Bring Back Housing By Bringing Back Tax Shelters

    Bring Back Housing By Bringing Back Tax Shelters

    Turning around real estate remains one of the biggest problems in fixing America’s economy. Investment sage Warren Buffettrecently said now is a good time for investment pools to buy thousands of residential homes, fix them up, and rent them out for a good rate of return.

    Problem is that renting out real estate is penalized in the tax code under Section 469 passive activity rules and that put a major damper on this timely investment idea. While Congress and President Obama can’t turn around the housing market, they can fix this penalty and help it improve.

    Section 469 was passed to put an end to rampant use of egregious tax shelters, including real estate syndicates. Investors were deducting tax losses on non-recourse debt — in other words taking tax losses for money they might never part with, unless they had gains later on. With these non-recourse interest tax losses baked in, investors were guaranteed to win after tax.

    I want Congress to allow all real tax losses again, and only apply Section 469 to non-recourse debt, suspending those losses to later gains. Congress went too far with Section 469 by suspending all tax losses, and now that housing is suffering, it shows the mistakes Congress made.

    When I became a CPA in 1979 in New York, the city was recovering from a municipal bankruptcy. After the bankruptcy, tax shelters were all the rage and they certainly helped generate more economic activity to pull the city, state and country out of recession. Tax shelter investing helped turn NYC from bust to boom, and the economy was further buttressed under President Reagan’s fiscal policies. Tax shelters helped real estate overcome very high interest rates, which could have sunk real estate otherwise. Deducting interest on non-recourse debt was needed with very high interest rates, but it’s not needed with low interest rates now.

    Individual income tax rates were extremely high in the 1970s — close to 70 percent — and President Reagan needed to significantly reduce tax rates as part of his economic and fiscal reform package. Just like today, Democrats insisted on repealing tax expenditures and closing tax loopholes as part of that grand bargain on lowering tax rates.

    Many wealthy Democrats in NYC avoided higher tax rates with plenty of tax shelters, mostly in real estate and energy. I worked on a tax return for a family member of one of the biggest family Wall Street brokerage firms. He had close to 100 tax shelters plus very high dividends. He paid plenty in taxes. You couldn’t have 70 percent tax rates, high inflation, and 20 percent interest rates without tax shelters in real estate and other hard assets.

    The year 1986 was huge for tax reform. Tax rates were slashed, Volcker tamed inflation and interest rates and tax shelters were abolished with passage of the Section 469 “passive activity loss” rules. Entire industries including real estate tax shelters were shut down overnight. In my opinion, it was a major contributing cause to the 1987 stock market crash and related real estate market crash by 1989, which led to government bailout 1.0 with the federalResolution Trust Corp.

    Real estate recovered in President Clinton’s 1990s with low interest rates, low real estate prices, reasonable inflation and an improving economy. After the 2000 tech wreck and stock market meltdown, Fed head Greenspan used free credit policies and with corrupted mortgage GSEs, America’s economy remained afloat. Real estate prices rose and ATM home equity lines kept consumers spending.

    We’ve now come full cycle: Real estate is mired in the mud, and we need a new match to re-spark housing. Other policies and stimulus aren’t working. Interest rates are at historic lows, real estate prices are much lower, supply is plenty, yet the real estate market is not turning around.

    Take the excessive tax penalties off investment real estate and watch real estate turn around.

    Real estate entrepreneurs will grow like Apple iPhones. Just tweak Section 469 to limit its application to non-recourse debt only.

    While homeowners still receive some tax breaks — mortgage interest itemized deductions for primary and second homes on up to 1.1 million of debt — many people can’t afford to purchase homes under higher lending standards. Others feel burned and are afraid to buy again anytime soon. So, those fiscal tax breaks for housing aren’t helping much now.

    Banks don’t want to invest in real estate and they need to clean their balance sheets of home foreclosures, which are on the rise again. We need new investment pools of private investors to do what Warren Buffett recommends: buy, fix and rent out residential homes. Leaving decrepit properties on bank books is a recipe for disaster.

    Section 469 passive loss restrictions applied to economic losses is unfair and it alone is a sufficient reason for repair. It’s not fair for Congress to say that some investments aren’t entitled to true economic tax loss treatment, whereas other investments they choose are. That’s like Congress picking and choosing industries of favor with tax breaks — for example renewable energy. Why limit capital losses to $3,000 per year? A real economic loss is a loss and it should be deductible in full. By freezing tax losses, Congress freezes investments, too.

    Meanwhile, Congress didn’t shut down real estate tax breaks entirely for investment pools, anyway. While Congress took away tax breaks from private syndicates, it turned over real estate pool tax breaks to bigger players — and campaign contributors — on Wall Street with new tax-advantaged REITs (real estate investment trusts).

    Democrats are calling for redistribution of economic and fiscal tax breaks from Wall Street and the rich to Main Street and the middle class. Enabling Warren Buffett-inspired real estate investment pools with fair tax law — with my simple repair job to Section 469 — is just the ticket.

    The problem with Section 469 passive activity losses: They are currently limited to passive activity income, which is hard to find in this market. Hedge fund syndicate income is widely available and although it’s passive, Congress exempted it from Section 469 under the “trading rule,” so there is no relief. In effect, too many real estate losses are suspended under Section 469, and it’s a huge obstacle to new real estate investment.

    The phrase “passive activity” isn’t very fair. If you invest your money these days, you often conduct intensive research. Current tax law only allows “real estate professionals” spending over 700 hours per year in real estate to deduct real estate losses. Only active owner-managers with AGI income under $100,000 may deduct a passive activity loss on real estate up to a maximum of $25,000, and that amount is phased out up to $150,000 of AGI. Real estate professionals don’t have much money these days and they are a small group to begin with, so they can’t be counted on to turn the real estate market around. We need a modification to Section 469 to fix this huge problem.

    Repair Section 469 by applying its limitations to non-recourse interest losses only and exempt economic losses to cost basis, and then watch the real estate market turn around fast. This boost will generate more tax revenue than will be temporarily reduced with allowing more tax losses. It will rekindle American entrepreneurship in the real estate business, which makes America great.

    I’m calling for mini tax shelters, not old-fashioned abusive tax shelters. Going into 1986, there were tax shelter abuses, mostly from the use of non-recourse debt, and investors writing off much more than their cost basis. That abuse can be restricted with a more narrow rule change. Limit Section 469 to non-recourse cost basis only, not tax losses on cost basis — true economic losses to investors. That will put a damper on excessive use of debt in real estate syndicates, which is good public policy. Who needs excessive leverage when prices are low? Non-recourse debt was the biggest culprit in housing fraud and inappropriate behavior with too many buyers walking away when things turned bad, handing the keys back to the bank for foreclosure. (For more background on why Congress passed Section 469 passive activity losses in 1986, see our blog.)

    Modifying Section 469 is not reopening a tax loophole. The 2010 Deficit Commission, Congress and current administration want fundamental tax reform, closing tax loopholes and lowering income tax rates. Allowing economic business loss treatment is not a tax loophole. In fact, disallowing these losses is a tax penalty. The only loophole was deducting interest on non-recourse debt, and that should remain limited in Section 469.

    Fundamental tax reform is a difficult endeavor and it will most likely wait until 2013, with the next Congress and President. My simple tax repair to Section 469 is far easier, and it will have immediate and positive effect on housing. Follow the example of Steve Jobs and Apple using a simple tweak to fix a big problem.

    Our economy, business cycles and industries are dynamic and subject to creative destruction. Let’s be creative and dynamic with tax code changes, too.

    Published by: Robert A. Green/ Forbes/5-9-2012