It’s the Taxes, Stupid

by Dechert LLP
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In this commentary we have talked about a lot of challenges facing commercial real estate finance and other capital market activities over the years.  With more or less “pants on fire” anxiety, we’ve talked about Dodd-Frank’s regulatory compliance burdens, the Volcker Rule, Risk Retention, the glorious and multitudinous products of the gnomes of Basil, the efforts of the “we hate all Anglo-Saxon bullshit” gang in the European Community to strangle securitization, the LIBOR scandal, geopolitical risk, and the famous unknown unknowns.

But, right now, we need to concentrate people:  it’s the tax code, stupid.  For those with limited bandwidth, and I count myself among them, this is where much of our energy needs to be focused.  

While this commentary doesn’t concern itself with politics, we do pay attention to the policy ramifications of the political process, and right now the political process is beginning to focus in earnest on tax policy.  The current incumbent at 1600 Pennsylvania Avenue promised his electorate a lot of things, but at the core was a promise of renewed prosperity and a key component of that promise was fixing the tax code – making the country more competitive both domestically and internationally.  Many (most?) members of Congress seem to think that this is a good idea too, albeit with widely varying and usually conflicting (and always intellectually suspect) ideas of what “fixing” means.  There’s been a continued conga line of lead-lined balloons floated over the Washington establishment for months now about tax reform, but it seems the White House is actually intent on doing something now that Labor Day has come and gone.

Perhaps all this noise about comprehensive restructuring of our tax code is just that, noise.  One might conclude that we may as well enjoy the tax code we have because there’s virtually no chance for any comprehensive change.  In a capital that can’t agree on anything and in a Senate that can’t get 60 votes for the proposition that one plus one equals two, the notion that we can get major tax reform passed may indeed be ludicrous.  Maybe.

However, past is not always prologue, and just because this White House and Congress have not gotten anything of note done so far, doesn’t mean that tax reform is off the table.  Any member in good standing of the political chattering class will tell you that the Republicans are toast unless they get something done on tax reform.  Policy, principal and conviction – they’re not entirely illusory and members of Congress and even the White House really have them and they matter…sometimes.  But what matters all the time is losing your job because of a political backlash over a failure to get tax reform done and the economy moving.  That’s the dog whistle in DC that is never ignored!

Moreover, if the members of Congress could move beyond a reflexive urge to pee on the other guy’s boots, there’s actually a fair amount of support across party lines for doing tax reform.  Talking heads have recently observed the disasters which are Houston and Florida might actually bring about one of those rare moments when the static trench warfare of the past few years shatters and something actually gets done.  It hard to predict where that Christmas football match may breakout, but it may be on tax reform.

If tax reform really happens, there will be an awful lot in play.  I am concerned that the capital formation business could wind up on the short end of that stick.  In a speech on August 30th, the President laid out his plan, with characteristically impressionistic brushstrokes:

  • Relief for the middle-class taxpayer
  • Competitive corporate tax rates
  • A fix for the repatriation of offshore corporate profits
  • The elimination of the Obamacare tax surcharge on investments

Strikingly, and this is a piece with the way Washington has worked in recent time, there’s no actual bill to be seen and, of course, the devil is in the details.  But maybe there is a draft bill somewhere in the deep dark recesses of the White House or the Republican caucus.  Maybe there are real conversations occurring amongst the congressional leadership and the White House on getting to an actual bill.  Maybe there is something real that might happen here.

Depending on how you look at it, that could be good or bad.  Many think that a core principal of comprehensive tax reform is that it’s revenue neutral.  Many more think that it has to be at least revenue neutral-ish, or, at least, optically revenue neutral.  Even assuming we flat line the government’s operating expenses (a silly assumption), it’s pretty much a syllogism that if you cut taxes in some place, you have to raise revenue somewhere else.  Where is that somewhere else?  Turning to my trusty Occam’s Razor Analytical App, the answer that flashes immediately:   Business Interest Tax Deductibility.

