One of the top priorities of Congress next year will be restructuring the federal tax code, which is a nightmarish prospect for commercial real estate owners that survived the 1986 Tax Reform Act. That effort hit commercial real estate like a Category 4 hurricane, battering both the markets and real estate investors.
The already over-stimulated commercial real estate market of the early 1980s was brought to an abrupt halt by the 1986 Act and a subsequent recession. Investors suffered staggering losses, and the economy was pushed into a steeper recession. Even the Treasury Department agrees that “some of the over-reaching provisions of the [1986] Act also led to a downturn in the real estate markets, which played a significant role in the subsequent collapse of the savings and loan industry.”
Apartment executives are cautious about pending tax reform, having suffered from other small-scale efforts to tweak our tax system. In 1997, when Congress lowered the maximum capital gains tax rate to 15%, it singled out real estate by imposing a 25% tax rate on gains attributable to depreciation deductions taken in earlier years. While this 25% recapture rate is better than original proposals to tax depreciation gains at ordinary income rates — usually higher than 25% — it still means that property owners pay higher taxes when they sell vs. investors who sell stocks or bonds.
In 2003, early proposals to reduce taxes on dividends initially attempted to restrict the Low Income Housing Tax Credit, the only remaining federal program to support affordable housing production. Now, Congress is considering estate tax repeal that would significantly increase the tax burden on heirs of commercial real estate.
Although 1986 is still vivid in our memories, it was nearly 20 years ago, and the unfortunate fallout is ancient history to policymakers. In fact, few politicians of the 1986 era still serve in Congress. Today's policymakers need to understand that even though entrepreneurial real estate professionals are willing to assume risks, they cannot be expected to shoulder the consequences of Congressional “overreaching” again.
Fortunately, many of today's leaders seem to appreciate the complex and long-term nature of real estate investments and the need to maintain stability in the commercial real estate markets. The National Multi Housing Council (NMHC) and its joint legislative partner, the National Apartment Association (NAA), are already working with a wide coalition of real estate organizations to prepare for the battle ahead. When formal legislation is introduced, NMHC/NAA will consider the following priorities in its analysis:
Estate tax — There is momentum in Congress to permanently repeal the estate tax, but these proposals harm real estate owners by also eliminating what's known as “stepped-up basis.” For example, assume you inherit a property worth $5 million for which the donor paid $1 million. Now, the basis of that property is stepped up to $5 million. Without stepped-up basis, when you sell the property, you would pay capital gains on a $1 million purchase price, not a $5 million basis. Commercial property owners are generally better off with proposals that retain the estate tax and stepped-up basis, albeit with lower tax rates and a higher limit on the amount of an estate exempt from taxation.
Capital gains and depreciation recapture — The current 15% capital gains tax rate should be extended beyond the scheduled sunset in 2008. Moreover, the 25% depreciation recapture rate should be repealed to eliminate a discriminatory tax against owners of real estate.
Depreciation — Apartments are currently depreciated over a 27.5-year period, even though NMHC/NAA research suggests that the true useful life is closer to 20 to 25 years. The tax reform initiative should include a study of useful depreciation lives to ensure that tax law reflects economic reality.
Low Income Housing Tax Credit — As the only federal support for the production of affordable housing, any tax reform proposals should retain the successful program. Since 1986, this tax-credit program has supported the construction of more than 1.8 million affordable homes, and drives the production of 125,000 units annually.
1031 exchanges — The Bush Administration's efforts to clarify requirements surrounding like-kind exchanges has made these transactions a significant factor in the commercial real estate market. Tax reform should preserve this critical mechanism that enables property owners to efficiently attract and reinvest capital.
Anytime Congress changes the tax laws, there are winners and losers. With these clear priorities, though, the apartment sector can help educate policymakers about the importance of retaining a level playing field for real estate in any new tax structure.
Howard Menell serves as the tax advisor for the Washington, D.C.-based National Multi Housing Council