Flat tax looks bleak for owners.

Members of the Community Housing Improvement Program (CHIP) heard the bad news about flat tax from the National Multi Housing Council's Vice President Jim Arbury last month.

At a meeting held at the Association of the Bar of the City of New York on West 44th Street, Arbury predicted that under any new tax bill, current owners of property will lose - and lose big. And by the end of this year, Arbury believes lenders will also become wary of lending to current properties.

Paradoxically, those who start out with cash and no holdings - if any of the currently proposed versions of the flat tax arrives - will make out just fine.

How can this be? Under proposals now being considered by Congress, owners of income-producing properties will lose both their current depreciation schedules as well as mortgage interest deductions - sending current profit-making properties into loss situations.

On the other hand, your property that would suddenly being showing a loss could be attractive to an equity purchaser and start off fresh under the new tax codes. In essence, current owners will have to sell to new, all-cash investors, and the real estate market will start out at a new ground zero for tax purposes.

Under some proposed transition rules, those buildings purchased before the flat tax would lose their current depreciation, and those that own real estate with heavy mortgages "would be devastated," according to Arbury.

The lack of an "intelligent" transition for current owners is shaking the real estate industry at it foundations.

"It is a very, very serious issue because these tax proposals should radically change the tax system in place and do it to investments already made and locked in, and in many cases illiquid investments," said Steven A. Wechsler, president of the National Realty Committee (NRC).

Wechsler says the NRC's concern, increasingly, is focused on the transition to a new system.

Under the Dick Army proposal, there is no transition and Wechsler says the suggestion has been that owners have to go to the new system "cold turkey."

That would mean when such a law began, "if you were deducting interest you could no longer deduct interest, and no longer depreciate your building." An owner of a new building across the street, with a new small mortgage, would then be able to charge less in rent. "It's highly problematic," said Wechsler.

Because during the first years of such a new tax law owners will be able to completely expense new purchases, no taxes at all would be generated, and that isn't good for the economy either, says Wechsler.

"The primary issue is not in five or 10 years, is one better or worse. The primary issue is what happens over the next five years?," he warned.

Deborah Beck, executive vice president of the Real Estate Board of New York (REBNY), has been attending Washington briefing meetings to keep up with the legislative maneuvering. She says there is an awareness on the part of some legislators that the same forces that caused some of the Savings and Loan crisis after the 1986 Tax Legislation was passed may be at work should they pass a flat tax without some transition for current owners.

Most Americans, whose single real estate asset is their home and as a group translate into mucho votes, will emerge without financial incident, as Arbury predicts Congress will probably let them keep their mortgage deductions.

But for income-producing property owners, Arbury warns, "the less leveraged you are, the better off you are. But you will still be worse off than present law because you will have a deduction you can't take."

He believes something will pass that has the title "Tax Simplification Act" because, "How can they not say, 'Let's make it [the tax laws] easy?'"

The trouble for building owners, however, is just beginning.

As leaders go through pro formas for new lending or for refinancings, Arbury says banking officers will begin comparing the building's bottom line to what will happen under various proposed tax legislation. Arbury believes that once they start examining the proposals, if they lend at all, it will be for very short terms, perhaps a year or less.

Wechsler, on the other hand, doesn't think the lenders will be reacting so fast to proposals that are still on the drawing boards.

Nevertheless, preparing to ward off as much of the bad effects as possible, the NMHC, along with the National Realty Committee, hired Price Waterhouse as consultants after interviewing the top accounting firms in the country.

"We talked with five different CPAs. Most sat there with jaws hanging open and had no idea of the ramifications," recalled Arbury of his conversations.

More recently, the National Association of Realtors, as well as the International Council of Shopping Centers and the Building Owners and Managers Association, have agreed to help fund the studies.

Price Waterhouse will prepare data using its nationwide property information to show the presumed devastating effects of the proposals on both owners and lenders.

"The main reason to undertake this study is to educate ourselves and others on what effect these proposals will have," said Wechsler. "Once we have that, we'll be in a better position to make recommendations."

Both the Senator Sam Nunn and Senator Pete Dominici bills reward investment and tax consumption or debt. "They reward people building up the rate of savings in America," Arbury explained.

While the Nunn-Dominici proposal has some limited transition, "it is not sufficient," said Wechsler.

Beck said under their USA Tax proposal, a/k/a "the Unlimited Savings Account Tax," a business would take the total value of its receipts from sales and subtract its purchases from other businesses, which would make it a form of value added tax. "They would not tax savings, which is fully deducted from income, and the USA tax retains the mortgage interest and charitable deduction," she said.

Arbury agrees they won't go after the home mortgage interest deduction, but says they will go after other debt, and that includes commercial mortgage interest, "the theory being that sooner or later, everything will be financed with equity. But someone with equity is willing to lend it to someone." And when does it become a mortgage? Or does this mean the lender becomes your partner in the deal?

In the short run, says Arbury, whether or not Congress gets down to legislation, there will be reactions from the lending side.

"It's the people you borrow money from," he said. "It will be their fiduciary duty to say, 'Wait a second! If there is tax reform, this thing doesn't make this money and I can't lend money to this outfit, at least for 10 years.' There will be kickers put in if there is tax reform, and all bets are off."

Arbury advised the CHIP owners that if they had any refinancing to do, "it's time to look at it. The next year will be fraught with danger."

While Arbury believed the IRS would issue some kind of effective date whether or not Congress had passed a law, three days after he spoke at the CHIP meeting, Rep. Bill Archer, Chair of the House Ways and Means Committee, and Sen. Bill Roth, Chair of the Senate Finance Committee, said it wasn't up to the Treasury to decide when a bill that didn't exist would become effective. They said any new tax legislation will become effective when it is passed.

The biggest fear, Arbury says, is that Congress will debate and pass something and call it the Tax Simplification Act, "but it won't be anything like you see now."

After discussions with Congressional staff members, Arbury believes Congress will pass a flat tax that only directly benefits those making somewhere up to $80,000 in income.

"I don't care what Steve Forbes says," said Arbury. "Above that you will not get a break."

Such legislation would provide about two-thirds of the working people with a tax reduction, but then, Arbury added, "Congress also has to figure out how to pay for it."

Should a Flat Tax pass in one of the current forms, Arbury believes investors will be watching building owners "panic or going through massive failures and will be asking themselves where they are best off putting their money." Should they put it in a long-term investment, i.e. real estate, or "run for cover CDs or readily tradable stock."

Under Dick Army's proposal, the investment is expensed right away and is indexed for inflation so the property will be just as valuable 15 years from now as when you bought it.

"You'd want to be in the brokerage business then," Marabou said, "buying and selling real estate. It will be wholesale churning of real estate."

Under Dominici, the tax rate is graduated, with the highest rate being 40 percent. But insiders believe that will rise to 50 percent.

As to a reduction in the capital gains rate, Marabou believes the Washington climate has changed, and so has the focus of Speaker Newt Gingrich.

"Now," said Arbury, "it's 'Let's make a down payment on debt, and do a middle class tax cut, but we can't afford capital gains and the Democrats are hammering away.'"

Besides, he added, any capital gains reduction may hinge on depreciation recapture. "The proposal from a real estate standpoint is awful. It's far better to have no reduction than to have it with recapture."

Wechsler too believes a cap gains cut is unlikely, "but the weather is subject to quick changes... Much still depends on who wins [the presidential race], the state of the House and Senate after the election, and hearings that are held this year."