By Louis Rogers, president of Capital Square 1031
Last year, the Congressional Republicans proposed a sweeping overhaul of the Internal Revenue Code that would essentially repeal Section 1031 along with the deduction for business interest. A key provision would allow taxpayers to expense (write off) 100 percent of their depreciable basis in the year of purchase.
As described in part one of my call to action, expensing of business assets has the potential to jump-start the economy to create jobs and economic prosperity; expensing of real estate will not create jobs, costs the Treasury billions of lost revenue, may have adverse unintended consequences, and is not supported by the real estate industry. The simple solution is to exclude real estate from any expensing legislation.
The following example will illustrate the point: Taxpayer purchases a newly-constructed property that is triple net leased to a large, investment-grade company for 20 years.
Taxpayer pays a purchase price of $1,000,000, with $900,000 allocated to depreciable assets and $100,000 to non-depreciable land. Taxpayer puts $250,000 down and borrows $750,000 of the purchase price from a commercial lender. The property generates a 5 percent net return (flat for 20 years) or $50,000 per annum in taxable income (tenant pays all expenses under the triple net lease).
Applying the expensing theory, Taxpayer would recognize a $900,000 taxable loss on the tax return for the year of purchase. Taxpayer has $100,000 of taxable income from salary and non-real estate investment income. Taxpayer would use the loss from expensing to offset real estate income ($50,000), salary and non-real estate investment income ($100,000), for a total of $150,000 in year one, leaving a balance of $750,000 to be carried forward and used against future taxable income.
Assuming taxpayer’s rental and other income does not change, the following summarizes the impact of expensing:
Expensing of Business Assets vs. Real Estate
Expensing of business assets has the potential to jump-start the economy and create a great deal of business activity; the same is not true for real estate. In our simple illustration, Taxpayer is unlikely to buy another real estate investment while he or she has a substantial tax loss from the last real estate investment that cannot be used.
The illustration demonstrates that it will take six full years to fully offset taxable income from all sources against the loss from expensing. Tax-motivated taxpayers will not need to purchase another investment property until the seventh year. Plus, the loss of mortgage interest deductions will eliminate one of the traditional advantages of investing in leveraged real estate. Thus, when applied to real estate, expensing will not accomplish the goal of increasing economic activity.
Finally, expensing has the potential to create unintended consequences – millions of taxpayers will be able to use losses from expensing to offset federal income taxes on salary, investment income and real estate income, essentially paying no federal income taxes.
This would violate the policy set forth in the passive loss rule adopted as a part of the last major tax reform, the Tax Reform Act of 1986, potentially leading to a tax shelter economy where taxpayers have the ability to pay no federal income tax by purchasing real estate.
The passive loss rule has effectively ended real estate tax shelters. Expensing could have the unintended consequence of reviving tax shelters to the detriment of the Treasury and sound public policy that all taxpayers should contribute to the operation of government. If the passive loss rule were applied to expensing, Taxpayer would not be able to use tax losses from expensing against salary or non-real estate investment income. In this case, it would take 18 years for Taxpayer to use the tax losses against real estate income from the property.
Taxpayers are not likely to buy another real estate investment with such a large tax loss that cannot be used; this further demonstrates that expensing, when applied to real estate, is not likely to increase transaction activity that would lead to new jobs and economic prosperity. Expensing of real estate will cost the Treasury billions of dollars in lost tax revenue. According to the Tax Foundation, expensing will cost over $2.2 trillion over a 10-year period; real estate constitutes a substantial part of this sum.
Real estate markets are active and liquid; the real estate industry is already a substantial job creator. Moreover, real estate assets are currently bringing record prices. Some real estate executives fear that expensing may cause real estate markets to overheat, with the potential for overbuilding and a return to the boom and bust cycles of past decades.
Others believe that the passive loss rule will be incorporated to halt the growth of tax shelters and, thereby, eliminate one of the primary benefits of expensing. Many real estate groups strongly support Section 1031, including the National Association of Realtors (NAR), Alternative & Direct Investment Securities Association (ADISA), and Federation of Exchange Accommodators (FEA). These organizations represent millions of real estate professionals across the country who are active participants in the real estate market and see the many economic benefits of Section 1031.
Expensing of business assets has the potential to jump-start the economy; expensing of real estate will not create jobs, costs the Treasury billions of lost revenue, may have adverse unintended consequences, and is not supported by the real estate industry. The simple solution is to exclude real estate from any legislation adopting expensing.
The opinions in the preceding commentary are those of the author alone and do not necessarily reflect the views of The DI Wire.