Financial and tax policies of the United States government can help Americans achieve significant wealth through real estate ownership. These policies tend to favor taxpayers who, like the Trump family, are willing to commit to “the long game”, where the full benefits of real estate ownership accrue over decades and even generations.
This Blog reviews some of the more important financial and tax policies favoring real estate ownership. Many of these policies benefited Donald Trump and his family, but anyone can use them. The description of these policies has been slightly simplified for ease of reading. Accordingly, this blog does NOT constitute financial or tax advice.
Financial and Tax Policies of the United States Government Favoring Long-Term Borrowing
1. A 2% “target” inflation rate coupled with long-term loans that are repaid without an inflation adjustment are a potent combination. Specifically:
The United States is committed to providing long-term residential mortgages for up to 30 years and long-term commercial mortgages with amortization periods of up to 25 years, without inflation adjustments.
Note: Commercial mortgages with long-term amortization periods are offered under the so-called 504 program of the United States Small Business Administration.
Inflation is a form of wealth transfer where purchasing power is transferred from creditors (pension funds and banks) to debtors. The Federal Reserve has a “target” target inflation rate of 2%. Two percent may not appear significant, but over time the “target” rate of inflation can result in very substantial transfers of wealth.
For example, over the 30 years of a standard residential mortgage, a $100,000 mortgage (after 2 percent inflation, compounded annually) becomes worth about $55,200. This means that inflation has resulted in the transfer of $44,800 of purchasing power from lenders to borrowers. This example is realistic for owners who expand their real estate portfolios by re-borrowing the repaid equity of a mortgage to invest in other real estate purchases.
Note: While the purchasing power of debt decreases, the fair market value of both the real estate and the rental estate rentals keeps pace with inflation.
2. Interest payments made on long-term mortgages are generally deductible for purposes of the United States income tax. This represent tax forgiveness, a tax subsidy granted to homeowners, but not to tenants.
3. Commercial real estate may be depreciated for tax purposes. Depreciation is a non-cash expense that offsets rental and business income. This “depreciation offset” often approximately equals the annual principal amortization of real estate mortgages. As a result, the income taxes on income used for principal repayment is deferred.
Note: Depreciation, however, might result in a higher capital gains tax (25% in place of 20%) on the recaptured depreciation (so-called “unrecaptured Section 1250 gain”) when the real estate is eventually sold.
Tax Policies of the United States Government Benefiting Home Ownership
Some significant policies which favor home ownership are:
1. The Deduction for Mortgage Interest. As noted above, mortgage interest is generally deductible and represents a tax subsidy granted to homeowners, but not to tenants.
2. Section 121 Planning. The tax code permits couples filing joint returns to avoid up to $500,000 in capital gains on the sale of their primary residence. They can take advantage of this exclusion every two years. There are even special rules to exclude gain where the taxpayers sell land contiguous to a principal residence in a separate sale within two years before or two years after the sale of their principal residence. This represents tax forgiveness and recognizes the unfairness of requiring homeowners to report capital gains arising from inflation-fueled price increases.
3. The Solar Energy Credit. Many homeowners are now installing solar energy panels on the roofs of their homes. Generally, 30 percent of the cost of solar energy panels are creditable against the homeowner’s income taxes. A credit is a dollar-for-dollar reduction of the homeowner’s income tax. Solar energy credits not used can be carried forward indefinitely and used to offset income taxes in subsequent years. Massachusetts also has a solar energy credit program. This tax forgiveness also represents a tax subsidy granted only to homeowners.
Favorable Tax Rates for Real Estate
1. Capital Gains vs. Ordinary Income. Typically, real estate gains are subject to capital gain treatment and result in a 20 percent capital gains rate, but 25 percent for recaptured depreciation.
2. Commercial Real Estate: “Heads You Win, Tails the Government Loses”. Gains arising from commercial real estate receive capital gains treatment. Losses, however, are treated as ordinary business losses and may result in net operating losses that can be carried back for 2 years and forward for 20 years. These net operating losses can offset ordinary income and result in refunds and reduced taxes.
Deferrals of Real Estate Income and Losses
1. Depreciation. As noted earlier, depreciation provides a current non-cash tax deduction against income arising from real estate ownership – even if the real estate is appreciating in value. Thus, depreciation is a form of tax deferral granted to owners of commercial real estate.
2. Section 1031 Swaps. Section 1031 swaps of real estate held in a business or for investment can help taxpayers defer capital gains taxes arising from the exchange of properties. The computation of the deferred gains is complicated when the properties being sold or the properties being acquired are encumbered by mortgages. The use of Section 1031 swaps also may limit future depreciation deductions. Finally, there are strict statutory requirements to achieve tax deferral.
