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The impact of tax policy on commercial real estate.

For many years it has been governmental policy to encourage home ownership and to provide decent housing for the citizens of this country.

FHA and VA programs were begun in the 1930s and 1940s to provide lowcost, high-ratio loans to home purchasers. Interest on home mortgages has been deductible as a part of tax policy to make home ownership affordable. With inflation a significant factor after World War II, a tax policy allowing people to sell a home and reinvest in a more costly home while deferring any capital gains was instituted.

The real estate industry has always been very sensitive to changes in interest rates. Times of tight monetary policy and high interest rates have always caused drastic reductions in home sales and new construction.

The ownership of a single-family home has always been considered the American dream. However, many people still have been unable to become homeowners. For these people, the rental housing market has been the only alternative.

Governmental policy has typically addressed the needs of low income tenants in two ways. First, subsidies have been utilized, either as direct payment of a portion of the rent as in the HUD Section 8 program or as an indirect subsidy by granting favorable mortgage rates to the building owners to encourage construction of low-income housing. The second method of encouraging rental real estate has been to provide tax benefits to the owners of commercial real estate. This article will examine this area and the changes that have occurred over the last 15 years.

Tax policy

Real estate ownership has historically provided several ownership benefits. The purchase could be leveraged using borrowed funds. In inflationary times the value of the asset has traditionally increased at least as rapidly as the rate of inflation.

A significant amount of the income stream would be sheltered by the allowable depreciation. Any losses would be written off against any other income source. This was very significant for the high-income, high-tax-bracket owner because it gave a cushion for the risk being taken.

Lastly, the proceeds of the ultimate sale of the property would be taxed at a rate significantly lower than the owner's normal tax rate. The use of depreciation was not a tax avoidance method but rather a method of delaying the tax and converting it from a tax on ordinary income to a tax on capital gains.

Figure 1 charts the changes in tax policy from 1975 to 1990. The typical investor in commercial real estate is a high-tax bracket individual, so any change in tax policy will have an immediate effect on his or her willingness to keep or increase a real estate portfolio.


Figure 1 clearly shows several major shifts in tax policy. The top tax rate has declined from 70 percent to 28 percent. The capital gains rate started with 50 percent of the gain being taxable, and dropped to 40 percent of the gain being taxable. Now the gain is fully taxable at a maximum rate of 28 percent.

Depreciation rates have varied greatly. Perhaps the most damaging change in policy for the real estate investor was the change in the 1986 Tax Act eliminating the ability to write off passive losses against ordinary income. This single change removed the limited partnership syndications from the field of players.

Figure 2 is a simple illustration of the change in the benefits provided by depreciation. The illustration assumes a $1 million purchase, with a down payment of $250,000 and the balance conventionally financed. It also assumes that the building at least breaks even.


The illustration clearly shows that the government tax policies have caused wild gyrations in the benefits available to an owner of real estate. The original return of 17 percent made real estate a very attractive investment. The returns of 33 percent and 23 percent actually caused an imbalance in the market and encouraged marginal, or even downright foolish, decisions. The massive overbuilding in some areas of the country may be attributed to the abusive tax shelters created.

The 1986 Tax Act made a drastic change in the value of depreciation but also made a significant change in the value of owning any type of real estate. The revenue code created a new category of income called "passive income" or "passive losses." For the first time, losses, be they actual cash losses or losses created by depreciation, could not be deducted from earned income. The day of the tax shelter was over.

At the time the law was written, the purpose was to restrict abusive tax shelters. The actual result went far beyond that intention. It has been reasonably estimated that the market value of most investment real estate dropped 20 percent. In some areas of the country the drop approached 40 percent. This drop wiped out the equity in much of newer real estate and was one of the major causes of the savings and loan debacle. With most S&Ls having their major assets tied up in real estate loans, the collapse was almost unavoidable.

As a side note, another governmental action that contributed to the S&L collapse was the political decision to increase deposit insurance from $40,000 to $100,000. This removed the market discipline imposed by a concern for stability. After all, the deposits were insured.

What have the results of our tax policies been? The S&L collapse certainly grew in part from tax law changes. The other result has been the rapid escalation of rents, causing affordable housing to become harder to find. In the past the government has encouraged rental housing with tax incentives. This is no longer the case. Today the real estate must create its own return, which means rents must rise.

The future

From the view of the real estate industry there are two critical goals. First, the rate of capital gains taxation must be reduced. Second, the passive loss restraint must be removed. These changes are the only way the real estate industry will be able to adequately house future generations without the government becoming the landlord of last resort.

These goals are sound and desirable, but with the current political climate favoring more taxes rather than less, I fear they are not politically attainable.

The best-case scenario in our industry is stated above. A strong, healthy housing market needs affordable interest rates, reasonable tax policies, and a government that taxes less by spending less.

The worst case is far easier to envision. The budget problem continues to worsen, taxes continue to increase, and real estate becomes less and less attractive. Rents will either rise, or more and more properties will be abandoned to already strained financial institutions. The political pressure will then be on government to "do something." Rent control? Possible. Government ownership of housing stock? Probable. Better housing for our children? Not a chance!

Paul A. Reeder, CPM [R] SRA, is president of Reeder Management, Inc. in Tacoma, Washington. Prior to founding his present firm, he worked in the mortgage banking industry, as vice president of Coast Mortgage Company, and in construction, as vice president of Crest Builders, Inc. He has acted as an expert witness in numerous cases involving valuation and management.

Mr. Reeder holds B.A. and M.B.A. degrees from the University of Washington and is a graduate of the School of Mortgage Banking at Northwestern University.
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Title Annotation:Viewpoint
Author:Reeder, Paul A.
Publication:Journal of Property Management
Article Type:Column
Date:Sep 1, 1991
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