Originally published on Forbes.com.
The National Apartment Association and the National Multifamily Housing Council are concerned that looming tax reform might have a bad impact on the rental housing industry. So they have initiated a grassroots program to raise the alarm. The flagship of the program is a website for the initiative – Protect The Lease. Launching with a website and press releases from two 501(c)(6) trade associations that each gross over $20 million seems a little more astroturf than grassroots, but maybe that is just me. They were very kind to let me have a sneak peek at the website, so maybe I should be a little nicer.
The website tells us that multifamily housing is a very big industry that a lot of people work in. And it provides apartments, which is where a lot of people, you know, live. The way they correlate all this with tax reform is a little indirect. Frankly, I think the logic is a bit disingenuous in most cases, but here is how it works. There are six impacts that Protect The Lease is concerned with and you need to drill down through each impact to find the tax principle that is, in their view, related.
The impacts are enhancing livelihoods and careers, creating and securing jobs, ensuring housing affordability, advancing neighborhoods and communities, meeting future housing demand and promoting investment in the industry. Just for fun I am going to leave it as an exercise for the reader to determine how the impacts correlate with the specific proposals. In my mind, with one exception, they don’t, but I’ll give you that one to get you started.
The specific tax issues that are of concern are the treatment of flow-throughs, like-kind exchanges, depreciation, carried interest, the low-income housing tax credit and deductibility of business interest.
Low Income Housing Tax Credit
We’ll start with the low-income housing tax credit which is the one I’m giving you. Protect the Lease connects the low-income housing credit to “ensuring housing affordability”. I wanted to do a little more than just looking at Forms 990 to assess how credible NAA and NMHC were. What I did was ask Mike Novogradac. Mike built a substantial national CPA firm (over twenty offices- ranked about 30 nationally) around the Low Income Housing Tax Credit. Mike assured me that the sponsors of Protect the Lease are substantial and credible.
And concern about the LIHTC is well-grounded. Even the threat of tax reform has had an impact on the LIHTC. The credit is rationed by state population and assigned to developments by state housing agencies. Developers, in effect, sell the credit, which is spread over ten years, mostly to corporations. Concerns about tax reform, such as lower rates, have already affected the appetite of corporations for the credit pushing down the development dollars that credit allocations yield.
Flow-Through Entities
For a variety of reason, the real estate industry favors flow-through entities and there is a concern that the desire for a lower corporate rate will somehow harm them.
Flow-through entities should not be taxed to make up for the lost revenue from a reduced corporate tax rate, and a corporate tax rate cut should not be financed by denying flow-through entities taxpayer credits and deductions.
This is actually a more moderate position than one advanced by the President and others to lower the rate that flow through income is taxed at.
Business Interest Deduction And Depreciation
Protect The Lease addresses these separately, but I have a reason for putting them together,
Tax reform should recognize the key role that debt financing plays in building and strengthening American neighborhoods and communities.
Tax reform should continue to ensure that depreciation tax rules match the economic life of assets by accounting for the natural wear and tear of buildings and technological obsolescence.
One of the proposals bruited about by several of the campaigns is immediate expensing of capital expenditures and the denial of business interest deductions. For some reason, this proposal is beloved by economists. When I did a little thought experiment on it in a post about the Jeb Bush campaign , the idea struck me as a nightmare for the way a lot of housing deals are structured. With a deal that is leveraged under current law there will be a difference between cash flow and taxable income from year to year as principal payments do not perfectly match depreciation deductions. Over the whole life of the project, though, cash flow and taxable income match. In the expensing model, there is a huge up front deduction, but over the long haul, taxable income ends up greater than cash flow.
Like-kind Exchange
I’m actually pretty skeptical that scuttling like-kind exchanges is a threat to housing.
Like-kind exchanges are more than an investment tool: They enable individuals, families and investors to participate in the apartment housing industry in an efficient manner. By increasing the frequency of property transactions, the like-kind exchange rules enable continued investment in the apartment sector that supports additional reinvestment and construction activity in the industry.
