Originally published on Forbes.com.
The Editorial Board of the New York Times is outraged about the thoroughly wicked provisions concerning real estate in the Tax Cuts and Jobs Act. I have found that the New York Times tends to be a little weak in its tax analysis so I thought it would be a solid to my real estate friends to explain the wickedness that would benefit them a little more thoroughly. I’m going to use a made-up example for illustrative purposes. No guaranty how realistic it is.
That Building Over There
As you are out and about driving from here to there you will see many buildings – offices, retail outlets, and the occasional manufacturing facility. Many, if not most of them, are not owned by the companies whose name is plastered all over the signs. Instead, the company is leasing the building from somebody. Let’s call him Daddy Warbucks. It is common for the lease to be triple net – meaning that the tenant pays the real estate taxes, building insurance and maintenance. Daddy’s whole job is to collect the rent every month and worry about what the heck would happen if the tenant ever went under. So Daddy Warbucks bought that building over there (TBOT) for $12 million. He allocated $2 million to land and $10 million to building and improvements. The tenant pays him $720,000 per year – a cap rate of 6%. You and I both know that if we just knew the rent and the cap rate we could figure out the value, but you have to consider the other readers.
The income from the building goes on Schedule E of Daddy’s Form 1040. I’m going to say that he gets $300,000 per year in depreciation. Since old DW has oodles and oodles of other income TBOT is taxed at the top marginal rate of 39.6%. On top of that, there is a net investment income tax of 3.8%, or maybe not if DW qualifies as a real estate professional. Let’s be sensible and put TBOT in Texas or Florida or Wyoming, so we don’t have to worry about state income taxes.
The last couple of weeks have been a real roller coaster ride for me and Daddy as I have pondered his fate. In the past couple of years, TBOT had been costing him either $165,900 or $181,860 on $420,000 of taxable income depending on whether he meets the real estate professional test or not.
House Bill To The Rescue
The House bill was a thing of beauty for Daddy and his friends. It was made for them. Income from passive activities as defined in Code Section 469 would be taxed at a maximum rate of 25%. So I would tell him to goof off a little and live with paying NII which would bring the tax charge for TBOT to $120,960. But then I took a closer look. Rather than take the default rate of 30% of the earnings being from capital, Daddy could elect a computation. And 8% of $12 million is a lot more than $420,000, so he can work just a little harder and avoid NII, which makes the tab $105,000. That’s a savings of over $60,000 per year. Thank you Speaker Ryan. This Dom Perignon is for you.
Senate Amendment Dashes Our Hopes
The Senate Amendment took a different approach. Instead of a special rate, it allowed a deduction of 23%. Not quite as good as the special rate, but better than being poked in the eye with a sharp stick. But then came the sharp stick. The deduction was to be the lesser of 23% of qualified business income or 50% of the W-2 wages paid out with respect to the trade or business. I’m not going to say that DW and I would not have figured out a way around that restriction by shifting things here and there. But on a straight forward basis, the Senate Amendment would do nothing or little for businesses that are high in capital and low in wages and NNN real estate is the epitome of that type of business.
Conference Agreement Restores Hope
The Conference Agreement ended up giving something to NNN real estate people. The rate of 20% is lower and the W-2 test is still there, but there is an alternative test. Instead of 50% of W-2 wages you can use 25% of W-2 wages plus 2.5% of the unadjusted basis of depreciable property. It makes for typical confusing Internal Revenue Code language – the lesser or this or the greater of that or the other thing -. Regardless 2.5% of $10 million is greater than 20% of $420,000. So DW gets his $84,000 deduction, which saves him $31,080. Not as good as the House Bill, but it is still something.
The New York Times Conspiracy Theory
That brings us to the New York Times and its commentary on Senator Bob Corker committing to vote for the bill.
The beneficiaries would also include members of Congress like Senator Bob Corker, who last week decided he would vote for the bill even though Republican leaders did nothing to address his concerns about an exploding federal deficit.
The biggest winners would be people like Mr. Trump, his family and similarly advantaged developers who make tens or hundreds of millions of dollars every year on swanky office towers and luxurious apartment buildings. An earlier version of the bill passed by the Senate provided a 23 percent deduction but put limits on its use that would prevent wealthy developers from profiting from it. The House version would simply have reduced the rate at which pass-through income is taxed. (Emphasis added)
The way the Times puts it, it sounds like Conference Agreement has something slipped in to help the greedy developers, while the House bill was merely a modest reduced rate. When you run the numbers, as I did above you see that the House Bill did an awful lot for commercial real estate which the Senate Amendment pretty much entirely took away.
The thing is I don’t think this is a matter of the failing New York Times making fake news. I really think, based on some of their other coverage, that they don’t have people over there who run numbers. My hypothetical building owner would get about sixty grand from the House Bill and nothing from the Senate amendment. The Conference agreement splits the difference.
I still think the bill is terrible – as a citizen that is. It saves me money and will make for lots of interesting working, but it violates a fundamental principle of income tax simplicity in that it creates a new type of income with a special feature. If we can’t figure out a way to make income not be recognized, we try to have it be capital gain. Failing that we will now struggle to make it qualified business income. It’s going to be fun. Reilly’s Third Law of Tax Practice – Any reasonably complex tax matter involving significant dollars, regardless of whatever else it might be, is a white-collar jobs program.
Update
There is some controversy as to whether NNN real estate will qualify for the deduction. The reason is that “trade or business” despite its pervasiveness in the Code is not well defined and there is an argument that NNN real estate is too passive to be considered a trade or business. I don’t agree with that perspective and even if they turn out to be correct, I think the problem might be solved with relatively minor tweaking.