Stephen Schwarzman, Senator Joe Manchin, and Senate Majority Leader Charles Schumer (Photo by The Real Deal with Getty Images)
Real estate is an ever-changing industry. But few things have angered its private sector like talk of ending the tax break for interest.
Back when Barack Obama said it, Blackstone head Stephen Schwarzman compared it to “when Hitler invaded Poland in 1939.” Schwarzman later apologized.
Last week, Senators Charles Schumer and Joe Manchin made a surprise compromise for a spending bill that includes a tax increase on interest income.
In the world of real estate, this was no small matter. The “incentive” – the portion of the profit that the developers and fund managers get from the project – is considered as interest generated, which is charged as capital gain, not as ordinary income.
For high-income earners, that means Uncle Sam takes 23.8 percent instead of 37 percent. Along with depreciation and 1031 exchanges, it’s a huge tax advantage that real estate has. This is more than other businesses.
But the tax loophole that won’t be completely eliminated is the Democrats’ new plan, known as the Tax Cuts Act of 2022. Instead, Schumer-Manchin is simply asking real estate players to keep the property longer to continue enjoying the lower rate: three years instead of one. For non-property assets, the holding period will be increased to five years from three.
In real estate, three years is not a long time to hold a property.
“It’s not the final nail in the real estate coffin,” said Stuart Saft, a real estate attorney at Holland & Knight, about something that doesn’t make sense.
The Republican tax plan signed by President Donald Trump in December 2017 extended the holding period to three years from one for investors to receive a lower tax rate, but it provided a solution for the sale of real estate: The sale of property can be classified as “1231 gain” instead. than earning money.
The new plan would treat those 1231 benefits as short-term capital gains, subjecting them to higher taxes, according to real estate attorneys.
“The three-year holding period now has more bite than before,” said Stephen Land, chairman of Duval & Stachenfeld’s taxonomy.
Another big change, Land said, is when the three-year term begins. Under the previous law, it was assumed to start when a business or fund was established. But under the new bill, the calculation doesn’t start until the fund or business has acquired nearly all of its assets. For a real estate project, the developer may not be able to start the clock on the three-year period until the project is almost complete.
“If you start a new business and turn a profit and start development, but it takes two years to complete the project, that’s when the three-year period starts,” Land said. “If you add two years of development time, you have five years.”
There is another issue related to real estate. Developers often pitch their projects to small investors realizing that they have a stake in the effort. The Schumer-Manchin plan would weaken that balance of interests. Producers or managers will have an incentive to hold the asset until the sale qualifies for the lower tax rate, while their investors will not – and may push to write it down sooner.
Max Sharkansky of Miami-based Trion Properties said the tax hike could also have an impact on new investors, who tend to sell quickly and invest in new projects. Schumer-Manchin could discourage that by charging more short-term interest.
“This is a huge tax increase. It’s not like 1 or 2 percent,” Sharkansky said. “You have a higher tax rate, you have less money to spend.”
The offer has not been made yet. Sen. Democratic Kyrsten Sinema, who holds a crucial 50 votes in the upper chamber, remains undecided.
Private equity, a major focus of the bill, may stand for changes in power. The Wall Street Journal recently reported that the top 28 executives at the five largest private equity firms earned about $760 million in profits last year.
“As our economy faces headwinds, Washington should not continue with new taxes on the private capital that helps local employers survive and grow,” said Drew Maloney, president and CEO of American Investment Council, an independent trade group. in a statement.
Bill Ackman, a prominent hedge fund manager, differed from the industry consensus and expressed his support for tax reform.
“The profit loophole is a blemish on the tax code,” Ackman said in a tweet. “It doesn’t help small businesses, pension funds, other hedge fund investors or private equity and everyone in the industry knows it.”
He added, “It’s a disgrace and it needs to stop now.”