It is still early days in the presidency of Donald Trump, but there is no question his administration has brought sweeping change to financial markets already, with potentially “radical” changes ahead for private equity real estate funds and commercial real estate investors.
President Trump campaigned on promises of delivering financial, regulatory and tax reform, and his administration is clearly staying that course. Specific to private equity funds, the regulatory climate already has shifted, with an executive order to review existing financial regulations, a freeze on pending regulations, and a leadership change under way in key regulatory agencies, such as the Securities and Exchange Commission.
Signs of some easing in the regulatory environment are welcome news for real estate private equity funds. Yet, the main focus for fund managers and investors is looming tax reform. “Those are where the big changes are expected, and all the rest of the changes are going to be secondary,” says David Warburg, a corporate partner at law firm Seyfarth Shaw in New York City. If the Trump administration is successful in reducing tax rates and eliminating deductions, it will have a major impact on fund structure and investment strategy.
Some tax experts believe the tax reform proposals on the table could result in the most significant tax bill the country has seen in nearly 30 years. The Tax Reform Act of 1986 was a game changer for commercial real estate investment, and tax reform once again could bring transformative change to the industry.
Working out the details on tax reform means a “bumpy road” ahead, however, with specific details still emerging, notes James Wickett, a partner at the law firm of Hogan Lovells in Washington, D.C. President Trump has talked publicly about his plan in very general terms, while the House GOP has a more detailed tax reform “blueprint.” The Senate also is expected to introduce its own plan for tax reform. While tax reform has been discussed for years, it looks like it will have some traction with President Trump’s support and Republicans holding a slim majority in both the House and Senate. The odds are in favor of a significant tax reform bill being introduced either in late 2017 or early 2018, says Wickett.
TAX REFORM TAKES SHAPE
The Trump plan and the House blueprint both propose consolidating tax rates into fewer brackets, in addition to capping the highest tax rates well below current rates for corporations at 15 percent (Trump plan) or 20 percent (House blueprint). Both also reduce taxation of investors in pass-through entities, such as partnerships, S corporations and LLCs, to either a top rate of 25 percent (House) or a rate of 15 percent (Trump). Either would result in a significant reduction on pass-throughs compared with the current top rate of 39.6 percent.
“It seems pretty clear that the tax rate for investors in pass-through entities will come down, which is what is exciting the market,” says Warburg. It remains to be seen how far that rate will be lowered, and what reductions people will have to give up to get to that lower rate, he adds.
To balance out those tax cuts, the government needs to pull income from somewhere else, and there will be a move to eliminate or modify existing deductions. Specific to real estate, the House blueprint calls for major changes in how property is depreciated. Instead of depreciating an asset over 39 years, the total cost would be expensed in year one. At the same time, deductions for investment interest would not be allowed for corporations or investment entities operated as partnerships, S corporations, LLCs or proprietorships.
The ability to take depreciation over the life of the asset and to deduct the interest have been core elements to real estate deals for decades. This would be a fundamental change for the industry.
“It is a gigantic change that people are only beginning to think about seriously and anticipate all of the possible changes,” says Don Susswein, a principal in the Washington National Tax Group at RSM US LLP. One concern is being able to fully expense the total cost of a real estate purchase might invite overbidding on assets or bidding for the wrong assets, explains Susswein. So, a number of potential implications exist for private equity real estate funds specifically, as well as the broader real estate investment market, he adds.
From the institutional investor perspective, eliminating the interest deduction also could shift the capital stack toward increased equity investment and less debt, or it could lead to fewer debt funds if debt falls out of favor. In addition, the House blueprint does not allow for the depreciation of land. “So, depending on what kinds of investments firms are making, their tax position may get a lot better, or it may get worse,” says Wickett.
CARRIED INTEREST DODGES A BULLET
Specific to private equity funds, another hot topic in tax reform is the tax treatment of carried interest, or ownership interest in the appreciation of an investment’s value. Under current law, carried interest is taxed at capital gains tax rates. For private equity funds using a “2 and 20” fee structure — 2 percent annual management fee on capital deployed and 20 percent carry over a certain return threshold — that 20 percent is usually treated as a long-term capital gain and taxed at 15 percent, for example, whereas some critics would say compensation should be taxed as ordinary income, or 39.6 percent at the top rate.
It remains to be seen how proposed tax reforms will impact carried interest. What is clear is the next four years are likely to be very different from what they would have been had Hillary Clinton been elected, says William Birdthistle, a professor at Chicago-Kent College of Law who specializes in investment funds and corporate law. Prior to the election, the Democratic Committee on Taxation in the Senate brought on board as chief council a tax-law professor by the name of Victor Fleischer, who is known as a strong opponent of the current carried-interest tax rate “loophole.”
