Proposed Tax Changes Will Not Eliminate the 1031 Exchange

Within the last few weeks the Republican leadership in both the House and Senate released their tax plans. In light of this, we can now comment with more certainty on the potential effects on the private placement marketplace. Note: this is an update to a previous blog we posted in August.
 

Changes to the Individual Brackets

Both the Senate and House bills make changes to the individual tax brackets. While the House version drops from seven brackets to four brackets, the Senate bill retains the current seven. Additionally, the House bill eliminates several significant individual deductions including the deductions of student loan interest and medical expenses, as well as cutting the mortgage interest deduction in half, while the Senate bill keeps most of these as are and instead completely eliminates the deduction for state and local taxes. These changes are unlikely to drastically effect the private placement market, unless the final compromise really does increase the available capital in the hands of accredited investors.

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Lowering of the Corporate Tax Rate

Both the Senate and the House bills propose moving the corporate tax rate to 20%, with the only difference being when this new rate would go into effect. The House proposes immediate implementation while the Senate opts to delay until 2019. While this is not as significant a cut as was originally proposed (from 35% to 15%), this cut could still lead to corporations having more capital to put to work or dividend to investors. Either way this change may make the corporate entity structure more attractive to investors.

The House and the Senate have a far longer way to go on what to do with pass-through entities. The Senate proposes a deduction that would effectively set the top rate for pass-through entities in the low 30s, while the House proposes a special rate of 25%, but only for 30% of the owners' income from such an entity. As previously discussed, issuers generally structure special purpose vehicles as pass-through entities, making the pass-through entity, whether a LP or a LLC, one of the most common entities in the private placement marketplace. Whether the House’s version or the Senate’s version wins out a lower rate on pass-through income is a net win for investors, since pass-through income is currently taxed at the same rate as ordinary income – 39.5% for the highest income bracket. Though it is worth noting that whether the pass-through income tax rate is set at 25% or the low 30s, it remains higher than the originially proposed 20% rate.

Changes to Section 1031

In our earlier article we discussed the potential elimination of Section 1031 like-kind exchanges. Luckily, the extent of the changes was not that severe. The House’s proposal eliminates Section 1031 like-kind exchanges for personal property, but leaves it in place for real estate. This is a victory for the real estate investment space as 1031 exchanges are the core of the Delaware Statutory Trust business that many large issuers conduct. Removing this tax benefit would have caused substantial turmoil in the DST market and could have led to many investors facing significant tax consequences.
 

Until Congress actually passes a unified bill, the consequences to the private placement market will remain uncertain, but with two proposals on the table, it does seem likely that Congress may actually pass some form of tax reform. Until then, we will have to wait and see.

[WHITEPAPER] 1031 Exchange 101: 
A Guide to Real Estate Rollover

1031 exchanges offer sponsors an opportunity to present attractive property 
investments that can subsequently be rolled over into larger investments, 
potentially contributing to the growth and diversification of investor portfolios.