Originally published on Forbes.com.
Whatever the long-term effect of the Bush 2016 tax plan, there is one provision that may create something of a shock to both real estate and the financing of small business. In the “Backgrounder” for the Reform and Growth Plan, we read – “Generally, businesses would no longer be able to deduct interest payments.” The provision is seen as a corollary to another proposal
Under the proposal, businesses could fully expense all new capital investments, an approach that seeks to remove taxes on marginal investment returns. This would simplify the tax code and significantly increase incentives to invest in new machines, equipment, buildings, and other structures.
Devil In The Details
Now there are a host of devilish details that I would like to clarify about these proposals. For example there is that word “generally” which can cover a multitude of sins and what exactly does “new” mean? Is is it something I just bought for my business making it new to me or something that is really brandy new? Makes a big difference when you are talking about real estate. Also does the expensing apply to capital investments that would not be depreciable under current law such as land and does it apply to intangibles?
Hopefully more details will be forthcoming.
Economists Think It Is A Great Idea
If you poke around you will find that many economists approve of changes of this sort. A recent article in the Economist refers to the deduction for business interest as a “A Senseless Subsidy”.
In The Not So Long Run Though?
The economists may be right in the long run, but in my mind it seems that regardless of the ultimate benefit, the transition would be wrenching. The Tax Reform Act of 1986, sensible as it reforms may have been, was a shock to real estate values. In a 1991 article in the CPA Journal Roy Cordato wrote:
The Tax Reform Act of 1986 has contributed to the decline of the real estate industry. The changes that have contributed to the decline of the industry include the elimination of the capital gains tax differential, the increase in the period for writing off taxes for depreciable real property, and the limitation of the deductions of passive investment losses. These changes have reduced the market value of real property, created an incentive for divesting real property, increased the difficulty of divesting real estate, and reduced the attractiveness of investing in new housing and construction.
The elimination of the deduction for business interest threatens firms that are reliant on debt financing. It seems like it would make starting up very challenging and that when businesses hit a rough patch it would be equivalent to kicking them when they are down.
An Oversimplified Example
I’ve constructed a simple example to illustrate how the current system works and the effect that the change might have. My example sacrifices realism for easy math, but I think it shows the principles that are at work.
Joe inherited a bit of land from his uncle and has decided to build some housing on it. The equity in the land allows him to take a mortgage to fund the construction cost – $275,000 (You can make it $2.75 million if that sounds too chintzy and scale the rest of the numbers up by a factor of 10). Joe expects the net operating income (NOI) to be $24,000. NOI is the rental income offset by the actual expenses of running the property including taxes, insurance and repairs, but not interest or depreciation. A more hip term in some circle is EBITDA.
Joe has decided that he would really like his taxable income to match his cash flow. In order to achieve this he will pay $10,000 of principal on his mortgage each year for 27 years and $5,000 in the final year. Under that scenario cash flow after debt service and taxable income will be $250 in Year 1 gradually increasing til it reaches $24,000 after the mortgage is paid off. Joe will recover the principal payments through depreciation deductions. In real life, they would not match on a year to year basis, but they will ultimately line up. Over the 28 years in my simplistic scenario Joe would collect $672,000 in net operating income, pay $196,000 in interest (at 5%), $275,000 in principal and have taxable income and pre-tax cash flow of $201,000.
Under the Bush plan, things are different. Joe gets to immediately deduct the entire $275,000 which is really cool if he has a lot of other income to shelter, but not so great if he doesn’t. It would however turn into a net operating loss, which he would probably get to mostly deduct over the next several years. Conceivably that could shelter Joe’s net operating income for the first twelve years or so. It gets hard after that though, since neither the interest nor the principal is deductible. Over the life of the scenario Joe has $672,000 in NOI and an upfront deduction of $275,000 for total taxable income of $397,000 and the same pre-tax cash flow of $201,000.
When Things Don’t Go So Well
A much more disturbing thought, one for which I will not try to construct examples is what happens with firms that borrow to finance receivables, inventories and to deal with irregular cash flow. During periods in which inventory and receivables are stable there might be a pretty good match between taxable income and after-tax cash flow. The notion that you could run into a rough patch during which there is barely enough operating income to cover your interest expense, but you are still generating taxable income because the interest is not deductible is frightening.
The Economist article actually notes that eliminating interest deductibility could be quite disruptive.
But outside the public markets, taxing interest would bash a cohort of firms with low margins or that have over 75% of their balance-sheet funded by debt. In America the obvious victims are utilities, cable-TV firms and commercial real-estate firms. Many leveraged buy-outs would be in trouble. One private-equity chief warns, “You’re opening up a Pandora’s box…It would cause massive disruption and market turmoil.” Firms might rush to list their shares and issue new equity, causing the overall stockmarket to fall in the face of the extra supply of shares.
Taxing interest would hurt bits of Main Street, too. Small firms find it hard to raise equity. Farmers would find it more expensive to get loans to smooth the seasonality of their incomes. In Europe and Asia indebted holding companies are often used to control corporate empires: some of these structures would wobble.
My observations are of course anecdotal and perhaps not good evidence, but it seems to me that the entrepreneurs who pull themselves up by their bootstraps do it with debt more than equity. One of the big differences is that equity returns don’t have to be paid during dry spells, but interest keeps ticking and must be paid. If operating income just covers interest where is the money to pay taxes, which would be required under the new system going to come from?
The Other Changes Affecting Real Estate
Bush’s plan eliminates the deduction for state and local taxes. With the local taxes goes one of the subsidies to home ownership. The other, the home mortgage interest deduction is not directly attacked, but there is an indirect assault. Itemized deductions other than charity are subject to a cap.
The cap would limit the tax value of itemized deductions to two percent of a filer’s adjusted gross income. Since it is dependent on a progressive tax schedule, a filer in a lower bracket will be able to have more deductions as a share of their incomes. Low- and middle- income filers in the 10 percent tax bracket could deduct up to 20 percent of their income, while high-income filers in the top bracket could only deduct about 7 percent.
Someone with the maximum deductible mortgage balance of $1.1 million might be paying between $40,000 and $50,0000. If their adjusted gross income is $400,000 the cap would limit them to about $28,000 total non-charitable deductions. If they have large medical bills or gambling losses, there might be no benefit at all from the mortgage interest.
Winners And Losers
The Tax Foundation has done its analysis of the Jeb Bush plan and finds that all income groups are winners whether you score it statically or dynamically. The plan, scored statically reduces federal revenue by $3.66 trillion over 10 years. Dynamic scoring more than halves the revenue loss bringing it to $1.6 trillion. If that $1.6 trillion is covered by benefit cuts, the tax savings might look a lot less exciting to the lower portions of the 99%.
Putting that aside though the really big rate savings under the plan go to families with joint income over $151,200 which is where the 33% bracket kicks in under current law. Even above that though those who live in high tax states, have large mortgages or use significant leverage in their businesses might find themselves far behind.
Of course the economists will tell us that this will be good for us in the long run. As John Maynard Keynes noted in the long run we are all dead and that
Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again
I’m thinking that the transition to non-deductible business interest might well be quite tempestuous.