Pretty much all real estate is considered like-kind to all other real estate. The like-kind exchange rules allow owners of multi-family housing to get out of the housing business and into commercial real estate without recognizing gain. I believe the like-kind exchange rules have created a bubble in property leased to chain drugstores such as Walgreens and CVS. New construction can be financed with like-kind exchange money, but it is pretty complicated, since you have to have the stars align properly in order for it to work. Clearly repeal of like-kind exchange would hurt owners of highly appreciated real estate – except for the ones who are thereby dissuaded from exchanging into overpriced drugstores – but Protect the Lease does not make much of a case that it would actually affect housing supply.
Carried Interest
Eliminating carried interest would mean a higher tax rate for real estate investment at a time when demand for apartments continues to grow and is outpacing the current rate of new apartment housing construction.
Americans from every walk of life will be directly impacted if tax laws change. It will be exponentially more difficult for the industry to develop enough apartment housing to meet increasing demand. Less money for expansion and growth will result in fewer apartment communities, reduced housing stock, and fewer jobs.
The threat to carried interest in real estate is collateral damage from the resentment toward hedge fund managers during the Occupy Wall Street days. Carried interest is not some sort of subtle loophole, but rather the result of fundamental principles of partnership taxation. Eliminating carried interest would add significant complexity to the code. The idea is that a general partner shares in the capital gains of a partnership in an amount that is disproportionate to the amount invested. Tax reform advocates want that income converted to ordinary.
I don’t think converting carried interest income to ordinary is a very good idea. On the other hand, I’m skeptical that it would have much effect on the housing industry. What is going to happen? Because they have to pay income taxes like regular people do on big bonuses, reals estate developers are going to move into other fields. I don’t think so. There would, however, be motivation to do highly leveraged deals rather than bringing in equity, which might create instability.
Is It As Bad As The Last Time?
When the Tax Reform of 1986 went into effect, Donald Trump was a real estate maven, not our President. He was very concerned about the effect that the act would have on real estate as he related in Art of The Deal:
Jack Mitnik, my accountant, calls to discuss the tax implications of a deal we’re doing. I ask him how bad he thinks the new federal tax law is going to be for real estate, since it eliminates a lot of current real estate write-offs. To my surprise, Mitnik tells me he thinks the law is an overall plus for me, since much of my cash flow comes from casinos and condominiums and the top tax rate on earned income is being dropped from 50 to 32 percent. However, I still believe the law will be a disaster for the country, since it eliminates the incentives to invest and build—particularly in secondary locations, where no building will occur unless there are incentives.
You can find evidence that developer Donald Trump was right about the act creating a shock to the real estate industry. For example here is something from 1991 titled – Destroying Real Estate Through the Tax Code by Roy Cordato. And here is The Effect of the Tax Reform Act of 1986 and Overbuilt Markets on Commercial Office Property Markets by Stanley Smith, Larry Woodward and Craig Schulman.
This is the first empirical study to test the impact of the Tax Reform Act of 1986 on office property values and the impact of regional economic conditions. The results for the period 1983 to1988 indicate that it had a significant negative effect on values in all four regions and the highest loss was in the South. The significantly higher losses in the South and the West are supportive of the argument that the effect of tax or regulatory changes on real estate will vary across regions based on vacancy rates and economic growth.
When it comes to the supply of affordable housing though, the Low Income Housing Tax Credit created a new source of capital as it obliterated another source. Now public companies were investing in housing deals instead of groups of dentists. Almost all improved rental real estate had an implicit tax shelter component in its value, that the act squeezed out creating real hardship for owners and the financial institutions that had financed them.
Current proposals do not represent the same threat to supply with the very big exception of the Low Income Housing Tax Credit. During the last thirty years, we have gotten used to capital flowing into affordable housing via tax subsidy. If that is turned off, it will have to affect affordability somehow, but it will probably not be immediate.
Why We Can’t Have Nice Things Like Tax Reform
Protect the Lease is a reaction that illustrates the difficulty of tax reform. Over the years, Congress has chosen to use the Tax Code as, in the words of Joe Kristan, the Swiss Army Knife of social policy. Thus tax policies develop strong constituencies. Protect the Lease is an effort to convince people that others should care about the industry’s tax benefits. We’ll see how it goes.
Protect the Lease also has released a video.