Tax Reform: The Debate Begins

Spring 2011

On January 20, 2011, Michigan Republican Dave Camp, the new chairman of the Ways and Means Committee in the House of Representatives, held the first of what will surely be many congressional hearings on reforming the U.S. tax code.

As such, it was the opening salvo in what is likely to be a contentious, two-year policy discussion on the structure of the federal tax system, requiring decisions affecting the nation’s long-term fiscal future and the shape of the economy. While no one can predict what the specifics will be, if compre­hensive tax reform legislation is signed into law, the real estate industry will be deeply affected.

Implications for Real Estate

The last major comprehensive tax simplification effort was the Tax Re­form Act of 1986, which was widely perceived to have had disastrous effects upon the real estate industry. Before that, President Ronald Reagan had signed into law the Economic Recovery Tax Act of 1981 (ERTA), which lowered ordinary income tax and capital gains rates, and changed depreciation rules for commerical real estate. These provisions improved the rate of return on commerical real estate investments, and therefore made them much more attractive. As you might suspect, this had a positive impact on the market. Real estate limited partnerships took advantage of the new law’s provisions and increased rapidly in number and size.

In the midst of a strong economy in Reagan’s second term, policymak­ers turned toward simplifying the tax system and eliminating many of the preferences, or “tax shelters” that existed in the code. Of particular note to the real estate industry was the existence of “passive loss” provisions which favored real estate inves­tors. Before 1986, groups of inves­tors would invest in properties, and losses associated with their real estate investments could be deducted from the investor’s income, lessening the taxes they had to pay. In an effort to simplify the code and eliminate what many economists consider distortions of economic activity caused by such preferences, the 1986 Tax Reform Act changed the rules and limited the extent to which losses associated with real estate investments could be used.

The value of many real estate invest­ments that were being held for the tax advantages they had been providing was reduced as a consequence of the changes brought about by tax reform. Holders of these assets moved quickly to sell, leading to a further downward spiral of real estate prices. Because a large portion of the portfolios of the nation’s savings and loans (S&L’s) were composed of real estate assets, significant declines in the market value of these properties undermined the financial position of these institu­tions. Many observers believe the Tax Reform Act of 1986 was a major contributor to the S&L crisis of the late 1980’s.

Today’s Issues

In August, the President’s Economic Recovery Advisory Board issued a report presenting ideas on tax sim­plification and reform. Among these were options that would have a major impact upon the real estate industry. Included in these were proposals to eliminate the Low-Income Housing Tax Credit (LIHTC), elimination of pro­visions providing accelerated deprecia­tion and elimination or reduction of Section 1031 “Like-Kind” exchanges. In addition, many are calling for signif­icantly restricting the home mortgage interest deduction. Taken individually, any of these changes would have an impact on real estate markets and the industry.

In addition, the effort to streamline and rationalize the code will also ensure that many tax law changes will be characterized as “closing loopholes” by those advancing the proposals. In this context, it is very likely that changing the treatment of carried interest from capital gains to ordinary income, which would have a disproportionate impact on real estate partnerships, will again be tried. The Republican majority that assumed power in the House of Representa­tives after the mid-term elections has stated that new spending initiatives should be offset not with tax in­creases but with reductions in existing spending programs. It will be more difficult than in the prior Congress for sponsors of the carried interest tax increase to add it to otherwise routine tax bills moving through the legisla­tive process. However, the possibility that the provision will be raised when negotiations begin on simplifying and reforming the tax code is very high due to its populist appeal as closing a loophole benefitting billionaire Wall Street hedge fund managers.  

Political and Legislative Outlook

The December 2010 tax deal ensures that the issue of tax reform will be prominent over the next two years since provisions governing tax rates, the estate tax level and other aspects expire at the end of 2012. President Obama has referred to the tax reform debate as a “conversation” rather than a negotiation of legislation, and many believe nothing will happen unless there is a strong White House push. Republicans will also be hesitant to give President Obama a major legisla­tive victory that would help in his re-election efforts. However, a lowering of corporate tax rates to make American companies more competitive in the global marketplace appears to be one item that both parties want to act on quickly. Whether comprehensive tax reform legislation is signed in Obama’s first term, or by the person occupying the White House after the 2012 elections, most believe the fundamental elements of reform will be determined over the course of the debate in the next two years. Whether it is advocating for favorable capital gains tax rates, the 15-year qualified leasehold improvement depreciation, brownfields expensing provisions as a permanent feature of the tax code, or ensuring that changes to carried inter­est treatment do not hurt real estate, NAIOP will be an active participant in the debate.