Could the government pop real estate's bubble?

As many veteran real estate professionals will admit, there is always a sense of doom and concern in any overly exuberant market.

Unquestionably, we are in a heady phase of the real estate cycle. The case for the current environment not being a "bubble," is valid. Fundamentals are strong; interest rates are at 30 year lows, the increase in demand far outstrips the supply, etc.

However, anyone familiar with the last real estate bust of 1986-1990's, will recall that the elements that contributed to the decline of the real estate market were not, necessarily, all market driven, but mostly government related.

In January of 1986, Congress put into effect changes in the tax laws that altered real estate investing overnight. The Tax Reform Act of 1986 eliminated many of the tax advantages of traditional ownership and syndication. What followed was a tumbling of values which rippled through the real estate industry with devastating consequences. A record number of foreclosures took place, straining banks and bankrupting scores of investors. This trickled down to consumers and sent the economy into the ground.

The Tax Reform Act of 1986, crippled the real estate industry. It included these major alterations which were to blame;

1. The increase in capital gains tax from 20% to 33%

2. The passive loss limitation restricted the deduction of real estate losses against regular income

3. A longer tax write-off period for depreciating real estate from 19 years to 31.5 years and elimination of the 175% declining balance write-off method

These changes contributed to the deterioration of the industry by ending the incentives that made real estate an attractive investment. These changes resulted in decreasing the value of real estate and caused the market to decline.

Once again, tax reform is high on the government's list of priorities this term.

Policy makers are currently assessing the feasibility of switching to any of following three methods:

1. Consumer-income tax; otherwise known as a flat tax rate

2. National sales tax; or

3. Value added tax 

It is critical for real estate professionals to understand each of these methods and how it can affect the ownership of real estate. While radical changes are unlikely, any change could cause a ripple effect that would unsettle the delicate balance between boom and bust.

1. Consumer Income Tax includes a flat tax rate for all income including business income. Any sale of real estate would trigger a tax on the entire proceed of the sale in the year it is sold. Interest and property taxes would not be deductible items any longer.

2. National Sales Tax would eliminate the deferring of capital gains through 1031 exchanges. Almost all real estate sales and income derived from rents would be subject to sales tax.

3. Value-Added Tax would effect any new real estate developments which would be taxed. Rental income and 1031 exchanges would also be eliminated under this scenario. REITS would lose their shine as all dividends would be deductible.

While a complete tax overhaul would be political suicide, some versions of the above may be incorporated into the current system. Some potential land mines for real estate ownership would be the loss of important deductions such as property taxes and mortgage interest payments. 1031 exchange benefits could disappear entirely. Trades could be subject to a sales tax based on actual sale price.

The focus of any change in the current tax system must be to not discriminate against real estate investing and ownership. Great influence must be used to keep it on par with all other investment and asset classes. In addition, whatever changes do take place must come with an extensive transition period to take into account that real estate is not a liquid asset. Any thing that might affect its values must come with ample timing to protect the value and not catapult the marketing into a free fall.

Even any potential changes could diminish values and lead to catastrophic consequences. The mere discussion of possible modifications could cause skittishness in the marketplace.

The behavior of the real estate market would be unpredictable until the fallout actually occurs. It would be too late to shift investment dollars to other assets classes without an impending loss in values. There would be a halt of cash flow to real estate, causing the industry to be depressed.

If one were to predict how the "bubble" will pop, tax reform would be a potential culprit. By mobilizing now, before any changes are made, we can halt a most certain demise for the real estate market.