Opinion

What You Are Not Expecting From Tax Reform

The time may be right for a once-in-a-generation opportunity for comprehensive tax reform.

However, certain proposals could do more harm than good to the real estate market – they are, frankly, misguided. Particularly troubling are proposals to change the taxation of real estate investments.

Two of the proposals are especially troubling: 1) “immediate expensing” and 2) elimination of “interest” deductions.

Commercial real estate values have eclipsed their previous peak in 2007 by 23 percent. Real estate doesn’t need immediate expensing, and the interest on mortgages is a legitimate and necessary business expense. Congress should not attempt to fix what is not broken.

Here’s why.

Immediate expensing for real estate would be a huge and unprecedented tax break; but hold on a moment. Historically, too much tax stimuli has created a boom-and-bust cycle for this industry. Immediate expensing will, once again, turn real estate into a major tax shelter on paper, just waiting for a match.

Immediate expensing will do little or nothing for existing real estate investments – but it will provide an artificial stimulus to drive new investments with dubious economics. As proposed, rather than contributing to sustained growth, immediate expensing would create a major economic distortion. We’ve seen the results of artificial stimulants on the real estate market before. If you think you haven’t, just ask your neighbors who lost their homes and livelihoods when the last real estate bubble burst 10 years ago.

Here’s how to blow a bubble.

When the tax deductions afforded by immediate expensing are used up, the resulting “taxable income” of the property would be greater than economic profit as there will be no deductions available for depreciation and interest.

This perfect storm of misguided meddling will create a tremendous pressure to sell, trade up and buy a new property, commonly known as “flipping,” to take advantage of another new write-off period.

Hedge funds and other well financed investors would unquestionably take advantage of this flipping strategy. The ensuing glut of capital investment and flipping would artificially drive up property values and create that bubble. Bubbles burst when valuations get into the stratosphere or when investors run out of resources — usually when credit starts to tighten or when the rules change again.

We’ve tried this before.

Aggressive tax incentives were enacted by Congress in 1980 to jumpstart the economy. With real estate in recession, they cut depreciation schedules in half. Real estate investors responded with alacrity, making investments on a gigantic scale.

But it was too much of a good thing, creating a bubble of “see through” buildings that were built as tax shelters without regard to tenant demand, which was negligible. These buildings remained largely empty.

When Congress corrected its mistake with a 1986 law, which lengthened the real estate depreciation schedule, the flow of capital stopped abruptly, triggering what became a major contributing cause of the savings & loan crisis. Thousands of financial institutions failed, requiring a government bailout of more than $125 billion, paid for by the taxpayers. In today’s dollars that would be $281 billion. We can’t afford another well-intentioned mistake.

 

Stephen M. Breitstone is vice chairman of Meltzer, Lippe, Goldstein & Breitstone LLP in Mineola, N.Y., where he leads the firm’s Private Wealth and Taxation Group.

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