The Impact of Tax Policy on Commercial Real Estate

Article excerpt

For many years it has been governmental policy to encourage home ownership and to provide decent housing for the citizens of this country.

FHA and VA programs were begun in the 1930s and 1940s to provide lowcost, high-ratio loans to home purchasers. Interest on home mortgages has been deductible as a part of tax policy to make home ownership affordable. With inflation a significant factor after World War II, a tax policy allowing people to sell a home and reinvest in a more costly home while deferring any capital gains was instituted.

The real estate industry has always been very sensitive to changes in interest rates. Times of tight monetary policy and high interest rates have always caused drastic reductions in home sales and new construction.

The ownership of a single-family home has always been considered the American dream. However, many people still have been unable to become homeowners. For these people, the rental housing market has been the only alternative.

Governmental policy has typically addressed the needs of low income tenants in two ways. First, subsidies have been utilized, either as direct payment of a portion of the rent as in the HUD Section 8 program or as an indirect subsidy by granting favorable mortgage rates to the building owners to encourage construction of low-income housing. The second method of encouraging rental real estate has been to provide tax benefits to the owners of commercial real estate. This article will examine this area and the changes that have occurred over the last 15 years.

Tax policy

Real estate ownership has historically provided several ownership benefits. The purchase could be leveraged using borrowed funds. In inflationary times the value of the asset has traditionally increased at least as rapidly as the rate of inflation.

A significant amount of the income stream would be sheltered by the allowable depreciation. Any losses would be written off against any other income source. This was very significant for the high-income, high-tax-bracket owner because it gave a cushion for the risk being taken.

Lastly, the proceeds of the ultimate sale of the property would be taxed at a rate significantly lower than the owner's normal tax rate. The use of depreciation was not a tax avoidance method but rather a method of delaying the tax and converting it from a tax on ordinary income to a tax on capital gains.

Figure 1 charts the changes in tax policy from 1975 to 1990. The typical investor in commercial real estate is a high-tax bracket individual, so any change in tax policy will have an immediate effect on his or her willingness to keep or increase a real estate portfolio.

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Figure 1 clearly shows several major shifts in tax policy. The top tax rate has declined from 70 percent to 28 percent. The capital gains rate started with 50 percent of the gain being taxable, and dropped to 40 percent of the gain being taxable. Now the gain is fully taxable at a maximum rate of 28 percent.

Depreciation rates have varied greatly. Perhaps the most damaging change in policy for the real estate investor was the change in the 1986 Tax Act eliminating the ability to write off passive losses against ordinary income. This single change removed the limited partnership syndications from the field of players.

Figure 2 is a simple illustration of the change in the benefits provided by depreciation. The illustration assumes a $1 million purchase, with a down payment of $250,000 and the balance conventionally financed. It also assumes that the building at least breaks even.

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The illustration clearly shows that the government tax policies have caused wild gyrations in the benefits available to an owner of real estate. …