Licking their wounds from the healthcare reform debacle, the Trump administration and Republican Congress seem poised to move to comprehensive tax reform, which commentators have suggested may be less controversial. Reforming the tax system without creating a major disruption to our economy may prove to be a surprisingly difficult task. Everyone loves to hate the tax code. But major changes will undoubtedly have unintended consequences — which could turn out to be very bad. While healthcare represents one-sixth of the economy, its size is no doubt dwarfed by our tax system — which aside from borrowing, is how our government pays for just about everything.
The time may be right for comprehensive tax reform. However, certain of the GOP Blueprint proposals could do more harm than good — they are, frankly, misguided. Particularly troubling are proposals to change the taxation of real estate investments.
Harkening back to the 1986 tax reform, the GOP Blueprint purports to broaden the tax base by eliminating deductions and special tax preferences while decreasing rates. In fact, the Blueprint proposals would do exactly the opposite by creating an immediate tax shelter of unprecedented proportions. This would be accomplished by allowing investors to immediately expense newly acquired buildings (but not land). The GOP Blueprint would use immediate expensing to justify eliminating deductions on mortgages, depreciation, and likely section 1031 exchanges. The short-term tax shelter that would result from immediate expensing would be followed by an increase in the effective tax rates on real estate investments, since deductions for mortgage and depreciation would be eliminated as well as section 1031 exchanges, which play a major role in facilitating the real estate market generally.
Ultimately, these changes would almost certainly result in higher rent levels. For multifamily residential owners, to survive they would be forced to increase rents on tenants with modest or low income. As to office and industrial real estate, the rents charged to small businesses would similarly have to rise. As to agricultural real estate, there would be an immediate increase in the effective rate of taxation on these investments, since they would not benefit from immediate expensing but would lose their interest deductions.
The GOP Blueprint purports to take tax planning out of the economic decision-making process, but it would do the exact opposite. These changes would likely overstimulate the real estate industry in the short term by effectively eliminating taxation of these investments (except land) and thus create a bubble. Once the benefit of immediate expensing wears off, the loss of the interest deduction on mortgages would no doubt cause that bubble to burst. Our current system of taxing real estate is much more tax neutral by taxing what is much more reflective of economic income.
Let’s not repeat the mistakes of the 1980s. Aggressive tax incentives were enacted by Congress when Ronald Reagan entered the White House in 1980. At that time, the economy was in the doldrums. Reagan came to office with a mandate to jump-start the economy, and his legislative agenda did just that. Since real estate was in recession, they cut the amortization schedule in half and allowed investors to write off their investment over 15 years. This treatment incentivized capital to flow into real estate investments on a gigantic scale. But it went too far, creating a bubble.
The last comprehensive tax reform passed a bipartisan Congress in 1986. The laudable theme of the Tax Reform Act of 1986 was simplification, base broadening, and the reduction in special tax preferences and so-called “loopholes,” which enabled maximum marginal rates to be reduced from 50 percent to 28 percent. With the passage of the 1986 Act, they corrected the mistake they made in 1980 with real estate by lengthening the depreciation schedule to what we still use today. But the excessive flow of capital into real estate came to an abrupt end. This caused a significant correction and decline in values. This was a major contributing cause of the Savings and Loan crisis, in which thousands of financial institutions failed, demanding a government bailout of more than $125 billion paid for by the taxpayers. In today’s dollars, that would be $281 billion.
Congress now seems poised to repeat the mistakes of the 1980s — perhaps even worse. The GOP Blueprint would enact a much more aggressive tax stimulus than Ronald Reagan’s by allowing buildings to be immediately expensed. Indeed, this may help the GOP with the 2018 mid-term elections. However, it should not go unnoticed that this short-term stimulus will be followed by an effective tax rate increase on these investments that would result from the denial of interest deductions on mortgages — frankly the lifeblood of real estate. This will be coupled with a loss of depreciation deductions and possibly section 1031 exchanges, leaving a tax code in place that would be hostile to real estate investment.
The underlying premise for these fundamental policy changes as stated in the Blueprint is to “reduce tax-induced distortions in investment financing decisions.” Moreover, the Blueprint justifies the elimination of the deduction for interest (coupled with immediate expensing) as a way to avoid a “distortive . . . tax subsidy for debt-financed investment.” In fact, the Blueprint’s proposals would create unprecedented distortions and short-term incentives to make investments whether or not those investments make economic sense. Moreover, denial of interest deductions imposes a penalty on debt financed investments — even those that are not overleveraged. Contrary to the assertions in the Blueprint, in the context of domestically owned real estate held by pass-through entities, the interest deduction does not present an abuse and does not get favored treatment over returns paid on equity. This point is irrefutable.
As stated, immediate expensing can have a stimulative effect by artificially reducing taxable income when a new investment is purchased, but that short-term benefit has a major cost. Once the up-front deduction has been used, there will be no depreciation deductions and no deduction for interest on debt incurred to finance the investment. At that point, the effective tax rate on income from the real estate investment will be significantly increased. Even though the GOP Blueprint purports to reduce tax rates to a maximum of 33 percent, these real estate investments will be subject to tax at effective rates that could exceed 66 percent or more. This tax increase will probably not be survivable for the overwhelming majority of property owners who rely upon debt to finance their investments. The economic distortions that would result from the GOP Blueprint could be catastrophic.
Commercial real estate values have eclipsed their previous peak in 2007 by 23 percent. Real estate doesn’t need immediate expensing. Immediate expensing can only serve to stimulate imprudent speculation and overinvestment in real estate. The real estate industry and the financial institutions they turn to for financing should be literally screaming in opposition to these changes, which would create an enormous economic distortion and penalty for borrowing. While the Blueprint purports to eliminate tax consequences from the decision as to how to finance an investment, it actually creates a penalty for borrowing. It also undermines the basic economics of these investments by imposing a tax penalty for using leverage — which is the lifeblood for economic growth in the real estate industry. Congress should not attempt to fix what is not broken.
Stephen M. Breitstone
Meltzer, Lippe, Goldstein & Breitstone LLP
Apr. 4, 2017