How Will the Election Impact Taxes?

President-elect Trump promised a broad range of sweeping tax changes during his campaign, and it is not yet clear which promises he intends on, or will be capable of, delivering. However, with both houses of Congress also in Republican control, we can take an educated guess about where his administration plans to take the tax code by focusing on any areas of agreement with House Republicans. Included at the end of this note is a summary chart which shows the current law for many tax provisions, as well as the House Republican Tax Plan (“House Plan”) and the Trump Campaign Tax Plan (“Trump Plan”).

Some key similarities between the Trump Plan and House Plan are:

Lowering both individual and corporate income tax rates

Eliminating the alternative minimum tax

Eliminating estate and gift taxes

Imposing deemed repatriation of deferred foreign profits

Any plan that is ultimately adopted may not happen in one piece. A likely starting point is corporate tax rate reduction combined with a deemed repatriation, and possibly a shift to a territorial tax system (i.e., a system in which U.S. based multinational corporations pay U.S. tax only on their domestic income).

How will the election impact real estate?

Assuming that tax rates are reduced, the real estate industry can expect these effects:

Given the prevalence of pass-through entities for real estate investments, a reduction in individual tax rates, and elimination of the AMT, will boost after-tax returns.

If the Affordable Care Act is repealed, the 3.8% net investment income tax would also likely be eliminated. This would be a “uuuge” benefit to individual real estate fund investors and REIT shareholders who primarily earn passive investment income.

A reduction in corporate rates will boost returns for foreign investors in U.S. real estate, since these investors often invest through leveraged corporate blockers to avoid FIRPTA. REITS will become relatively less attractive if withholding tax rates on dividends are left unchanged.

Trump has promised to close the carried interest loophole so that fund managers and others receiving carried interest pay tax at ordinary income rates. However, the Trump Plan also lets owners of pass-through entities to make the election and cap their tax rate at 15%, which brings the tax rate on carried interest back to its current level or even lower. It is also unclear how any resulting legislation would apply to existing arrangements.

How will the election impact tax reform generally?

Since Republicans hold the White House and both houses of Congress for the next two years, tax reform is certainly on the table. Importantly, while both the Trump Plan and the House Plan limit various tax breaks, neither plan contain enough revenue raisers to balance out the effects of the tax cuts. The Tax Foundation estimated that the House Plan could increase deficits by $2.4 trillion over the next decade if fully enacted, and the Brookings Institute estimated the Trump Plan would increase deficits by $6.2 trillion. The actual effects of any legislation may differ substantially from the estimates, resulting in a need for subsequent course corrections. This is precisely what happened with Reagan’s large tax cut in 1981, which was followed by several rounds of tax increase legislation in the succeeding years to fill in the newly dug revenue hole.

Although it may be hard to tell in some parts of the country, the United States has experienced a sustained recovery from the Great Recession. Triggering large deficits at this point could be inflationary and bring up interest rates. We have already seen evidence of this immediately after the election: the Treasury 20-year interest rate rose by 40 basis points in the week following the election. An interest rate hike would mean higher financing costs for investors, as well as increased cap rates that could dampen valuations of real property.

As Congress moves forward with tax reform, any lost revenue will need to be managed one way or another:

Scale Back the Plans. The reduction in tax rates could be downsized or delayed. Or Congress could tackle business taxes quickly next year (for example, by cutting rates on companies’ overseas earnings) and postpone individual cuts. The phasing in of tax cut benefits would delay the full effects of any revenue losses.

Live with the Humongous Deficit…for a while. Since 2009, the U.S. federal government has seen its historically high deficit (over $1.4 trillion) gradually reduce. Either plan could potentially bring the deficit right back to that level, or higher. Republicans may just live with this deficit for a time, but if the economic consequences become severe, tax increases may be needed (as in the Reagan-era).

Add a New Revenue Source. The federal government has been studying a new potential new source of revenue in the form of a Value-Added Tax (VAT). The VAT imposes a tax on each value adding step of the entire business chain, as opposed to imposing a sales tax only on the final sale to customers. While VAT is routine in the rest of the world, it has long been considered politically toxic in the United States. It might become acceptable, however, if coupled with significant tax and trade reform.

Key Takeaways

Real estate investors could reap the benefits of across-the-board tax cuts, but huge deficits might hit the real estate sector with higher interest rates. Meanwhile, the fate of carried interest is not as doomed as it seems. Post-election tax reform is likely over the next two years in some form, but the current proposals may be cut back or delayed because of concerns about the deficit or negotiations to win some Democratic support.

The D&S Tax Practice Group is closely monitoring these developments. If you have any questions about tax reform or its impact on real estate, please reach out to a member of our Tax Practice Group.

D&S is proud to have a world-class tax group chaired by Stephen Land, who is one of the most pre-eminent tax lawyers in the United States. Stephen is a Triple Harvard (college, law school and business school), and was previously at “magic circle” firm Linklaters (where he launched, chaired and grew their US Tax Practice). He is also the current Chair of the Tax Section for the New York State Bar Association.  Stephen regularly meets with government officials regarding tax rules and regulations. This is the most prestigious position a tax lawyer can hold.

The contact information for the members of our tax group are as follows:

Stephen Land
Jessica Millett