Individual deductions have largely been whittled down to charitables, state taxes, and residential first mortgage interest deductions.  All are politically charged goodies.  On the corporate side, many academic economists from both the left and the right have pointed out that while the US has, on its face, the least competitive corporate tax structure in the world, there is a big difference between the marquee rate and the effective rate by virtue of a complexity of credits, deductions, offsets and accounting legerdemain.  There is plenty to play with here but largely no discrete, easily understood and easily explainable change will produce material new revenue.  So you’d have to close a lot of these loopholes all at once to make a difference.  Closing numerous loopholes and reversing innumerable deductions and credits to gin up some significant revenue, all at once, with each tax goody protected by cohorts of lobbying shock troops ready to pounce, would be extraordinarily hard.  Hard?  Read:  Not doable.

Standing out for its clarity and simplicity and potential revenue power in this sea of credits, deductions and offsets is the business interest deduction.  While a significant part of the interest deduction for high income individual taxpayers has already been whittled away to virtually nothing, the deductibility of interest for corporations and businesses has been a core part of the tax code since its birth in 1913.  If you’re a politician swimming in the populist seas of 2017, the business interest deduction may seem the perfect fatted calf for sacrifice.  And it moves the needle.  It has been estimated that reversing business interest tax deductibility could raise $1 trillion over ten years.  That will pay for a lot of votes…er, I mean tax reform.

What would happen to commercial real estate and the US lending marketplace in general if interest deductibility were to go away?  There is about $12 trillion of commercial real estate out there and almost $5 trillion of mortgage debt.  That’s a big hunk of our economy.  If interest deductibility went away, we would wildly torque business decisions for years to come across business communities and across the commercial real estate marketplace.  Decisions made thoughtfully and carefully in years past will be confounded.  Real money would be lost, real pain would be incurred.  Going forward, debt and equity would begin to look increasingly alike as debt becomes materially more expensive.  As debt gets more expensive, the capital stack for commercial real estate owners gets more expensive and valuations would tumble.  Commercial mortgage lending would materially retreat.  We have seen commercial real estate lending lead the general economy into a recession before and it would almost certainly happen again.

So, as that is all so awful and so obvious, reversing the business interest deduction is safely off the table, right?  I don’t think so.  In fact, I think the political forces at work now might find trading the business interest tax deduction an extremely good alternative to fund other goodies for constituents.  Hey, if a year or two down the road the economy contracts because of this, our glorious elected representatives, all expert at dodging collective responsibility, will likely conclude that causality will not be proven and blithely choose to loudly and sanctimoniously blame various and sundry fat cats, plutocrats and denizens of the street who, without regard for the good of the American people, bid up real estate and paid inflated prices and therefore were really the causes of the problem.  And then move on to the next fundraiser.

And here’s where commercial real estate could end up holding the really short end of the stick.  We may be fighting this fight alone.

For the broader corporate world, getting material above the fold tax relief and keeping most of their “special interest” tax goodies for the loss of interest deductibility (a devil’s bargain to be sure) might be an acceptable trade.  For the really big boys, they can simply move their borrowing into other G20 countries where interest deductibility remains a part of their tax code.  (Regrettably, it is very hard to move commercial real estate and hence, commercial real estate will remain a domestic game, stuck with domestic tax rules.)   Real estate relies disproportionately in its business model on interest deductibility.  Loss of that deductibility for many will be annoying.  Loss of business interest deductibility for us will be an unmitigated disaster.  So, we might be in this fight largely alone.  Maybe broader corporate constituencies will contribute their voice to the fray, but will their heart really be in it?  The commercial real estate industry could look at trading more rapid depreciation for loss of interest deductibility but in the hunt for a trillion dollars in tax revenue, giving it back to the industry from which you took it doesn’t seem like it will be a political winner.

Commercial real estate and commercial real estate lending probably is not quite in the same category in terms of the public imagination as used car dealers, soldiers of fortune and congressman, but it’s not far removed.  And who loves commercial real estate?  Mr. Trump is the current face of commercial real estate and for an awful lot of Americans (and therefore for our elected officials) the friends of my enemy are my enemy and punishing putative bad guys is always fun and profitable for a politician.  I’m afraid we may be politically at risk in this current financial version of the Game of Thrones and if we’re not extraordinarily diligent and proactive, we may be setting the industry up for a major fall.

So, focus here people.  I wish we could fight all wars on all fronts at all times, but the reality is we can’t and until the risk to business interest tax deduction goes away, it should be all hands on deck working across industry segments and with our trade organizations and the like. We have to get to work on a strategy ASAP.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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