who are sure to be busy during the next 12 months:

• Carried Interest Rule // This was retained in the final Act, but assets must be held for three years.
• Real Estate Interest Deduction // Now developers have a choice between the following:
  • Limiting their interest deduction to 30 percent of net income without regard to depreciation, amortization and depletion. This distinction makes the limitation less restrictive than one based on adjusted gross income.
  • A 100 percent deduction for business interest, but with certain trade-offs.
• Depreciation Election // Beginning in 2018, the TCJA provides real estate investors and owners of
  multifamily units with a choice for depreciation, with the option of either a 27.5-year or a 30-year depreciation schedule, depending on how they elect to treat their business interests. This is a valuable tool to help customize cash flow and retirement/estate planning according to individual preferences.
• Small Business Methods of Accounting // Beginning after 2018, small businesses with average gross receipts of $25 million or less will be allowed to use the cash method of accounting, regardless of whether it is
  a C corporation or a partnership with a C corporation partner. Moreover, taxpayers that meet the $25 million gross receipts test are not required to account for inventories.
• Revenue Recognition // TCJA generally requires accrual method taxpayers subject to the “all events test” for revenue recognition to be in conformity with its “applicable financial statements,” if such are prepared by the taxpayers.
• Business Interest Expense Limitations // The TCJA limits the deduction of net interest expense for businesses with average gross receipts in excess of $25 million. The deduction is generally limited to 30 percent of adjusted taxable income (after adding back depreciation and amortization expense).
• Corporate Net Operating Losses (NOL) // For losses generated after 2017, the TCJA limits the NOL deduction to 80 percent of taxable income and disallows most carrybacks, but generally allows indefinite carry forwards.
• Business Entertainment Expenses // The TCJA generally repeals the business deduction for entertainment, amusement or recreation expenses. The 50 percent deduction for business meals is generally retained.
• Domestic Production Deduction // The TCJA repeals this popular deduction.
• Affordable Care Act (ACA) or “Obamacare” // The TCJA repeals the ACA’s individual mandate to buy health insurance by making any required payment $0 beginning in 2019.

Impact on Lenders

The TCJA is mostly good news for lenders given the lower tax rates for corporations and pass-throughs and potential stimulus for the economy. However, near term there is a certain amount of pain because many lenders will need to take big charges in the fourth quarter of 2017 because of the pending changes. This pain is just temporary—the lower corporate tax rate in the legislation will sharply lower the value of tax-deferred assets, forcing write-downs. Lenders will have to immediately shrink the size of an asset on their balance sheet because the future value of the tax deductions will be worth less. Nearly all lenders should feel some short-term effect since a tax-deferred asset is generated through loan-loss reserves, but the amount of the charge-offs will vary considerably based on the level of reserves and other factors.

Among the large banks, only Citibank has indicated the size of its charge. Citi estimates it will take a short-term $16 billion to $17 billion hit, but even for regional banks, the charges could be sizable. Capital One Financial, for example, may record a charge of about $976 million, according to an estimate by FIG Partners. For other major banks, the impact is significant too. FIG Partners estimated that U.S. Bancorp’s charge could total $514 million; the $19 billion-asset First National Bank of Omaha may record a $50 million charge; the $30 billion-asset Associated Banc-Corp may take a $36 million charge; and the $27 billion-asset Hancock Holding in Gulfport, Mississippi, could record a $29 million charge.

The Case for Economic Growth

The main premise of the TCJA is to boost economic growth and funnel overseas corporate profits back to U.S. soil, ultimately to benefit workers, households and investors and, of course, the construction and private lending industries. For individuals, the TCJA retains seven tax brackets, with rates ranging from 10 percent to 37 percent, with the top rate down from its previous rate of 39.6 percent. This will represent a net tax cut for most taxpayers. It doubles the standard deduction for individuals, and increases the child tax credit to $2,000 per qualifying child, up to $1,400 of which may be refundable. There is also a $500 nonrefundable credit for qualifying dependents other than qualifying children. The adjusted gross income threshold for phasing out the credits is increased to $400,000 for joint filers and $200,000 for others. The effect of these reductions should be expansionary for the economy until these elements sunset in 2025. However, it remains to be seen how other external factors will play out, not the least of which is the Federal Reserve’s policy over the next several years. Before passage of the TCJA (and continuing through press time), the Fed was expected to maintain its policy of steady
but modest rate increases. So far, the consensus is that status quo is likely, but any deviation from this path that results in a stricter monetary policy from the Fed could undo the expected GDP benefits of tax reform. It’s a high-wire balancing act, because the combination of profit repatriation and tax relief could goose inflation above current expectations, essentially robbing Peter to pay Paul.

Even just some early signs of creeping inflation as a result of this tax relief could have the effect of causing the Fed to alter its course. Jay Powell, the incoming chairman of the Federal Reserve Board nominated by President Trump, is a bit of a wild card. He is expected to stay the course on monetary policy if the economy continues its steady growth, but it’s less certain where Powell would lead the Fed if inflation rises more than expected. Powell, a member of the Fed’s board of governors since 2012, has consistently voted with current Fed chair Janet Yellen to slowly raise interest rates and sell off assets that the Fed bought up in the wake of the severe recession of 2008 and 2009. Colleagues consider him to be a centrist and a pragmatist, but he lacks the deep background in economics that some of his predecessors had. He also has expressed skepticism in the past about the unconventional measures that the Fed took after the recession.

Fed aside, economists are all over the map regarding the potential for the TCJA to boost GDP over the long term. The optimistic view is that tax reform will bring solid economic expansion, although the amount of growth acceleration is unknown at this juncture. For example, economists at Fannie Mae expect it could add a half percent or more to annualized economic growth above baseline each of the next couple of years, due to investment increases driving productivity gains resulting in real income growth.

The pessimistic view is that there may be no incremental expansion as a result of the TCJA because most of the personal income tax reductions are temporary, while the permanent reductions for corporations may fail to deliver the promised economic expansion. The fear is that corporations, to whom much of the dollar share of the tax revenue reduction applies, will mostly use their lower tax burden to buy back their stock and cut larger dividends, yielding no tangible improvement in GDP nor unleash job growth, boost middle class income levels or lead to increasing capital investments. The pessimists include in their gloomy assessments the impact of the growing deficit and national debt and the potential for interest payments on the national debt to begin crowding out private capital down the road.

At the end of the day, a prudent professional in the private lending or construction industry is wise to stay on top of the details even if the true endgame with GDP is not knowable at this stage. There’s plenty of work to keep tax planners and investment strategists awake for nights on end. This is the most significant new change to the tax code in more than three decades, and it offers tremendous possibilities for those who keep abreast of the developments and tailor strategies to take advantage of all the new twists and turns.