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Taxes & real estate: the clench connection; federal and local revenue schemes are combining to put the pinch on an already vulnerable industry.

TAXES & REAL ESTATE: The Clench Connection

The near-desperate plight of the U.S. real estate industry is apparent to anyone in this country who even casually reads a newspaper or magazine these days. The Resolution Trust Corporation, the government entity charged with administering the skyrocketing Savings and Loan bailout, has reportedly amassed a portfolio of real property assets that, for a complex set of reasons, never proved sufficiently profitable to allow a sustainable return on a financial institution's investment. The consequence of the S&L debacle? Each day Americans are reminded that both they and their progeny will be saddled with rectifying this monumental financial crisis.

To put total blame for the S&L fiasco on officials responsible for developing and implementing tax policy is, of course, misguided; however, tax structures put in place during the past several years may have exacerbated the cataclysm recently felt within many real estate markets.

* The federal income tax bite

By almost universal assent within the real estate profession, the Tax Reform Act of 1986 is regarded as one of the most devastating legislative blows ever delivered. The element of the Tax Act deemed particularly problematic is the limitation placed on the deductibility of losses associated with rental properties. By classifying all such rental enterprises as "passive" the federal government effectively prevents real estate practitioners from deducting losses directly associated with their principal source of income. Succinctly stated by Sharon Frey, CPM, vice president of JMC Realty Group, a Dallas, TX-based commercial brokerage firm, the introduction of passive loss rules was "onerous." When the dynamics of these rules are understood, such an assessment is defensible.

Michael Costello, an associate with the Philadelphia-based accounting firm of Laventhol & Horwath, explains that "when the 1986 Tax Reform Act adopted the passive activity rules, [lawmakers] made the decision to treat all rental real estate alike, and to treat all losses on rental real estate alike. That means that any loss attributable to rental real estate - whether it's derived from a cash loss via a poor marketplace, or whether it's a `phantom loss' generated primarily through depreciation - falls into the passive category and can only be offset against passive activity income. The Tax Act thereby created a disincentive for putting money into property. The reason? Even a cash, out-of-pocket loss cannot be deducted on a rental property unless you've got gains - overall income from rental properties - which is an unusual thing to have."

The ramifications for the real estate industry are stark. According to Dr. Loren Simkowitz, CPM, president of Bethesda, MD-based Monocle Management, Ltd., "The Tax Act negated one of the prime benefits of real estate ownership and took away the desirability for people to invest in real estate as opposed to other types of investments. Consequently, there has not been a big thrust of people ... investing in real estate, so the market has just died down dramatically because of the tax law."

Aside from placing substantive restrictions upon the use of passive losses, the Tax Reform Act of 1986 contains at least two other salient features. First, the Tax Act is not, technically, a property tax; rather, it is a federal income tax measure that indirectly affects decisions relating to real estate investment. A national real estate tax has yet to materialize, at least in part, because it might be deemed a federal encroachment upon a source of income traditionally considered the exclusive province of political subdivisions. According to Greg Van Gorp, managing accountant for the Cedar Rapids, IA-based real estate management firm of AEGON USA, Inc., "Real estate taxes are not affected by the Tax Reform Act of 1986. They are taxes put in place by local authorities, generally counties and/or cities, that are used to fund county, city, and school operations for the locale. Generally, they are administered by local authorities. There is typically not a state or national taxing authority for real estate taxes."

Of some solace to real estate professionals is Van Gorp's prediction, echoed by others, that, despite Washington's mania to cut the imposing budget deficit, "there is no indication there will be a national real estate tax [any time soon]."

* The active nature of passive losses

A second particularly troubling aspect of the Tax Act is how the term "passive" is functionally defined. Although the connotation is that tax benefits are to be denied to real estate dabblers who only use property investments as a tax shelter, the harsh reality is that everyone devoted to participation in real estate markets is adversely affected. Costello points out that passive loss rules apply "without regard to how much time is spent dealing with real estate. If it's income, or if it's loss from the rental of real estate of any type, even if you spend 100 percent of your time working in that real estate activity, you may not deduct those losses against non-rental, non-passive incomes. The terminology is very strange because while it says passive, that includes a rental activity that somebody works at 24 hours a day."

