What Lenders Need To Know About Tax Reform – Part 3

Tax Reform and Banking

Let’s pick up where we left off in Part 2. In that post, we covered interest deductibility, provided a prioritized list of industries of where banks can make their largest impact based on profitability, and looked at how to advise companies with international operations. In this article, we wrap up the series by looking at how the new Tax Cut and Jobs Act of 2017 (TCJA) impacts net operating losses, tax impairments and different types of financing. In particular, we will focus on real estate and then touch on specific situations. Finally, we end with a strategic discussion on a framework that might help banks decide how much of this tax reform windfall they should pass on to their customers to optimize performance.


Net Operating Losses, Deferred Tax Assets & 2017 Charge-Offs


Discussion Point: Impact of NOLs – TCJA generally limits the amount of net operating loss (NOL) that can be utilized in any taxable year to 80% of the firm’s taxable income (excluding the NOL deduction) concerning losses arising in taxable years starting in 2018. Carryovers to other years are adjusted to take account of this limitation and may be carried forward indefinitely. The TCJA does away with carrybacks after 2017.


Banker Leadership: Bankers need to discuss with their borrowers on what material adjustments they are expecting to make for year-end 2017. At risk are businesses with net operating losses, deferred tax assets, tax credit investments and other tax advantaged-assets that may need to take a write-down. These write-downs could impact covenants and cloud financial statements. Good bankers will want to get ahead of this early to understand potential problems and put in place the needed waivers. Bankers will need to determine the extent to which this is a credit event or if it is just a minor adjustment to a borrower’s financials.


Cost of Capital


Discussion Point: Equipment Financing: Another way to understand the impact of tax reform on financing is to look at what happens to a borrower’s cost of capital. A businesses cost of capital takes into account the cost of debt, equity, and taxes. The lower the cost of capital, the more various investments make sense for a business. While subject to some interpretation, the way we analyze it, Tax Reform has various effects on different types of investments. Currently, for example, most major equipment purchases are depreciated on a tax basis over either five or seven years.  The old tax law allowed an accelerated depreciation schedule so that an additional 50% of the scheduled depreciable amount could be deducted immediately. Given the recent historic low levels of interest rates, the present value of an accelerated depreciation schedule was just a little less than one. Thus, the current tax rate reduction combined with the new ability for businesses to fully expense equipment purchases has only a minor impact on the cost of capital.


To put this in perspective, if you assume four to six more interest rate increases, the cost of capital for financing gets reduced by about five percent. This isn’t a large impact, but it will make banks that finance equipment slightly more in demand. In other words, there isn’t much of a new discussion to have when it comes to equipment financing other than the fact that the lower tax rate makes more equipment purchases and leases achieve their return on investment. The change in depreciation, as it pertains to equipment, has just a slight impact on the cost of financing and businesses that were tax sensitive. Tax astute would have likely been capturing most of the value under the old tax structure by using accelerated depreciation.


However, when it comes to real estate, the TCJA does make a big difference.


Discussion Point: Cost of Capital and Real Estate Financing – One change in TCJA is that depreciation increases for real property. If you are looking for a real challenge, try figuring out what is going on with depreciation, alternative depreciation, and leasehold improvements.  It is daunting. The effort isn’t made any easier as this legislation was crafted so quickly that there are several items that are referenced that lead to nowhere. The simplified, Reader’s Digest version is this - for residential investment property, the depreciation schedule goes from 27.5 years to 25 years for property placed in service in 2018 or after. For non-residential investments, depreciation speeds up even more and goes from 39 years to 25 years. In the old law, there used to be a 15-year depreciation allowance for leasehold improvements that was a favorite of our restaurant and retail borrowers. Apparently, this section was forgotten about as there is now no mention of a 15-year life (but the TCJA lists assets that would qualify if there was a 15-year allowance, so go figure). Leasehold improvements can be aggressively argued to fall into a general 10-year schedule, but we suspect that this will be one section that gets quickly amended as it is a mess.


