August 26, 2007
May 8, 2012
Real estate tax mini-shelters could turn economy
By Robert A. Green, CPA
Forbes blog version: 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 Buffett recently 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. But renting out real estate is penalized in the tax code under Section 469 passive activity rules and that puts a major damper on this timely investment idea. While Congress and the President can't turn around the housing market, they can fix this penalty.
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 the tide went out, to paraphrase Warren Buffett. Don't throw the baby out with the bath water and allow these mini-tax shelters based on recourse and real economic losses. This tax repair job is simple and positive. But it's a negative for politicians to jawbone banks and for mortgage investors to write down mortgage debt.
When I became a CPA in 1979 in New York City, 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 federal Resolution 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 entrepreneurism 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.
How to deduct a loss on the sale of your home, avoid debt extinguishment income in foreclosure and deal with abusive mortgages
Traders and others should start focusing on tax and legal planning in connection with declining real estate values and (predatory) mortgages.
Learn how to convert non-deductible losses on the sale of your home into ordinary loss tax deductions.
If you face foreclosure, learn how to avoid phantom taxable income on debt extinguishment by claiming insolvency.
Finally, did your bank or mortgage broker sell you a fraudulent mortgage that was the worst available product and can you get it fixed, without incurring too much pain? Read the NY Times Sunday 8/26/07 expose article on the (predatory) unsavory sales practices at Countrywide (the largest mortgage broker). Countrywide promised the “best” mortgage product, but highly compensated their brokers to instead sell customers the “worst” mortgage product. Isn’t that fraud?
Convert non-deductible home sale losses into ordinary and capital losses
There is a nasty flipside to the tax-beneficial rules of owning your principal residence. Yes, the capital gains are tax-free until you exceed the home sale exemption amounts: $250,000 for single status and $500,000 for married filing joint status.
But tax losses on the sale of your home are not allowed! Few taxpayers realize this unfortunate tax fact until it’s far too late.
If your real estate is not your principal residence, it can be deemed an "investment property" and normal capital gains and loss rules apply. But then the dreaded capital-loss limitation of $3,000 comes into play. Add stock losses with declining markets to the mix and you are again stuck with unutilized losses.
We saw a huge housing price correction before, in the late 1980s and early 1990s. Here's a nifty tax planning strategy that worked well then and should work great again now in this correction:
Rather than incur a non-deductible loss on the sale of your principal residence, convert your home to a rental property first (a short period of time can work) and then incur an (allowable) ordinary tax loss on Form 4797.
There are some nuances to this tax strategy, so check with an expert (such as our firm). When you convert your property to a rental property (income-producing use), you are supposed to use the lower of cost or fair market value (FMV). But FMV on an illiquid and unique home is not readably available, so there is some leeway here.
Avoid phantom income taxation in foreclosure
If you can't pay your mortgage and you suffer home foreclosure, understand that you will be given a Form 1099 for debt extinguishment income from your lender. That's taxable income on your tax return.
But there is a way out of this income. If you are financially insolvent (negative net worth) at the time of debt extinguishment, you don't have to report that phantom income. Many who face foreclosure are probably insolvent.
Demand that your broker and bank fix your mortgage
After you read the NY Times article on the alleged wide-scale abusive sales practices of Countrywide, you should examine your own mortgage loan terms carefully and consider engaging an attorney to help you. I am guessing these types of abusive lending practices are more widespread and not unique to any one mortgage broker.
Don’t think the term “predatory” only applies to sub-prime mortgages for lower income people. Reports of wide-scale lending excesses based on poor credit and highly risky loan terms (zero down payments) seem to support the position that abusive mortgage sales practices were used by many providers across the board, especially if the underlying loans could be repackaged as mortgage-backed securities and sold to unsuspecting investors. This process took the cooperation of several (knowing and perhaps conspiring) banks and brokers.
In my initial view, many mortgage holders can probably engage an expert to review their mortgage terms to hunt for conflicts of interest, compensation tied to selling them the inappropriate terms and other abuses.
These types of abusive lending practices seem very worthy of wide-scale legal attack by consumers and regulators (who are charged with protecting consumers). Maybe it’s not on the scale of asbestos and tobacco, but it’s still very important to millions of families. Fraudulent lending practices may not kill you from a health standpoint, but over-burdening fraudulent mortgages are destroying many people’s finances, which can go on to ruin families and health. Will families have to cancel health insurance to pay for fraudulent mortgage interest-rate hikes and endless fees?
I don’t think everyone should just pay for these abusively generated mortgages without a fight first. Will judges award home deeds to (perhaps fraudulent) abusive mortgage holders in light of this fiasco? I imagine that several law firms will start class-action lawsuits against these mortgage brokers and banks soon to get to the bottom of these abusive lending actions. Many mortgage brokers that have not already succumbed to market changes will go out of business to avoid this onslaught. In my view, this is Enron-like, only on a much bigger and wider scale.
If attorneys do attack mortgage brokers, don’t you think it’s “catching a falling knife” to buy mortgage lenders’ stocks now? Don’t misinterpret recent investment and loan support from larger banks to distressed mortgage brokers; that may be an effort to constrain legal attacks away from their own borders. Again, the mortgage brokers cooperated closely with other banks to package and sell these mortgage-backed securities based on carefully constructed excess (rather than reduced) risk. Isn't that a conflict of interest, too? Shouldn't the cooperating banks try to assemble lower-risk securities, rather than building excess risk? If the securities fail, shouldn't the seller of the securities be liable for the losses if they built in excess risk on purpose and did not disclose it (just to get more fees for themselves)?
This mortgage meltdown story is getting bigger, not smaller, in my view. I fully support the Federal Reserve Bank for adding liquidity and lowering the discount rate. In my view, that is putting out financial market fires (that can burn everyone), and that’s not a moral hazard. But it will be a moral hazard for regulators to interfere with (coming) legal attacks on mortgage brokers and banks that participated in these alleged abusive sales and business practices.
Here’s the bottom line:
If you have a brewing loss on a recently purchased home, consider converting it to a rental property, so you can deduct your loss for tax purposes. If you can’t pay your mortgage and you get foreclosed, don’t get hit with a tax bill on that phantom income by reporting insolvency. If you think you were subjected to abusive lending practices and you face high adjustable interest-rate hikes plus fees, seek legal help before proceeding.
Feel free to contact our firm for help. We can help plan and execute the above tax strategies. We can also refer you to legal counsel, although we don't know any law firms that have taken on this challenge yet.
Robert A. Green, CPA & CEO