Now that interest expense of up to 30% of taxable income can be deducted under tax reform, financial planners are being advised to explore real estate activity among alternative investment vehicles.
“There is a carve-out in that interest provision for certain real estate investments,” said David Sites, an international tax partner at Grant Thornton LLP. “Investors can mitigate the interest limitation by focusing on qualified real estate transactions. The partnership deduction can also be applied more favorably upon real estate businesses.”
The fact that the corporate tax rate has been cut from 35% to 21% makes investing through a corporate structure more beneficial than it was in the past when compared with a flow-through or pass-through structure. As a result, the C corporation could now be a viable investment vehicle, according to Sites, who lectured at a New York alternative investment round table on January 25 called “U.S. Tax Reform: Opportunities and Challenges.”
“You traditionally would never think about a corporate structure to invest from an alternative perspective,” said Sites. “Now investors will want to evaluate whether it makes sense to lower that first incidence of taxation to 21% so that there is more money to reinvest or if it’s more beneficial to pay the tax at the individual level and then distribute enough money to shareholders to pay that individual tax.”
A company can only deduct interest expense up to 30% of earnings before interest, taxes, depreciation and amortization.
“Because of the limitations on interest deductions, we're going to see a shift in the global demand for leverage,” Sites said. “We may see an asset manager consider putting 40% leverage on a business instead of 80% in order to alleviate some of the disallowed interest expense and return more of it to equity.”
As a result, hedge funds and private equity funds are expected to be more focused on businesses that are going to return the most after-tax cash flow.
“What that means for the alternative space in the U.S. is less of an ability to invest in a pool of debt securities or buy a bundled, collateralized obligation and more demand for equity from the public markets, private markets, private equity, hedge funds or owner-operated businesses that have reinvested their earnings,” Sites said.
The interest limitations play off expensing provisions, Sites said, which highly favor capital- and labor-intensive industries.
“The tax law is not as beneficial, on both the domestic and the international side, to technology companies or pharma companies, which are more knowledge- and IT-based, as opposed to businesses heavily invested in machinery, equipment or building plants,” he said.