Offsetting some of this value is the fact that the timing of the interest rate deduction phase-out (see Part I for more detail). At 2021, depreciation and amortization get taken out of the cash flow calculation, so the 30% cap moves lower as it is calculated off the lower earnings before interest and taxes (EBIT instead of EBITDA).


Now, if you are in the real estate business (i.e., leasing, construction, development, management, brokerage, etc.) then you can opt out of the interest deduction cap, but you need to use the longer (40-year) alternative deduction system (ADS).



 All of this is a little confusing, so here is a rule of thumb - To the extent the business is going to finance a building with all equity - The present value taking into consideration, the faster depreciation schedule and the lower tax rate of 21%. This means the cost of equity falls by some 14%. If the borrower wants to finance a building with debt and is subject to the limit on mortgage interest deductibility, assuming a loan-to-value of 50%, the new tax law will reduce a borrower’s cost of capital by about 8%. We point out that this isn’t life-changing for most businesses, but material on the margin. Note that the use of equity becomes relatively more attractive than debt in many cases - a fact that bankers should keep in mind when selling to an astute borrower.


However, while most businesses will be impacted by the 30% cap on interest deductibility, this provision does not apply to investor-owned property. Investment property can still deduct mortgage interest in full. This should further spur interest in investment property.


In summation, all commercial real estate should get a boost and combined with 100% depreciation of many asset purchases over the next five years should result in more real estate activity and financing for banks. For businesses, investments in manufacturing facilities (because of the greater all-in depreciation), office, distribution and warehouse space should all accelerate.


Specialty Lending Areas


Discussion Point: Multifamily: The new tax law changes do not impact all real estate equally in practice.  Since increasing the individual standard deductions will allow fewer households to itemize and when combined with a lower cap on mortgage deductibility (both first and second lien loans) the result will be an increase to the cost of homeownership. What is bad for the single family, condominium and co-op home buyer is good for the multifamily owner. While all multifamily will benefit, properties in high taxed areas will benefit the most. Because households will also lose their state and local income tax (SALT) deduction above $10k, the cost of homeownership will go up even more in high-tax areas such as New York, New Jersey, and California.


Further, those areas such as northern VA, MD, CT, NY, and northern CA that have a high percentage of itemized filers they should see the largest shift to the utilization of the standard deduction. It is within these areas that should see the biggest shift regarding numbers of households that are now priced out of the market and move away from homeownership and choose to rent. The net result is banks should prioritize those areas with the combination of the highest tax rates and the largest percentage of itemized filers as a priority to discuss with their multifamily borrowers.


Of course, there are many factors that go into home affordability, so there is not be a perfect relationship between aggregate tax rates and the impact on home prices. However, for bankers with multifamily investors, the relative value change in cash flow is a good place to start. On the margin, demand for rental units should increase helping to support rents and occupancy rates. The result is the value of multifamily product should increase allowing banks to finance a greater number of properties than before the TCJA.


Discussion Point: 1031 Exchanges – The discussion point here is the lack of change. Despite being initially threatened, the 1031 exchange provision in the tax code remains intact and will continue to allow real estate sellers to defer capital gains by rolling over investments into larger “like-kind” properties. Banks should see pent-up demand starting immediately, and with real estate getting a boost in value because of TCJA, more alternatives for 1031 players should now be available in 2018. As a result, bankers should ignite conversations as 1031 financing.


Discussion Point: Agriculture: TCJA ends Section 199 which was known as the “Domestic Production Activities Deduction” that allowed farmers to deduct the cost of joining and participating in cooperatives and grower-owned organization. The loss of this deduction will hurt and will offset some of the gains on a lower tax rate. That said, TCJA does now allow for a 20% deduction on co-up payments so while the cost may not be deductible, more income will be sheltered from co-ops.


