Comprehensive federal tax reform. It is a subject of considerable political currency, with numerous Senators and Representatives, backed by expert economists, lining up to extol their particular recipe for a fundamental overhaul of the federal income tax. Whether the Leviathan that is our current income tax can be halted mid-bite and sent off on a new and largely uncharted course remains to be seen. Many tax professionals think not. And even those pressing for tax reform acknowledge that the transition to a new tax system would spawn considerable complexity and dislocation, at least in the short term (whatever that means). But rather than considering "whether" fundamental change is in fact possible, let us instead suspend disbelief and ask "What if?" What issues and opportunities might tax reform bring to the real estate community?

While the politics and particulars differ from one proposal to the next, most of the major reform proposals fall into two categories: a national sales tax and a business-level tax on net business receipts. (Most of the current "value added tax" -- or "VAT" -- proposals are more akin to the business-level tax on net business receipts than to a sales tax.)

In broad scope, a national sales tax looks pretty simple. It largely mirrors the state sales taxes with which we are familiar, but would be imposed on sales of services as well as goods. This would not be a tax on business profits, but rather on expenditures; every time a dollar was spent -- whether on lumber, or cleaning services, or a lawyer to draft a lease -- the consumer of the product or service would incur a tax.

A business-level tax on net business receipts, by contrast, would retain the income tax's basic concept of subtracting business expenditures from business receipts. The definitions of taxable business receipts and deductible business expenditures would, however, be radically changed. Of most significance to the real estate industry:

* investment income (dividends, interest, gains from sales of non-business assets) would (under most versions of this tax) not be taxable at all;

* rental income derived in a trade or business would be taxable;

* the cost of business assets would be fully deductible when acquired;

* interest expense would not be deductible;

* state and local taxes (such as property taxes) would not be deductible;

* wages, salaries, pension contributions and fringe benefits might not be deductible (depending upon the system); and

* net operating loss carryforwards would be indefinite and, under some proposals, earn interest.

Turning to the particulars of the two proposed regimes, a sales tax would do away with most of the income tax as we know it (assuming that Congress did not decide simply to layer it on top of the existing tax system). This approach to tax reform, however, raises two fundamental problems of its own for business taxpayers. First, the basic nature of a sales tax requires that the tax be paid up front, at the time an investment is made or a cost is incurred. While measuring the tax may be simpler, paying for it may be considerably more complicated -- a federal sales tax, at a rate of 17% or even higher, would have to be financed as part of the cost of acquisition and then recouped out of later profits. This is of particular concern to the real estate industry, because the large amount of money required for investment in real estate, and the long life of such investments, make the prepayment of tax a particularly burdensome proposition.

The imposition of sales tax on businesses also raises problems of multiple taxation. A full sales tax would be imposed on the price of an asset each time it was transferred. Even if a particular asset is used in a business, rather than resold, a sales tax raises the prospect of "cascading" taxes on businesses.

A simple example illustrates this problem: an earth-moving company will pay the sales tax when it buys a backhoe, and a developer will also pay sales tax on the fees it pays to have its earth moved. If rents are taxed as well, there is a third level of sales tax on the amounts received by the developer to recoup its investment. To ameliorate this multiple taxation it is necessary to include exemptions for sales-for-resale. Such an exemption system would however be far from simple; to operate effectively, it would have to track the intended and actual use of all business purchases and, in the end, would look quite a bit like the VAT version of a business-level net receipts tax (although the locus of the tax would be different).

The VAT and similar business-level taxes included in current tax reform proposals are not such blunt instruments as the sales tax, and therefore seem more viable candidates for replacing the income tax. The pared-down particulars of these proposals appear to reflect an assumption that taxation can be simplified by replacing our current income tax with a new tax on business "profits" that has fewer components. And indeed, the business taxes included in various proposals do eliminate a number of the complications inherent in our current income tax.

Gone are the double taxation of corporate income, complicated depreciation and cost recovery rules, inventories, distinctions between capital improvements and repairs, interest tracing, etc. Under some proposals, businesses could even borrow to purchase an asset and deduct the full cost of the asset immediately, raising dramatic tax shelter possibilities! But most businesses cannot use a deduction on the order of magnitude of an entire real estate investment in one single year, so the benefit of immediate expensing will vary. Moreover, since interest expense, property taxes and (in some proposals) wages would no longer be deductible, the tax favor bestowed by immediate expensing may be more than paid for by the inability to offset many costs against rental and sales income.

Furthermore, the business taxes introduce new distinctions that will engender new complexities. Under these proposals, for example, rent is taxable, interest is not; gain from business assets is taxable, but gain on investments is not; payments to independent contractors are deductible, but (under some systems) wages are not. These new classification rules set up numerous instances in which the tax characterization of a payment will be crucial and would no doubt spawn new forms of tax planning and tax litigation.

One of the most far-reaching issues raised by the business-level tax proposals is a simple one: What is a "business"? We are accustomed to a tax system based on the taxation of individuals and corporations, rather than on the taxation of "businesses." Members of partnerships and other pass-through entities, corporations that own different businesses and members of consolidated groups currently have considerable ability to net the income from one business against losses from another. If we change to a system in which each business is taxed as a stand-alone entity, this netting, and the liquidity it indirectly affords, may be lost. For real estate principals, whose current business structures usually comprise numerous and different entities owned with a variety of partners, losing the ability to net their differing shares in multiple projects could be very expensive.

There could be many other consequences of fundamental tax reform. Moving to any new system raises basic questions about the role of special entities like REITs and pension funds. We will need to rethink the entire structure of most state tax systems. And then there are the difficult transitional problems for existing investments, loans, contracts, net operating losses, suspended passive losses and similar attributes of the income tax. Each of these basic questions has far-reaching implications involving issues of considerable technical complexity and political sensitivity.

It is not possible in this short article to broach all of the issues raised by tax reform. And because the real estate industry is not monolithic, it is impossible to generalize about the effects of tax reform on members of a community as diverse as home owners, home builders, commercial developers, investors in rental properties and service providers. It is very important, though, for the different segments of the industry to begin thinking about the impact of tax reform on the direct participants in the real estate industry and on the buyers, users and financiers of real estate. The time to start thinking about these issues is now, while the proposals are still taking shape, and before the rhetoric of tax-bashing creates a poorly thought-through momentum. Simplification and reform sound great, but so does the Lorelei.