Tax Reform: The commercial property dilemma

Tax reform hit the national agenda with a firestorm two years ago, and each of the various proposals - flat tax, national consumption tax, business investment tax - promised to solve all the problems associated with the current tax code. Reformists proclaimed their tax solutions would abolish the incredibly complex and "unfair" existing tax system and replace it with one that is easier to understand, reduces overall tax rates, does not penalize investment and even promises lower interest rates. While none of the proposed reforms made their way into law, many in Congress now believe in tax reform and promise to develop and implement a new system no later than 2002.

Flat-tax considerations Will a new federal tax system, such as the latest "flat-tax" proposal of U.S. Rep. Richard K. Armey of Texas, be good for the commercial real estate industry? If you believe the headlines proclaiming "Less Complexity/Rewards Savings and Investment," the flat tax sounds good. That the flat tax would eliminate all capital gains taxes makes it even more appealing. But headlines do not tell the whole story. The details behind proposals for a flat-tax, a business investment tax or a national consumption tax will have a severe impact on present commercial real estate properties. A review of the flat-tax idea will demonstrate the magnitude of the impact.

At the National Multi Housing Council and National Apartment Association we began working on the tax reform issue in early-1995 to help investors, developers, owners and financiers of apartment properties understand the potential impact of each tax reform proposal. As part of that process we met with owners and investors from around the country to analyze how a new tax system would affect their individual properties. Specifically, we calculated cash flow under new and old tax law for a given building under two possible scenarios: (1) assuming the property was purchased after tax reform went into effect; and (2) assuming the property had been purchased before tax reform. Finally, we determined the impact of the new and old laws regarding capital gains tax.

The calculations quickly revealed that investments made after tax reform took effect would be treated better under a flat-tax system. Under a "flat tax" new investments can be immediately expensed. No more hassles with a 27.5-year depreciation life for apartments. Although interest expense is no longer deductible under a flat tax, the combination of immediate expensing, promised lower tax rates and elimination of capital gain tax makes the new system more attractive than our present one.

Capital gains quandary As for capital gains, as long as a commercial property owner continues to invest in new properties upon the sale of another property, that investor/owner will not have to pay any capital gains taxes. Note, there is a catch to the need for continual reinvestment which I will describe later.

Existing property focus The implications for properties purchased before tax reform took effect, on the other hand, were much more alarming. We looked at the cash flows of more than 40 properties. In every case, the tax burden would be greater, and in some cases, it would lead to bankruptcy. Most of these properties carry a sizeable amount of debt. On day one of a new tax system, however, these properties would no longer be able to deduct their interest expense. Owner/investors would also immediately lose their depreciation deduction. Since these properties would not be new, they could not be expensed. Losing their two largest deductions would spell disaster for many properties on an after-tax basis.

Surely Congress does not want to repeat the debacle of post-1986 when the passive loss rules took effect. Certainly they do not intend to send property values plummeting thus throwing the economy into a downward spiral. Do they? Our analysis leads to the conclusion that unless Congress builds a bridge to the new tax system through a transition rule, that is exactly what we can expect. The challenge, then, for the commercial real estate industry is to get from the present tax system to a new system without being destroyed in the process.

Existing properties must be able to continue with the present tax code rules regarding deductions and tax rates for a reasonable period of time, e.g., 10 years. In addition, special rules must also be crafted for capital gains taxes. Under the various proposals, paying off outstanding debt is not looked upon as an increase in savings. Therefore, the gross proceeds minus asset basis must be reinvested as a commercial property to avoid taxation. Existing properties would be locked in by such a rule.

Point of view What should people in the commercial real estate industry do? Fortunately there is still time to make your point of view known. First, do the numbers. Using a three-column worksheet, compare the flat-tax or business investment tax to your present tax situation. Assume depreciation, interest expense and local taxes (such as for water, sewer, etc.) are no longer deductible. Then assume a flat-tax rate of 20% and a business investment tax rate of 30%. Review the results and then make an appointment to meet with your elected officials to discuss the key transition rules (see sidebar) needed for all existing commercial properties.

A third type of tax reform, a national consumption tax, is not directly addressed in this analysis but does pose an additional risk for apartment properties. Under such a system, apartment rents would be taxed as consumption; either paid by the resident or the property owner. Such an additional burden on renters would most likely be rejected outright.

Major tax reform offers great promise assuming the reformers acknowledge and overcome the challenges involved in transitioning from our current income tax system. Failure to include the key transition rules will either doom reform efforts or produce a system that will cause serious economic upheaval and tremendous capital dislocation.

James N. Arbury is vice president of tax for the National Multi Housing Council based in Washington, D.C., and its Joint Legislative Program with the National Apartment Association.

To prevent severe economic dislocation and upheaval, the following transition rules for commercial properties owned before tax reform are absolutely essential: * Deductions for interest paid and depreciation must be al- lowed to continue for a reasonable period of time, e.g., 10 years. * Concurrent with deductions, present tax rates could apply for these property investments. * Only capital gain after deducting basis and the amount of any outstanding debt should be taxed if not reinvested.

Multifamily Housing is a column from the National Multi Housing Council.

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