This across-the-board denial of real estate related tax deductions has many in the industry questioning its fairness. Unlike other business professionals, some real estate entrepreneurs are being denied the opportunity to deduct legitimate operating expenses. Passed in response to public demand to tighten up tax loopholes whereby ingenious parties could shelter excess income through property investment, the Tax Act has arguably succeeded towards this end. "It's been a very long time since an investor has asked me about, or even alluded to, tax benefits of a particular investment," says Frey. But the problem lies not in the rationale of the Act, but, rather, with its draconian scope.

Costello explains that closing loopholes was "a big target of the Tax Act. However, as frequently happens when [lawmakers] write tax legislation, rather than defining to hit that specific target of people who deducted `tax shelter losses' in which they were not actively involved, [legislators] nailed everybody and defined all rental real estate activities as being passive."

Costello is among those who believe a key to reviving moribund real estate markets - and thus revaluing many properties now forced into government receivership because of the S&L situation - is to reconsider the severe passive loss provisions contained within the 1986 Tax Act. "I think Washington needs to sit up and pay some attention [to tax revisions] instead of just focusing on the problem of the S&L per se. Looking beyond that problem they can see from where it stems and they could help keep those properties from reverting back to the S&Ls [as tainted collateral]."

* The improving prognosis

Modification of the Tax Act to eliminate the stringent passive loss elements might ease the S&L problem, but this raises the question as to whether anyone on Capitol Hill is receptive to this reasoning and what is the prospect for reform of the Act. Some experts believe the chances for eventual overhaul of the passive loss rules are fairly good. Dr. Mark L. Levine, CPM, a professor at the University of Denver and vice chairman of the National Association of Realtors Tax Subcommittee, says revamping the Tax Act has influential patrons in Congress. "We have very strong support for a change in the passive loss rules that will take into account those in the real estate business. We are talking about amending ... the rules so that passive losses will not be a limitation on someone who is in the business, which is generally thought of as the `500 hours a year, or 50 percent of your time' rule."

Although he is optimistic about successfully introducing new passive loss provisions, Levine notes that the immediacy of such relief is still speculative. "It has very strong endorsers - it even has the votes now - except that some projections suggest the cost to the treasury could possibly total $1 billion dollars. In a situation where we have the Savings and Loan fiasco, the Iraqi conflict, and so on, some will argue the last thing we need is further budgetary shortfalls. That is probably the single greatest problem preventing passage at this time. But otherwise, I see it as passing. Whether or not it will be this year is hard to say."

* Property taxes: feeding the local wolf

Notwithstanding favorable resolution of the Tax Act's more troubling provisions, real estate professionals inevitably must confront the specter of property taxes endemic to virtually all local governments. However, for several reasons, the significance of traditional property taxes is becoming even more profoundly felt by real estate investors. Local tax levies on commercial real estate have changed comparatively little in form over the years, but the severity of their degree has become acute. The reason for this change is at least twofold.

One factor precipitating an increased commercial real estate tax burden was the severe rollback of federal funds initiated in the early-to mid-1980s. Prompted by the Reagan Administration's pledge to extensively de-centralize government influence, states, counties, and municipalities could no longer depend upon a generous stipend from Uncle Sam to finance the services and amenities demanded by their citizens. Although local officials often showed remarkable ingenuity in generating alternative forms of revenue (impact fees and user fees, for example), by far the most ready and conventional option was to escalate property taxes. And it is here that the other shoe drops.

In assessing property taxes, the taxing authority generally has two groups to burden: commercial/industrial and residential. Should one sector be spared for any reason, it would inevitably be at the expense of the other. As reported in the August 6, 1990 edition of U.S. News & World Report, it is the residential taxpayer who is increasingly being spared.

