¶ Overview of HR1's Impact on Real Estate
Welcome to the AAA storage podcast, your integrated real estate and development partner, exploring all things, self storage investing to bring you diversified success. Let's dive in.
Welcome back to another episode of the AAA Storage Podcast. I have with me as always, Paul Bennett. Thank you for being here. Today we are talking about the new legislation that was recently passed, uh, in the house and in the Senate called HR one, the one big beautiful Bill Act, and it is the landmark legislation from Trump administration and it has of course, some impact on real estate investing. And so Paul, you have.
Pour through the bill and notes and commentary and have some insight on how this might affect investors. So I would love to hear your thoughts on it.
Paul BennettGreat. Thanks
¶ State and Local Tax Deductions and Mortgage Interest
Brandon. Always fun to be here. Uh, yeah. HR one or the, the big beautiful bill as it's been referred to, um, does have an impact on commercial real estate investing. Uh, and I'm gonna try to cover about seven things. Actually. There are three or four that I think are really at the core, but we'll mention the others. But before we get started, I wanna be sure to, to remind everybody that I'm not a CPA and I'm not about to give tax advice.
Um, and so, you know, if you hear something and what we cover today, that's interesting, uh, and you wanna explore it further, get to the details and, and make sure it's applied correctly in your situation, you need to talk to your CPA, uh, we're just gonna try to give you. An idea of the areas that might be worth investigating, um, as a passive investor in commercial real estate. So, um, with that, Brandon, we'll, we'll jump in.
I'm gonna go from sort of least impactful to what I think is the most impactful provisions of this bill. Um, and, and we'll. Sort of roll over some things pretty quickly. Others will stop and dive in a little bit more. Um, a couple of things that the bill did, it, it expanded the state and local tax, uh,
¶ Enhanced Opportunity Zone Incentives
uh, caps. So particularly if you're in a high tax state, it will allow you to deduct more of the cost of state and local taxes that you pay related to your investment real estate. That really doesn't have an impact on, for example, our fund. Um, and, and. Typically syndicated investor investments, but more on personal real estate, uh, or rental, residential, re real estate, rental real estate that that an investor may own. Uh, but that was one provision of the bill.
Um, it preserved a mortgage interest deduction, which is, I think critical and, and crucial, uh, in real estate, both personally for your own home as well as for any investments that you make. Those were a couple of the smaller provisions of the bill, uh, that I thought were just worth mentioning. Um, the next thing on the list is opportunity zones. If you're not familiar with them, uh, the 2017 legislation created designated opportunity zones around the country
¶ 1031 Exchange Provisions Remain Unchanged
where they offered, um, specific and in. Pretty dramatic incentives to invest in real estate and operating businesses in those areas. I'm not gonna try to dive into every detail. Evidence's incredibly complex. There are investment opportunities that are built around the, uh, the, uh, opportunity zones. And if you're an opportunity zone investor, what you need to know is that they've improved the incentives and they've extended the life of the opportunity zone concept.
As well as added additional opportunity zones where if real estate is located in, in those zones, you can defer taxes, um, on a sale if you, if you hold it long enough and if,
¶ Elimination of Green Energy Tax Credits
and ultimately even avoid taxes completely if you hold a property for longer than 10 years, uh, that is in an opportunity zone. So the opportunities. Opportunity zone provisions were enhanced. Um, next on the list is the 10 31 exchange, uh, which is a like kind exchange provision in the tax code that allows you to sell a property and roll those proceeds into another investment in a similar type of, of real estate. Uh, and the 10 31 exchange provisions were protected.
There were no changes made to them. Um, and if you're familiar with 10 30 ones, and I know a lot of folks out there use them, uh, on a regular basis, uh, and may invest in some 10 31 oriented exchange funds, the opportunity to do that and the provisions around it weren't changed in the big beautiful bill. So, no, no new news there. But the good news is there were no changes.
Um. What some might view as a negative element of the big beautiful bill related to, um, to commercial real estate is that it eliminated almost all of the tax credits related to green energy. So, for example, in the storage industry, it's become more common to put solar panels on the roof of storage building. Uh, there were tax credits available that had value to the investors and obviously it created another, uh, revenue stream. 'cause you could sell that power back into the grid.
