DESTROYING REAL ESTATE THROUGH THE TAX CODE
By Roy E. Cordato, Senior Economist, Institute for Research on the Economics of Taxation. Excerpted with permission from a policy bulletin, published the Institute for Research on the Economics of Taxation (IRET), February 12, 1991.
The sharp decline of the real estate industry occurring over the past five years is a primary reason for the current recessionary woes. Many of the problems in real estate markets since 1987 can be traced to tax code changes that were made in 1986. In constructing TRA 86, legislators could not have done a better job of destroying this market if they had consciously set out to do so.
All of the important evidence shows that a serious downturn in housing starts and real estate markets began shortly after the enactment of TRA 86. Three major changes in the tax law contributed to this result: 1) the elimination of the capital gains tax differential; 2) the passive loss limitation rules; and 3) the lengthening of the tax write-off period for real property. Each of these changes represented a movement away from economically efficient tax policy. Combined, these changes made investment in new housing and construction less attractive and reduced the market value of existing real estate by creating an incentive to unload properties while increasing the difficulty of doing so.
Increase in Capital Gains Rate
Probably the most widely debated change to take effect was the increase in capital gains tax from a top marginal rate of 20% to a high of 33%. More concretely, someone in the top tax bracket who made an investment in real estate before 1986 expecting to keep $.80 on every dollar of capital gains was suddenly faced with a situation in which that return would be reduced to $.66 if the person were in the new 33% tax bracket (i.e., the bubble) or $.72 if they were in the 28% bracket. This depressed the value of real estate, in turn causing property values to decline. Many profitable real estate investments became marginal or submarginal.
Increase in Depreciable Lives
Adversely affecting real estate even further was TRA 86's lengthening of the write-off period for depreciable real property. This also had the effect of further reducing the market value of real estate.
Before 1986, under the Accelerated Cost Recovery System, the cost of an investment in real property could be written off over 19 years, using the 175% declining balance method of depreciation. This method allows a larger proportion of the investment cost to be written off in the earlier years of the depreciation period. TRA 86 not only lengthened the cost recovery period of most real property -- non-residential property to 31.5 years and residential rental property to 27.5 years -- it also eliminated the 175% declining balance write-off method. Instead, it required the use of the straight-line method.
The changes in the cost recovery provisions significantly decreased the present value of real property tax write-offs and, hence, increased the present value of the taxes to be paid on the returns on investment in such property. The result was a reduction in the value of these investments. By increasing the cost recovery period over 60% and by shifting much of the cost that could be recovered from the earlier to the later years, TRA 86 decreased the value of real estate both to current holders and to all prospective buyers.
Attempts to Level the Playing Field
At the time TRA 86 was being debated, some argued, as a justification for the change, that the pre-1986 tax treatment of real estate provided a tax preference for investment in real property. Because of this, it was argued, the tax law was causing inefficient over-investment in real estate at the expense of more productive investment in other kinds of capital. The change in the law was seen, then, as a move in the tax code to a more efficient treatment of real estate investment. …