Tax Reform Could Devastate the Real Estate Industry

By: Julio Gonzalez, CEO of Engineered Tax Services

As we get set for more details on tax reform from the proclaimed, "Big Six", the real estate industry awaits language that could take down an entire industry.

Will the industry lose 1031s? Will they lose interest deductions? Will the lose carried interest? Will they lose state and local tax deductions? This is certainly a big chance they could lose these tax benefits.

However, there is a bigger fear amongst the real estate experts. Two of the "Big Six", Chairman Brady and Speaker of the House Ryan, stress that real estate should be included in immediate expensing. This would amount to an estimated two trillion dollars in tax benefits for the Real Estate billionaires. Yet the real estate tycoons have come out against these elite tax benefits that are being pushed by Ryan and Brady.

Why would Ryan and Brady want to forgo lower income tax rates to give real estate investors such lucrative tax loopholes? They and the Tax Foundation tell us that this will be a great way to grow GDP. Did they miss the 1980s-tax reform when the real estate industry came to a screaming halt when the depreciation for real estate dropped from 40 years to 15 years? If they went back in time they would be reminded that accelerating real estate expensing in the 80s lead to the S&L bank crisis. Back then, the hope was for this more generous real estate expensing to create GDP. It had the very opposite impact. It collapsed the real estate industry. Immediate expensing would even create a much worse real estate bubble.

We don’t need to risk an expensive tax deduction scheme for the real estate industry at the cost of lower tax rates for the middle class. For this reason, I have the following recommendations:

·      Target immediate expensing, or the permanent extension of bonus depreciation, on tangible capital assets-only, such as business and manufacturing equipment, vehicles, tools, machinery and software—and exclude real estate.

·      This provides a focused approach to incentivize companies to invest in U.S. manufactured goods that have the highest potential to generate U.S. jobs, strengthen U.S. businesses, and contribute positively to GDP, while avoiding the unintended consequences that would result if applied broadly to real estate investments.

·      Removing real estate from immediate expensing proposals would also significantly decrease the estimated $2T in losses to the U.S. Treasury that full expensing of all capital assets could trigger, and would alleviate the challenge of scoring 39-year depreciable assets in a 10-year budget window calculation.

Why is immediate expensing for real estate not truly expensing at all? Why do our tax reform blueprint experts not understand real estate? Below are factors that are not being considered in the tax reform blueprint:

·    Under today’s tax code, real estate is providing a stable, predictable U.S. source of investment and job generation, contributing significantly to GDP while ensuring safe and productive spaces for Americans to work and live. 

·    Due to tax consequences and restrictions unique to real estate, immediate expensing for structures and buildings will NOT yield the same economic benefits that may result if applied to other short-term tangible capital expenditures.

·    A transition of this magnitude, even with carefully devised transition rules, would lead to an indefinite period of uncertainty, destabilizing today’s real estate industry with no tangible benefit to GDP.

·    Accelerated depreciation for real estate was attempted within 1980s tax reform. This effort resulted in the use of real estate development to create tax shelters without economic demand. which contributed to the S&L/Real Estate crisis.

·    While tax laws, including passive activity loss, at-risk limitations and NOL carry-forward rules were established in an attempt to stop real estate tax shelters, the rules are simple to avoid and the IRS is unable to effectively audit the number of claims made each year. (By example, a person selling a property for $1 million in gains, with $1 million in passive activity loss carryforwards accumulated over 20 years may opt not to report the real estate sale to the IRS. The IRS never sees the real estate transaction unless it happens to audit the return, which is rare. Immediate expensing would add to this problem; creating an NOL carryforward that will be difficult for the IRS to track). 

·    While some economists cite that structures (plants, office buildings, commercial real estate, residential rental properties) would contribute most substantially to the growth of GDP generated by immediate expensing, this is a flawed and economically irresponsible assumption for the following reasons:

1.    Economic Models are Flawed: Most economists' models that demonstrate GDP growth from the inclusion of real estate in full and immediate expensing, such as the Tax Foundation's, DO NOT factor in real estate recapture taxes, passive loss, basis, at-risk limitation rules, or other market drivers, such as company valuations and shareholder requirements. They also often rely on European data that does not effectively reflect U.S. economic realities. As a result, these models:

o   Do not reflect true, realistic economic effects that these provisions would have on real estate investment planning,

o   Ignore historic examples from the 1980’s where attempts to dramatically accelerate depreciation of buildings failed,

o   Weight equity unrealistically high over debt in an industry that relies almost exclusively on debt, and

o   Generate misleading expectations that real estate will account for nearly 70% of the growth factor resulting from immediate expensing, when real estate only accounts for approximately 12-15% of U.S. GDP.