The tax credit, you could still do the business part of it, but the tax credit for, uh, solar and other green initiatives have been, uh, eliminated as part of the big beautiful bill. The next two, uh, and I'll stop and take a breath there, Brandon, any, any questions on your part or any, anything that I missed or you want to add?
No, no. That's interesting about the solar panels though, to think about it. 'cause it, it, it, I wonder how that will affect the market, whether people or will continue to add solar panels onto the storage units because maybe, you know, it could help power the, the facility and all that kind of stuff. But yeah, I'm just curious how that would work.
Paul BennettI, I think from an economic standpoint, it probably removes most of the motivation. Um, we, we have not done it. We've looked at it. In fact, we were studying it, um, as we looked at fund two, um, and, and considered. There were a couple of groups out there that, uh, that brought concepts to us that looked interesting.
Without the tax credits, I'm not sure, just from a purely business standpoint, from a philosophical standpoint, um, you know, there, there may be lots of good reasons to do it, but from a purely financial standpoint, I think the tax credits were pretty important to that equation. So I wouldn't wanna be in the solar panel business right now. I, I guess is the way I'd put it.
Understood. Yeah. Okay. Good.
¶ Expanded Qualified Business Income Deduction
Paul BennettThe last two things on the list are, are I think where the biggest impact is, uh, in the big beautiful bill. And the first one is qualified business income deduction. And for many of you out there, particularly if you invest in income oriented real estate funds, this may be something that you're not familiar with and I would highly recommend that you talk to your CPA and get familiar because it's a pretty substantial benefit, the the qualified business income. Deduction.
Was increased in the big beautiful bill from 20% of the qualified business income to 23%, and they also added and refined some safe harbor provisions that make it much easier for a passive investor to take advantage of those deductions. Um. They, they, there are some earnings limitations, um, that, that come into play. If you make more than $191,000 a year as a single person or, or $383,000 as a, a couple filing jointly, um, you can find that your, your QBI deductions are limited.
Um, but, but there are even some exceptions beyond that, uh, around the, the, uh. The unadjusted basis in the property.
And, um, there are some calculations that can be done, but I, I think the thing I wanna point out and, and I didn't do this very well at the beginning, is that the qualified business income deduction allows you, let, let's say you're an investor, uh, in a, uh, in an income oriented self-storage fund that's buying existing properties and you're getting a, a 6 or 7% cash on cash return every year. Um, and reporting.
And your pro rata share of that income is being reported on your tax return, I mean on your K one, which is, is ultimately impacting your tax return. Just as an example. Let's say that, that you had $10,000 of income reported on your K1 to you as your pro rata share of income from that investment for a given year. The the qualified business income deduction allows you, in this example, to take a $2,300 deduction.
On your tax return to offset a portion, 23% of that $10,000 of income that you reduced, therefore reducing your ultimate tax bill. Um, and I think most people think the qualified business income deduction only applies to real estate professionals. That's not the case. Um, it's actually well designed for passive investors who own an interest in an LLC or a limited partnership or a real estate investment trust to take advantage of this deduction.
And depending on how much, um, qualified business income you have from rental real estate, um, it could be, it could be meaningful and I think it's often overlooked by most passive investors. So, um. I, I would just suggest I've done a, probably a poor job trying to give you some details. Um, there are some safe harbor requirements that have to be met for a passive investor, uh, to, um, to take advantage of the deduction. There, there has to be at least 250 service hours or work hours.
Own the property by somebody. It does not have to be the passive investor. Obviously they're passive. A property manager, in our case, a sponsor who's also the property manager. Uh, you do have to keep separate books and records for each property, um, in, in order to, um. Uh, qualify for the deduction, and then you have to keep written documentation of the hours of service and who performed them on the property each year.
Um, in our case, we tick all three of those boxes so our investors would be qualified to take the qualified business income deduction. And, and just to be clear. It can't be offset. It's not calculated based on service revenue. It's really only based on rental income generated by real estate. So, but which perfectly applies to commercial real estate because that's what we do.
