Finding a Framework: Fundamental Tax Reform Unlikely in 2012, but Changes Will Come

The past year has presented more than its fair share of uncertainty for the industry. From a near government shutdown to a hyper-expedited presidential campaign, preparing for the impact of future policy change is no easy task. By Mike Ratliff.

The past year has presented more than its fair share of uncertainty for the industry. From a near government shutdown to a hyper-expedited presidential campaign, preparing for the impact of future policy change is no easy task.

Topping the list of uncertain but important issues is the Tax Code. The House and Senate tax committees will continue to hold hearings on a series of tax reforms in upcoming months, though it is unlikely that a stab at fundamental tax reform willoccur anytime before the 2012 election, according to the Real Estate Roundtable. The public policy group points out that the combination of Bush-era tax cuts expiring at the year’s end, the automatic budget cuts coming in 2013 and calls for tax restructuring that continue to surface on the campaign trail will all keep taxes in the spotlight in 2012.

Given the current state of the deficit, it is inevitable that Congress looks to carried interest and capital gains as targets for raising revenues. An increase in either of these rates will certainly impact the flow of capital into commercial real estate. Raising the 15 percent carried- interest tax rate would “de-level the playing field,” according to Chuck Achilles, chief legislative research officer for the Institute of Real Estate Management. Although ending these tax expenditures could raise a significant amount of revenue each year, without an incentive, “those people who are getting carried interest as internal partners may decide to invest their money elsewhere,” Achilles said.

Such a move would discourage investment in commercial real estate—not exactly what the industry needs when considering the 11 to 12 percent vacancy rates in retail and 15 to 20 percent vacancy rates in office, Achilles added. Stan Ross, chairman of the Lusk Center for Real Estate at the University of Southern California, urges companies to begin thinking about how potential tax reform could change business practices. Tax revenue, in his mind, is “absolutely going to evolve because there is no way you can solve the deficit without it.”

Capital gains and carried interest tax rates, according to Ross, are easy targets in simplifying the code, especially if Democrats concede on across-the-board rate hikes in exchange for tax preferences, which would likely entail closing certain expenditures.

“Commercial real estate gets hit if they start picking preferences,” Ross said. “You are going to end up doing an analysis on the spread between a cap rate and a tax rate.”

Obama’s State of the Union Address in late January offered further proof that 2012, and perhaps beyond, will be a period when Washington looks to raise revenue and cut spending. There were, however, certain aspects of the speech that were promising for the commercial real estate industry. One was the incentivizing of companies to bring jobs back home from overseas, which could, according to Ross, “create opportunities in the industrial sector, and theoretically result in small-office needs.”

Another potential regulatory change that should benefit commercial real estate—and will perhaps see some movement in 2012—is an increase in incentives for energy retrofits to buildings. While Obama’s Better Buildings Initiative plan could create jobs and help owners modernize their portfolios, “the whole issue of revamping the tax incentives got caught up in Congress and weighed down by the cost of the proposal and the practicality,” said Karen Penafiel, vice president of advocacy, codes & standards for BOMA International.

She pointed out that there could soon be movement to improve the Section 179D energy tax deduction, which currently offers just $1.80 per square foot for retrofits that exceed the ASHRAE 90.1 standard by 50 percent—a difficult feat for retrofits. Penafiel is, however, enthused by the prospect that Sens. Olympia Snowe (R-ME) and Jeff Bingaman (D-NM) might soon introduce a proposal that would not only increase the dollar amount but lay out a mechanism to phase the incentive in. The move would let owners qualify for a deduction with 20 to 25 percent in energy reductions as the lowest hurdle, with the dollar amounts increasing as buildings approach the 50 percent reduction level.

“It is targeted more for existing buildings, and takes into consideration what they can and can’t do,” Penafiel said. “We think it is a much better approach that will actually get some of the owners and buildings that haven’t been doing this all along off the fence and doing more for energy efficiencies.” But Penafiel is quick to point out that such a policy will cost money, and the means for paying for it are completely up in the air. This could easily cause a stall-out.

Penafiel remains hesitant even on the meta-scale as to whether or not Congress will be able to put differences aside and enact any meaningful policy in 2012. “Even before the election hype started, it seemed that the Republicans’ goals were to win more seats and take control of the Senate, and the Democrats’ goals were to do the same on their end,” she said. “In my opinion, that is what has driven the debates, not good policy.”