The fact Fleischer was hired immediately prior to the election is a good indication he would have pushed to raise the tax rate on carried-interest income, which would have affected every private equity fund and every hedge fund, says Birdthistle. “That is probably the most important issue that was in front of everyone in the private fund industry. It was a multibillion-dollar issue,” he says. From that perspective, the industry is probably breathing a sigh of relief, from a change that might have come under a different presidency, he adds.
President Trump also has voiced his support for eliminating private equity’s carried-interest tax deduction. If Congress cuts taxes as proposed, however, the gap between ordinary income and capital gains tax rates would narrow and take some of the steam out of the argument against carried interest, notes Warburg. People might be less worried about defending carried interest if they are going to get a lower tax rate in any case, he adds.
ROLLBACK ON REGULATIONS
President Trump campaigned on his intent to roll back regulations, and in his first 45 days in office, he made some big moves to make good on those promises. The New York Times reported in March the Trump administration and Republican-controlled Congress have delayed, suspended or reversed more than 90 regulations; have dozens more under review; and have imposed a broad regulatory freeze that may delay or prevent the adoption of any rules not already in effect. Those regulations are scattered broadly across sectors ranging from finance and business to the environment and pollution control.
One that likely will not see the light of day is the Department of Labor Fiduciary Rule. The rule was enacted in early 2016 and scheduled to take effect April 10, 2017. The Trump administration put a 90-day delay on the introduction of that rule, however, and many believe it likely will be squashed all together. The DOL Fiduciary Rule would have put added litigation risk on broker-dealers managing money from defined contribution plans, such as 401(k)s and IRAs, and so would affect those investment products that rely on a network of broker-dealers for fundraising, which would include some small and mid-size funds.
Attention also has focused on proposed reforms to the Dodd-Frank Wall Street Reform and Consumer Protection Act, and the Volcker Rule within it, because of the impact on real estate capital markets. Most view a wholesale repeal of Dodd-Frank as unlikely, however, and any reforms that do occur would have little effect on private funds. Private funds have been directly affected by Dodd-Frank, as their managers are now subject to review by the SEC’s Office of Compliance Inspections and Examinations, and this is not likely to change, says Warburg.
EASING OF REGULATORY ENFORCEMENT
Another area where private equity and real estate fund managers are likely to see noticeable change is in a “kinder, gentler” SEC when it comes to enforcement, says Stephanie Monaco, a partner and member of the Corporate & Securities practice at Mayer Brown in Washington, D.C. The SEC filed a record-high 868 enforcement actions during fiscal year 2016, exposing financial reporting–related misconduct by companies and their executives and misconduct by registrants and gatekeepers. That compares with the 807 enforcement actions filed in fiscal 2015 and 755 in 2014, according to SEC data.
“It is the SEC’s job to enforce against wrongdoers. I think, though, that they should not be as quick to build their statistics by bringing actions against every single violation, even if a violation did not result in any investor harm. That is where I would predict that there would be some easing,” says Monaco. The Trump administration also appears intent on trying to “skinny down” government and regulation, which would indicate the SEC is not likely to get a bigger budget to hire more examiners to review investment advisers, she adds.
That said, the SEC is an independent agency, and President Trump cannot directly tell it what to do, but he can set the tone in his appointments to the SEC Commission. The SEC Commission consists of two Democrats, two Republicans and a fifth commissioner who is typically of the same party as the president. Three of the commissioners resigned after the November election, which gave Trump a lot of choices in new appointments, says Birdthistle.
Commissioner Michael Piwowar is the current acting chair, and President Trump has nominated Wall Street lawyer Jay Clayton as the new chair. Both Piwowar and Clayton have said, without being very coy about it, they are not interested in heavy-duty, aggressive enforcement, says Birdthistle. “Obviously, I think that is going to be good news for anybody that is under the jurisdiction of the SEC,” he says. Firms will still have to fill out required forms and follow compliance, but there is a very big difference between doing all of that compliance and fighting off audits and enforcement actions, he adds.
A CLOSE WATCH
It seems the advent of the Trump administration will have significant impacts on the commercial real estate and private equity fund businesses. From tax policy to regulatory enforcement, changes are afoot in Washington, though it remains uncertain what exactly those changes will be. Real estate investors will need to maintain a close watch.
Beth Mattson-Teig is a freelance writer based in Minneapolis.