Originally published on Forbes.com.
The New York Times publication of fragments of Donald Trump’s 1995 tax returns is one of those things that those of us in the tax blogosphere consider a teachable moment. You’ve got to give the Times credit. Somebody just handed them the pages – anonymously by snail-mail – but they had to do some slick investigative work to hunt down Jack Mitnick, the preparer, and, more significantly, get him to confirm that those pages were from Trump’s actual return. If it had been me or any other CPA I have talked to, they wouldn’t have gotten that and might not have had any story at all, but that’s for another post.
A Pretty Rough Translation
The discussion of the underlying tax law in the Times article was less good than the investigative work.
But the most important revelation from the 1995 tax documents is just how much Mr. Trump may have benefited from a tax provision that is particularly prized by America’s dynastic families, which, like the Trumps, hold their wealth inside byzantine networks of partnerships, limited liability companies and S corporations.
The provision, known as net operating loss, or N.O.L., allows a dizzying array of deductions, business expenses, real estate depreciation, losses from the sale of business assets and even operating losses to flow from the balance sheets of those partnerships, limited liability companies and S corporations onto the personal tax returns of men like Mr. Trump.
It kind of reminds me a little of the Dead Sea Scrolls. I mean what would have happened if Muhammed edh-Dhib had mailed the first ones to the New York Times and one of the reporters had drawn on his knowledge of Hebrew developed while studying for his Bar Mitzvah to translate them?
A Really Big Truck
Losses flowing through from entities such as S Corporations and LLPs are pretty mundane things that can happen to just about anybody with a business that has losses. S Corporations and LLCs are the preferred vehicles for most small businesses. Net Operating Losses are less common for individuals, but they are a perfectly logical adjustment to what Joe Kristan calls “the tyranny of annual accounting”. The Times attempt to find something villainous per se in either one falls flat to anyone with a couple of ounces of tax knowledge or business experience.
Stories like this always remind me of the two brothers who came into some money and decided to buy a truck and go into the produce business. They drive out to the country and buy apples for a nickel each and sell them in the city for four cents. After a while, they run out of money and try to figure out what went wrong. One of the brothers says to the other “I told you we should have bought a bigger truck”.
Trump was able to buy a really, really big truck with other people’s money. So in 1995 he had accumulated a lot of losses and owed a lot of money. There is really no tax genius at work there. For individuals, smoother income is better than net operating losses, since individual net operating losses often imply the loss of itemized deduction. The fairly ordinary nature of net operating losses can be illustrated, as one of my readers pointed out, by the fact that the New York Times itself in its 10-k discloses the value of net operating losses that it carries as an asset. (Page 80)
A Better Case For Trump As A Villain
David Cay Johnston of The Daily Beast makes a much better case for the large NOL being part of a villainous plot in his post Art of the Steal: This is How Trump Lost $916M and Avoided Tax. I had noted that Trump might have avoided recognizing debt discharge income without sacrificing his NOL at the cost of lower basis in his property, which constitutes kicking the can down the road. Johnston adds an extra wrinkle that would be genius if that is how it played out.
This exchange created a future problem for Trump. Real estate that cannot be depreciated is worth a lot less. Indeed, generous tax benefits drive real-estate investment. So while Trump escaped an immediate income-tax bill, the future tax benefits he gave up would mean that he would likely have to pay income taxes on his salary, fees for licensing his name, and other income.
To solve this problem, Trump sold stock for the first time in 1995. He founded Trump Hotels and Casino Resorts, which which then took ownership of his casino hotels.
That meant Trump got money for selling his casino hotels, while the investors got real estate with greatly diminished tax benefits.
If Johnston is right, Trump kicked the can down the road and got somebody else to pick up the can. I’m going to dig some to see if I can tell whether the stars aligned consistently with Johnston’s narrative, but I have to give him credit for tax literacy anyway.
It Is Really About Unrealized Appreciation
Buried in all these maneuvers is an aspect of our tax system that while being the feature that probably most contributes to wealth inequality is seldom remarked on. Unrealized appreciation is never subject to income tax. And when I look at the top people in the Forbes 400. I see lots of unrealized appreciation starting with Bill Gates with Microsoft and Warren Buffett with Berkshire-Hathaway (which I should note makes up a very large percentage of my unspectacular net worth)
Real estate turbocharges the unrealized appreciation feature since you are allowed depreciation deductions on real estate and real estate is one of the easier things to leverage. But for it all to not fall apart your real estate better appreciate if you are heavily leveraging it.
Real Estate Can Be Good For The Little Guy
The other thing about real estate is that it is probably the wealth-building vehicle most accessible to ordinary people. Those late-night TV commercials about how to buy real estate with no money down have a bit of truth to them. Their flaw is that they downplay the risk and work aspects of the enterprise. You can tell that the real estate industry has peaked when ancillary people such as lawyers, accountants, and small-time contractors, deranged by jealousy, decide to become developers. It does not end well. But regular people with a bit of entrepreneurial flair and a willingness to work hard and take a bit of risk can create economic security and even substantial wealth for themselves, with modest starting capital. In the process, they might exploit the same benefits as Donald Trump, just on a scale less grand.
We Won’t Learn How To Fix The Code By Studying Trump
The bottom line in all this is that there are not a lot of lessons in tax reform to be learned from Donald Trump’s maneuvers. You could make a case for not allowing depreciation on real estate that is increasing in value or not allowing basis in borrowed money (that would be real complicated), but those changes would hammer quite ordinary people. If you want to really attack inequality, unrealized appreciation is the place to look.
The only place I’ve seen proposals that would attack unrealized appreciation is in the Green Party platform which calls for a fifty basis point annual wealth tax on assets over $5 million and Community Ground Rent/Land Value Taxation. The latter has a long history going back to Henry George who proposed Land Value Taxation as a Single Tax in his book Progress and Poverty in 1879.
The Green Party as of now is not even a third party. That honor goes to the Libertarians last I looked. So the subject of unrealized appreciation will likely remain unaddressed. And those who believe that inequality is not such a bad thing won’t mind at all.