The U.S. News article reveals that, emboldened by the California tax revolt of the late 1970s and angered by what are perceived as ever-increasing property tax bills, "a spontaneous grassroots movement has sprung up across the nation, aimed at squashing the despised property tax." These rebellions have been so compelling and comprehensive that all but nine states impose some limit upon what can be extracted from a residential taxpayer.

In many jurisdictions such caps do not apply to both commercial/industrial and residential property, so the former is obligated to help make up resulting revenue shortfalls. In such an environment where there is pressure to raise the non-residential tax rate and/or inflate assessment values, anyone dealing with commercial real estate in a declining market confronts what amounts to a mortal double-whammy. The effect, according to Costello, is that it will put more strain on properties and industries that are already burdened. "If a rental income is coming down on a property, or it's hitting the market at a time when they just can't bring in new tenants, it just makes it that much more difficult for the developer if real estate taxes are escalating at the same time."

Not all revenue authorities are oblivious to the need for nurturing new commercial enterprises, or the dangers of taxing their non-residential base out of existence. According to Costello, in such relatively progressive jurisdictions real estate developers can qualify for almost a negotiated real estate tax - at least during the initial years of a project - based on gross revenues or other considerations. "Different states have, in an effort to revitalize cities or develop blighted areas, given some kind of tax credit applicable against real estate taxes," he says.

Unlike the federal Tax Act, where Congress can be lobbied for less debilitating taxation, no one body can unilaterally transform the sundry real estate laws of the various taxing jurisdictions. In the final analysis it is ultimately the judicious acknowledgment, by both tax raiser and taxpayer, of each other's respective needs and requirements that is key in establishing equitable tax bills. As stated by Lee Klein, CPM, president of the Institute of Property Taxation and president of Nationwide Properties, a Fair Lawn, NJ-based management company, "Tax assessors have a very difficult job to do under the restraints and circumstances imposed upon them by the cutbacks in funding. It is tough for them, and I understand and sympathize with their situation; but, from the taxpayers' standpoint, we are not a bottomless pit."

The S&L Crisis:

A Tax Act Legacy?

Perhaps the only element of the ongoing Savings and Loan debate growing faster than the estimated cost of the bailout is the complexity of its causation. Although the 1986 Tax Reform Act eliminated many advantages of real estate investment, was it the catalyst of the thrifts' collapse, or were more fundamental economic forces at work?

Dr. Mark L. Levine, CPM, a professor of real estate practice at the University of Denver and vice chairman of the National Association of Realtors Tax Subcommittee, says that the Tax Act played a definite part in deepening a crisis to which the S&L industry was inherently prone. "Before deregulation S&Ls used to make loans in this country at a fixed rate - 30 years locked in at 8 percent," he says. "But we all know what happened to interest rates in the 1980s when they went to 18 percent and beyond. The S&Ls are locked in on the earnings side to an 8 percent position, but to attract funds they are paying twice that plus. They are trying to derive funds in a marketplace where money funds are paying 16 percent and up."

In order to extricate themselves from these financial pincers, Levine says S&Ls were obliged to do two things. First, aided by deregulation, they increased the money paid to depositors. This required the S&Ls to go out in the marketplace and "compete" for deposits. Unfortunately, history is devoid of entrepreneurs who succeeded by buying dear and selling cheap, so it was not long, Levine notes, until the thrifts found themselves bound to making greater earnings than were possible through traditional loans. This necessitated the undertaking of other projects: constructing office buildings; buying ground and developing it through subsidiaries; and participating in loans. However, a development market softened through other, extraneous factors doomed many S&Ls because, as Levine explains, "this was a deal where they spent more money than they could possibly take in."

The Tax Act presents itself as one such "extraneous factor" which adversely influenced the profitability of the real estate market.

As Levine observes, when real estate markets were strong and bolstered by tax-sheltered funds, the S&Ls' ventures had promise; but with the introduction of passive loss restrictions the ready financial flow was partially stanched, property markets softened, and the stability of many financial institutions became compromised.
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Title Annotation:includes related information on savings and loan association crisis and Tax Act
Author:Stepanek, Steven
Date:Oct 1, 1990
Previous Article:Auditing the environment.
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