So, um, but it's a, it's a, it's, I think it's an overlook provision in the tax code and I think probably a lot of CPAs aren't. Focused on it. So if you have a, a portfolio of real estate that's generating significant income on an annual basis, I would suggest you talk to your CPA dive into it and see if there may not be a benefit in there for you.
I was gonna say, uh, I don't know, tax accounting at all. But that sounds like a really obvious one to bring up with a CPA, especially if they're investors in AAA's funds, because you guys do tick those boxes and can provide that documentation. So that sounds like an obvious choice to bring up. That's awesome.
Paul BennettYeah, I mean, you know, um, a, a a $2,300 deduction won't change your life, but it's better than a sharp stick in the eye, right? I mean, um.
a phone call. Yeah.
Paul BennettAnd, you know, at the 35% tax bracket, I can't do the math in my, my head fast enough, but that's seven or $800 worth of tax savings. Um, and uh, and, and obviously if you have a hundred thousand dollars of, of, of. Of passive income from real estate. Um, you know, then it becomes even more substantial. Now it's a $23,000 deduction. So,
¶ Reinstatement of 100% Bonus Depreciation
um, which, you know, which has a corresponding benefit. The last item on the list in the big beautiful Bill is the one that I think will impact, um, most passive real estate investors more than any of the others. Although I think QBI is sub substantial and that is the bonus depreciation. Uh, in 2017, uh, in President Trump's first term, uh, they created the bonus depreciation, uh, where in the, in the first years of that, you could deduct 100 of the depreciable basis.
You have to do a cost segregation study. You have to componentize the project in, in order to identify the, uh, the amount of, of depreciation. But you could take 100 That was phasing out. It was down to 60% in two. 2024 and would be and, and is 'cause that provision still survives 40% in 2025.
However, the big beautiful bill brought bonus depreciation back a hundred 100 depreciation in year one, which substantially improves or impacts cash flow in a positive way and provides potentially passive losses that you can use to offset other passive gains, uh, or income. Uh, and, and so it, it is reinstated at a hundred percent of depreciation in year one. The properties have to be purchased after January 19th, 2025, and they have to be placed in service by, um.
January 1st, 2030. Um, there is a special category called qualified production Properties. That's basically factories and industrial facilities, and they get an extra year to be placed in service so they can be placed in service as late as 2031. Um, but the, the. The, and they also increase the Section 1 79 limits, uh, which is the, the, uh, rapid depreciation of certain assets from 1 million to two and a half million dollars in terms of the limit of those deductions that you can take.
But all in all, uh, the, the. Reinstatement of the a hundred percent bonus depreciation in year one is likely to have the biggest impact on real estate investors across the board. Um, because it, it does allow you, particularly in, in our case, we, we happen to sit in a situation because we're developing real estate. Um, where the bonus depreciation obviously comes into play and allows us to deduct in self storage, about 60% of the total project cost is generally what would qualify, uh, for, um.
For the bonus depreciation. So on a $10 million project, we're looking at a $6 million depreciation loss or write off in the first year the properties when the property's placed in service. And that, of course passes pro rata, uh, to all of our investors. Um, if you, as we are in the fund, if you're building multiple properties at one time and you're also. That portfolio is not generating revenue yet. Um, because it's early in its maturity.
Um, you can get some pretty substantial losses in the early years of, of a development fund, a growth fund like our fund. So, um, we think that's gonna be, know, be a, a. A very positive thing for our investors. I, I will remind everybody that, that, that depreciation is simply a deferral of taxes. It does not allow you to, to escape paying taxes forever because when the property is sold, there's recapture of that depreciation, um, in generally as ordinary income.
There are, there are some nuances to that, but it is, is really only a deferral. But if you could avoid paying the tax own those dollars for four or five years, there's some value in that. You know, um, even though you have to ultimately pay the taxes, uh, down the road, so.
Okay, I, I may be naive, but I think maybe in an example might really help. So let's say I'm an investor and I put in $200,000 into the fund. And let's say it's this $10 million property, $6 million is, uh, has a depreciation effect. How, how does that impact me as, uh, if you were to kind of calculate my taxes over the couple years? I mean,
Paul BennettSo in, in, in your example, um, in your example, it was a single property fund with a $10 million piece of real estates and you invested $200,000. So that means essentially you own 2% of that partnership when they take the $6 million deduction. Um. For the bonus depreciation. And let's just to keep things simple, let's say there was no other economic activity.