Discussion Point: Municipal Financing: While previous versions did away with several popular tax-exempt lending sectors for banks, TCJA maintains the tax-exempt status for non-profit hospitals. TCJA continues to allow for the issuance of private activity debt on a tax-exempt basis. Banks need to adjust their tax-exempt and bank qualified pricing to take into account the lower tax rate so financing cost for municipalities will increase slowing down bank financing. At the same time, depending on the level of state tax rates, bond financing will become more or less desirable. Bankers need to take this into account when bidding on competitive bank financing proposals. We expect, on average, credit spreads will increase slightly on bank loans in-line with spread movement on municipal bonds. Bankers are encouraged to check the public markets for spread indications and apply those changes to both competitive and negotiated municipal tax-exempt loan transactions.


Discussion Point: Tax Professionals: Of course, one of the largest specific impacts that TCJA will have is to fill the profits of tax lawyers, accountants and consultants trying to help households and businesses make sense of this hastily designed legislation. Those industries will also see a material increase in profitability for banks and should not be overlooked when banks leverage their sales efforts. 


Putting This Into Action – Strategy and Determining Pricing Sensitivity To Optimize Alpha


TCJA is a gift for bankers



The first step to putting the plan into action of marketing and building relationships around the TCJA is for lenders to discuss with management and credit that they are all on the same page and working in concert. TCJA has given bankers a gift and banks must have strategic intent on how best to leverage that gift. At a minimum, this means a proactive decision from your asset-liability committee (ALCO) on how best to deploy this windfall. Like some American corporations, bankers can choose to spend increase profits on its employees, on infrastructure, on loans, on deposits or on fees.


As we highlighted in Part 1, for instance, pricing on the average commercial loan can be dropped some 40 to 50 basis points so that the bank maintains the same return on equity. Of course, by dropping pricing, banks will be able to increase their volume of higher quality borrowers. The question that all boards and management teams should be asking is – “Where do banks gain the most economic value of equity given the potential change in loan pricing, volume, and risk?”


The answer depends on your customer types and geographic market. The answer to the TCJA windfall is no different than your everyday decision on how to deploy capital – you want capital to go to the highest and best use. This means the TCJA windfall should go to where your sensitivities are the greatest and your bank garner the largest long-term gain.


For states like Florida, borrowers will be more sensitive to the improvement in credit and already show higher than average sensitivity to price. Thus, it makes sense for Florida banks to pass on the majority of the gain to customers in targeted industries based on profitability. What a bank loses in after-tax margins, they more than makeup for in customer lifetime value. The result will be an outperformance over the next five years above peers or a generation of “alpha.” 


Wrapping It Up


Hopefully, we have given lenders a good primer on the basic and intermediate points on how the TCJA will impact commercial customers. We also point out that this is one of the few times in the history of the U.S. when we have had a tax reduction when the economy was already at full employment. In addition to all that we have outlined above, greater capital investment should serve to increase demand for labor, services, and commodities which will then result in greater inflationary pressure. While we don’t predict that the impact will be large, we do believe the final result will be potentially higher rates and greater asset price inflation which all lenders should take into account while structuring their financing.


History has shown us that bankers want to get in early in this coming micro-cycle, structure loans for the long-term, mitigate the bank’s and the borrower’s interest rate risk and then increase asset quality over the next several years as both asset prices and rates increase. This makes the first half of 2018, critical for banks to front-load sales and marketing expense and captures the best deals early to not only get ahead of the national banks but put assets on the books earlier than budgeted in order to gain a compounding effect.


To do that, the Tax Cut and Jobs Act has given bankers the ideal topic to show their value and further build their stature as a true relationship banker. You now have much of the same training our lenders are getting, and as recommended, we are partnering with several law and accounting firms to deliver the very best advice we can to our clients and potential clients.


We realize understanding the new tax changes isn’t easy and bankers must put in their homework. However, if you have made it this far in our series, it is highly probable that you will be one of the bankers that can set themselves apart from the pack. Best of luck and if you have other ideas on this content, suggestions or if we can help, please do not hesitate to contact us.