As economists often express surprise that businesses have not rallied in support of immediate expensing for real estate, it is largely the result of the failure to account for actual U.S. business realities and behavior in their models, to include tax law implications that prevent immediate expensing of real estate from being a true or significant growth and investment benefit.

2.    Passive Investors:  The reality is that most real estate is owned by passive investors that are subject to basis and passive loss limitations and would not be able to use an immediate expense deduction to offset active income. As a result, immediate expensing will provide little to no benefit to the largest sector of real estate owners, as the Blueprint goals propose. 

3.    Non-Passive Investors:  For those that do qualify as non-passive (Active) investors, immediate expensing of real estate is not a true "expense". Due to recapture tax rules, it is a mere timing issue—an accelerated depreciation that must still be paid back to the U.S. Treasury at the time of building sale, diluting the intended investment incentive for most professionals.

4.    Recapture Matters: Unlike most capital assets, real estate is typically sold for a profit meaning that any expense deductions taken on buildings (whether immediately or over time) must be paid back to the U.S. Treasury under recapture rules upon sale of the building. Short-lived assets such as equipment, machinery, vehicles, and tools, on the other hand, are used to exhaustion and retired, avoiding recapture taxes, thereby making it a true deduction that can incentivize further investment. This is not the same for real estate.  While indefinite carry-over of Net Operating Loss (NOL) with interest could mitigate the impact of recapture for some experienced real estate professionals, many investors that will try to take advantage of immediate expensing will be inexperienced. Without proper financial planning, inexperienced investors will be left in an untenable financial situation if money has not been set aside to pay recapture taxes, communities will risk under-maintained or abandoned buildings, and the Treasury will lose significant revenue due to default. The impacts of recapture will matter!

5.    NOL Rules: "Immediate" expensing does not provide "immediate" cash-in-hand for investors that do not have enough active income to deduct the full expense. Net Operating Loss (NOL) rules, even if carried forward indefinitely with interest/inflation, do not solve the problem; an NOL schedule negates the goal of providing “immediate” cash to stimulate the economy and simply becomes an accrual system, much like depreciation, which is inconsistent with a true cash flow system. It is also highly unlikely that investors will treat an inflation-adjusted NOL as comparable to an up-front deduction, significantly diluting the practical incentive and, by extension, GDP growth.

6.    Current Depreciation Schedules Are Not Arbitrary: The current depreciation schedule and corresponding tax code has been carefully devised to accurately and deliberately tie maintenance and repair schedules to the normal wear and tear of a building throughout its life expectancy. If this distinction is eliminated with immediate expensing, it would eliminate an important driver that rewards and encourages people to keep property in good repair, which cannot be effectively offset by market demand or increased regulation. While some studies have attempted to defend a shorter building life, most non-residential buildings stand strong for decades and even centuries. The current 27.5/39 year depreciation schedule for real property is an important and appropriate timeline that should not be changed.

7.    Accounting Burden:  Currently, most businesses maintain two different accounting systems: one for their own internal purposes (GAAP), and one for tax purposes. Though the systems are similar, particularly in terms of asset depreciation schedules, businesses still spend considerable time and resources reconciling the two. The tax accounting system required for immediate expensing would represent a significant deviation from the current GAAP, meaning that reconciling the internal and tax accounting systems will actually be far more burdensome than it is at the present date. Furthermore, this issue will be compounded in states that cannot adopt immediate expensing, the number of which is likely to be substantial due to stringent balanced budget requirements and near-term losses. Companies located in these states will be forced to maintain three accounting systems: one for internal purposes, one for federal purposes, and one for state purposes. This significant complication runs counter to the Blueprint’s goals for simplification.

Ryan and Brady indicate that eliminating interest expense and allowing for immediate expensing will discourage debt and encourage equity. That could be no further from the truth. The lure of immediate expensing benefits could also, ironically, incentivize investors to leverage debt, rather than detract from debt financing as the Blueprint intends. For example, immediate expensing would allow an investor to invest 20% capital to purchase a building, yet expense 100% of the total cost (including the 80% of debt financing).  In the initial period, inexperienced investors could jump at this opportunity, but fail to account for the elimination of interest deductibility or certain tax responsibilities such as recapture and passive loss rules.  

As a result, the market could experience a near-term period of investment driven by perceived tax benefit rather than market forces, leading to massive over-building as experienced in the 1980's. Eventually, however, investors would realize they overvalued their investments, which could devastate the market and prompt further borrowing to pay recapture tax consequences.

It is hard to fathom a more harmful tax change initially drafted for the real estate industry. Let’s hope the "Big Six", which have real estate experience, save the industry and make sure lower tax rates for the middle class are far more important than billionaire massive tax deductions.