Um, you know, obviously there would be some, some small amount of income in the early months and, and, and some operating expenses, but let's just ignore them for the moment. So you've got a, you've, you've got a $6 million deduction and you, you own 2% of that partnership. So you would be allocated 2% of that $6 million. Um, uh. Uh, bonus depreciation loss, uh, which would equate to $120,000. So you invested $200,000 and year one you get $120,000. Uh, passive loss that you can use to offset.
Passive gains that are created in other investments that you made. And if you don't have any passive gains this year, or if they don't equal $120,000, you can roll that, that loss forward and use it in future years. So you can bank it and use it at a point in time in the future where you actually have, um, you know, have, have a, a gain offset with a loss.
Man. Fascinating. Okay. That could be extremely helpful. I could imagine. I mean, obviously there's a lot of calculations involved in how you do all that work with an accountant, but, um, yeah, that sounds amazing. So I, I, and you guys would, would, um, provide the documentation necessary? To, to kind of figure that sort of
Paul BennettAll of that, all your pro ratish here, as it as it relates to qualified business income that we talked about a minute ago, um, or as it as it relates to the ultimate net loss produced by a property or a fund. Because of this bonus depreciation, all that information is, is provided to you in your K one, your form, K one every year that the, the fund sponsor will issue.
And that's what your CPA uses to do the tax returns, and he can get all the information he needs in terms of how much qualified business income did you have, if any, or do you qualify for the deduction? Um, you know, all those things as well as, okay, what was the net loss on the K one and how can we apply it in your personal tax return in, in order to, to get the, the highest benefit? So yeah, in that example, you would've received a K one that showed $120,000 loss.
As your pro rata share of the economic performance of that property. Um, and, uh, and, and therefore you get to take that 120,000 loss on your personal return.
I'm glad people like you exist to do all this kind of stuff. Uh, okay. So this sounds like a really, um, positive or beneficial bill in, in specifically. For real estate investors in this case, uh, would that kind of, your overall, you feel like this is a, a good thing specifically for investors?
¶ Final Perspective on the Bill's Effect
Paul BennettYeah, it, it didn't change any of the fundamentals of real estate, which I think is, you know, probably a good thing. Um, the bonus depreciation has been a very valuable tool for people in the real estate industry. And so bringing it back, it was phasing out and almost gone to the point where it didn't have, you know, nearly the impact that it did, um, originally. So. Bringing that back.
I think the qualified business income, all in the whole, the bill for real estate, commercial real estate is a positive bill, but I don't think it changed the world. Um, you know, I don't think it it changed any, anything, uh, fundamental, but it did make some incremental improvements in some aspects of how the tax code impacts invested in commercial real estate.
Yeah, man. Helpful. Okay. Uh, what else? Is there any other kind of tidbits that you found in your research that are, are useful for investors that they should know about?
Paul BennettI, I, um, you know, I was really focused on trying to extract the major provisions of the bill that people needed to be aware of as they consider. Investments in commercial real estate. So there's, I mean, obviously the word big in the name big beautiful bill is no misnomer. Um, it's a, I think, I think they had a reading of
thousand pages, I think
Paul BennettYeah, I think they had a reading of the bill, um, as part of the process, um, during the, uh. The, the, the vote on the bill, and I think it took 16 hours to read it.
So, um, yeah, so it's, it's, there's, there's a lot in there and there's a lot of aspects that affect lots of different areas, but these are the ones that really impacted commercial real estate, and I just thought it would be timely and, um, hopefully helpful and interesting to, uh, to have a little chat about 'em since the, the bill was just passed on July 4th um, but anyway, thanks Brandon. Always good to get together. Really appreciate it.
And, uh, and, uh, if you have questions, uh, about the things we talked about today, like I said at the beginning, please talk to your CPA. And get guidance from them. That's the right way to approach this. I just wanted to make sure people were aware of some of the major provisions in the bill that impact real estate.