A federal tax break that shouldn't be restored

Robert Kuttner

March 11, 1992|By Robert Kuttner

A LITTLE noticed special provision in pending tax and budget legislation would restore tax breaks for real estate that were repealed in the bipartisan 1986 Tax Reform Act.

Before 1986, there was a brisk market in paper real-estate tax losses. A developer could put little of his own money into a building, falsely claim the property was losing value over time ("accelerated depreciation") even though it was actually appreciating -- and then sell the paper losses to wealthy absentee investors in exchange for cash.

The silent partners, by paying the developer real money for a nominal share of ownership, could then use the artificial deduction ("passive losses") to shelter other income from taxation. The supply-side changes in the tax code in 1978 and 1981 made the paper losses even more lucrative.

This was bad policy in several respects. First, it made real estate artificially attractive and stimulated overbuilding -- many office buildings and luxury apartments were developed mainly for the tax breaks. This subsidy only intensified the chronic boom-and-bust cycle in real estate.

Second, it created perverse management incentives. Many developers, especially of apartments, made so much money by selling tax breaks they had no reason to stay around and competently manage the property.

It was also bad economic policy. While productive investment was declining, these tax incentives sucked capital into uneconomic real estate. During the heyday of supply-side tax loopholes, 1981-86, business investment outside of real estate didn't even keep pace with inflation.

And it was terrible tax policy. It cost the Treasury a lot of money, which added to the deficit. Well-to-do people got tax breaks that reduced their tax bills and eroded the fairness of the tax system.

In the late 1980s, the bottom fell out of the real estate market. This had many causes, including a decade of speculative overbuilding, the sudden drying up of Japanese investment, the recession and the 1986 tax reforms requiring buildings to be depreciated more realistically and removing the ability of developers to sell artificial tax losses.

Not surprisingly, this set off a chorus of demands to restore the pre-1986 tax breaks. The idea is that if real estate is again granted special tax favoritism, this will attract more investors back into real estate and firm up local real-estate markets. The rising prices in turn will help bail out banks, who are taking a bath on half-empty buildings that they financed.

The politics are also instructive. Republicans support business tax breaks as a matter of principle. Democrats, however, support these tax giveaways mainly because developers are the backbone of Democratic fund-raising.

Since most city halls are in the hands of Democrats, local developers get cozy with local Democratic administrations, because they need political contacts to cut through red tape and get their projects expedited. The local developer then becomes an obvious target for Democratic fund-raisers.

Lamentably, a majority of Democrats as well as Republicans in both houses of Congress -- prodded by their financial backers -- have co-sponsored bills to restore "passive loss" deductions to the tax code. The White House version, at least, limits passive losses to developers. The House Democratic counterpart allows the tax break to "real estate professionals," defined as any investor who spends 500 hours a year on real estate.

The Democratic version would cost the Treasury even more than the Republican version, according to the Congressional Joint Tax Committee. The Democratic version also limits the tax break to existing properties, making it primarily a bailout measure.

The real-estate lobbies are making the usual high-minded claims for narrow-interest legislation. The National Association of Realtors has circulated a study arguing that "every person in this country is being hurt by a recession that may have been milder, and less lingering, if the real-estate industry hadn't been so hard hit by the 1986 tax changes." The truth is more nearly that earlier tax breaks stimulated overbuilding.

Housing, especially for low- and moderate-income people, is a more plausible candidate for subsidy. In a flat housing market, any subsidy is better than none. But the proposed restoration of passive losses, even for housing, is a stunningly inefficient subsidy.

Three conclusions are hard to escape. First, there is no special virtue to commercial real estate. On the contrary, if there is no economic demand for an empty office building, tax subsidies will not fill it up. And there are surely more worthy candidates for investment than see-through skyscrapers.

Second, if Congress and the president desire to subsidize housing, for social purposes, they should do so directly and not via the tax code, since tax shelter erodes the fairness of the tax system. Last, whatever Congress and the White House do, they should leave things alone for a few decades. Real estate is vulnerable enough to cycles of boom-and-bust, all by itself, without loopy tax policy adding to the roller coaster.

Robert Kuttner writes a column on economic matters.

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