Why Tax Incentive Changes Matter in RE

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Why Tax Incentive Changes Matter in RE

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Real estate developers and investors could face challenges posed by three big issues in the near future. These issues involve tax incentives and funding sources for development. Their resolution could have an impact on current mechanisms used to facilitate deals.

Nationally, Section 1031 exchanges and the EB-5 Visa program might face restriction or revision. In New York, after expiring on June 15, the 421-a tax abatement program was granted new life in the form of a six-month extension, followed by a conditional legislative package amending the program. Developers and investors should be aware of these issues and keep an eye out for any further changes.

Proposed Changes to Section 1031 Exchanges

Section 1031 exchanges are used extensively by real estate developers to facilitate deals. Section 1031 allows sellers to delay recognition of a normally taxable gain, which lets investors and developers rely less on leverage and make more efficient use of their cash. Under 1031, a seller can delay paying the taxes on a gain from the sale of property if the proceeds of a sale are used to buy like-kind property (in a real estate investor’s case, more real estate). The underlying principle is that a seller who uses the proceeds to buy more real estate only experiences a “paper” gain and therefore should not be taxed on the transaction.  

Some federal lawmakers are looking to restrict Section 1031 exchanges. In its proposed 2016 budget, Barack Obama’s administration suggests limiting tax deferral for 1031 exchanges to $1 million per year, per taxpayer. Michigan Representative Dave Camp has proposed outright repeal of the program and would use the increased revenue to fund a decrease in the corporate income tax rate.

Congress’s Joint Committee on Taxation estimates that the like-kind exchange provisions cost the government approximately $8 billion in 2014. Ernst & Young, however, recently issued a report finding that the repeal of Section 1031 would create larger tax burdens on businesses. This would result in “longer holding periods” and “greater reliance on debt financing.” In the long term, Ernst & Young estimated that repeal of the like-kind exchange rules would result in a decrease of $8.1 billion in GDP, a decrease of $7 billion in investment, and a decrease of $1.4 billion in labor income. The report concludes that the repeal is at odds with the objectives of tax reform because it will actually increase the cost of investing and reduce GDP in the long run.

EB-5 Visa Program

The EB-5 Visa program, established by Congress in 1990, allows foreign investors permanent residency in the United States in exchange for capital investment. A participant must invest at least $1 million (or $500,000 in a targeted employment area (“TEA”)) and provide evidence that the investment created 10 jobs over a two-year period of conditional residency to be granted permanent residency.

In 2009, changes in the regulatory guidelines surrounding the program helped open it up to use by developers. This contributed to huge growth in the program and led to utilization by real estate markets. Real estate developers look to foreign investors to provide much-needed capital for development in hot markets like New York City. Regional centers, which are third party investment vehicles that help guide investors and developers through the program, have dramatically increased in number in the last few years.

With all of the attention that the program has attracted in recent years, real estate developers have been anticipating changes in the law. Critics of the EB-5 Visa program argue that the program is vulnerable to fraud and poorly supervised. The proliferation of regional centers has alarmed some politicians. There is potential for positive changes that could cut down the red tape that currently delays funding through the program. Many have speculated that lawmakers would raise the price of the visa for the first time in 20 years because demand is so high.

On June 4, lawmakers introduced a bill in the Senate that would amend the current program. Proposed amendments include a change in the methods used to define TEAs. Currently, states provide their own methods of determining the boundaries of TEAs. The amendments would create a uniform federal standard defining TEAs that would likely result in fewer such areas, thereby reducing the availability of the lower $500,000 investment tier.

Another proposed change affects EB-5 job creation requirements. The amendment would require that no more than 30% of the jobs created by a project be created by capital from sources other than the EB-5 investment. This raises questions of how to allocate job creation to different sources of capital. If a proportional allocation method is used, this could affect the availability of EB-5 for projects relying on traditional construction loans and using EB-5 investments as mezzanine financing.

Surprisingly, the bill does not address one aspect of EB-5 financing that many expected to see changed. Currently the number of visas available is capped at 10,000 per year. Real estate industry experts have long thought that this cap would be adjusted by any amendments. Furthermore, one investment is currently required for a head-of-household with additional visas for children under 21 issued as part of that investment. The bill does not change either of these elements of the EB-5 program.

New York 421-a Abatements

New York’s four decade old 421-a property tax abatement program allows for a tax abatement on newly constructed multiple dwellings provided certain conditions are met. The most notable condition requires developers to build affordable housing in addition to market-rate construction. The program initially expired at midnight on June 15. State legislators were unable to come to an agreement before the end of the state legislative session about whether to adopt changes to the program or to renew the program in its most recent form. Uncertainty about the program’s renewal led to a spike in applications for the abatement before the June expiration date. On June 23, New York Governor Mario Cuomo announced that he and state lawmakers had reached a deal providing a six-month extension of 421-a in its current form. On June 25, state lawmakers passed conditional legislation amending certain elements of the 421-a program.

In New York’s real estate market, the 421-a program is often a key factor in the feasibility of a deal. The tax benefits provided can be substantial and provide significant incentives for investors to develop.

Critics of the program argue that it is vulnerable to abuse and that it provides the wealthy with subsidies that should instead be directed to the poor. The fact that 421-a was implicated in the recent bribery scandal surrounding former New York State Assembly Speaker Sheldon Silver casts a further shadow on the program. Silver was consistently one of the most active advocates for the program’s renewal. His absence most likely contributed to the legislature’s failure to agree on proposed amendments to the program.

New York City mayor Bill de Blasio publicly clashed with Cuomo in the final days of the legislative session. De Blasio advocated changes to the program including requiring affordable housing to be included in developments benefitting from the abatement and eliminating the abatement’s availability for condominiums. Cuomo rejected de Blasio’s proposed amendments in part because de Blasio’s plan did not require builders to pay construction workers a prevailing wage.

As the legislative session ended, state legislators were unable to pass even a temporary two day extension giving lawmakers time to strike a last minute compromise. The program expired on June 15. However, Cuomo announced the program’s revival in the form of a six-month extension on June 23. On June 25, the legislature adopted amendments that are conditional upon developers and labor leaders reaching an agreement regarding prevailing construction wages by the end of 2015.

The June 25 legislation adopted de Blasio’s proposed ban on so-called “poor door” arrangements in which buildings provide separate entrances for renters paying market rates and those paying affordable housing rates. Rather than eliminating the program’s availability for condominium developments, the legislation allows developers the option to receive the abatement for outer-borough projects with 35 or fewer condominium units. Three other options to receive the abatement depend on the percentage of units reserved for affordable housing and a tiered system of affordable rates based on average median income.

It is likely that the debate surrounding 421-a could heat up again as the deadline for an agreement on prevailing wages approaches. Developers and builders should watch for any developments and plan accordingly.