3. Deferring Gains and Recognizing Losses Through Installment Tax Accounting. Owners may sell a “basket” of commercial real estate holdings: some at a gain, and some at a loss. The taxation of gains are deferred and are recognized for tax purposes only as the buyer makes the installment payments. But losses are immediately recognized. These losses are treated as net operating losses that can be carried back for two years and forward for 20 years. As a result, owners who use installment tax accounting can sometimes achieve significant tax refunds from the carryback and carryforward of losses even if the overall transaction results in a significant gain.
4. Suspended Tax Losses. Tax losses in excess of rental income are deferred through the so-called passive loss limitation. But deferred losses are not lost. Rather, they are “suspended” and are deductible when the owner disposes of the real estate in a taxable sale.
A Step-Up in Basis at Death Sometimes Makes Tax Deferral Permanent
When real estate is part of a decedent’s gross estate, it generally receives a step-up in basis to the property’s date-of-death value and built-in gains are forgiven. As a result, tax deferral savings arising from Section 1031 swaps and from depreciation become permanent tax savings. Under Donald Trump’s tax plan, however, these forgiven gains are limited to $10 million.
Note: Gains deferred through installment tax accounting, however, must be recognized in full when received as “income in respect of a decedent”.
Grantor Retained Annuity Trusts
Under Donald Trump’s tax plan, the so-called “death tax” will be eliminated. In exchange, built-in gains over $10 million must be recognized when realized by the decedent’s estate and its beneficiaries. See above.
Under current gift and estate tax law, real estate owners can achieve a similar result by using Grantor Retained Annuity Trusts (GRATs). Basically, the real estate owner transfers income-producing real estate, without consideration, to an irrevocable trust, but retains for a term of years an annuity payment, payable at least annually. The annuity payment, for the purposes of calculating the taxable gift, is equal to the IRS-computed interest rate under Section 7520 in effect at the time of the property transfer TIMES the fair market value of the real estate property that is transferred. This is also referred to as the retained interest.
The amount of the taxable gift is value of the property transferred to the GRAT reduced by the retained interest. This is the remainder interest. Even at the current historically low interest rates these discounts to the remainder interest are considerable. If the original owner of the gift survives the annuity term, the transferred real estate is NOT included in the donor’s gross estate. Instead, the property in the GRAT passes to the beneficiaries, as do any built-in gains (there is no step-up in basis on this property at the donor’s death). When the gift is offset by the current life-time gift tax exemption, GRATs often allow real estate owners to pass down to the next generation well over the value of the real estate contributed without incurring additional United States estate and gift taxes.
For Example: Assume that spousal owners jointly transfer income-producing real estate worth $12 million to a GRAT. The donors retain an of annuity for ten years based on the December 2016 Section 7520 interest rates published by IRS, currently 1.8 percent or $216,000 per year. Under the GRAT discount rules, the taxable gift is discounted to just over $10 million. We will also assume that the annuity payments are consumed by the donors for the payment of income taxes and/or personal living expenses.
If the real estate owner and his spouse have not previously utilized their lifetime gift tax exemptions of $5.45 million per marital partner, $10.9 million for a married couple, the entire $12 million transfer is offset by United States gift and estate tax lifetime exemptions and through consumption. Moreover, any appreciation in the fair market value of the gifted real estate escapes estate and gift taxes if the grantor survives the duration of the GRAT.
Example Continued: As interest rates rise, the amounts of the valuation discounts based on the retained interest will also rise. Thus, in December 2007 – nine years ago – the Section 7520 interest rate published by IRS was 5 percent. At this interest rate, the $12 million transfer would have been discounted to a $7.37 million taxable gift.
Note: To avoid inclusion in their gross estates, owners using GRATs must survive the annuity term. To hedge their mortality risk, real estate owners typically use two or more “laddered” GRATs with terms of 5, 10, 15 and even 20 years.
Note: The discount from fair market value arising from the use of GRATs is NOT disturbed by the elimination of minority discounts under the proposed Treasury regulations to Section 2704.
Tax Policies Benefiting Debtors in Foreclosure
Foreclosures typically result in two reportable transactions:
The difference between the fair market value of the property and its adjusted basis may constitute gain or loss.
Note: Of course, the foreclosure of a non-business asset, such as a principal residence, does not give rise to a deductible loss.
The difference between the mortgage obligation and the lower fair market value of the underlying property may constitute cancellation of indebtedness income. Different rules apply when the debt is non-recourse: that is, debt that attaches to the real estate but is not the legal obligation of the owner of the real estate.
Note: Taxpayers who avoid cancellation of debt income have to forgo “tax attributes” such as net operating losses.
Successful financial and tax planning requires a detailed understanding of relevant tax law as applied to the facts of each specific case. Often, it is necessary to “run the numbers” to confirm that the anticipated financial and tax benefits can, in fact, be achieved.