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NAR Comments on Reform Draft

January 17, 2014

On Jan. 16, 2014, NAR joined with a group of 18 other real estate associations in sending a comment letter to Senate Finance Committee Chairman Max Baucus (D-MT) regarding a staff discussion draft released by the Committee on Nov. 21, 2013.  The discussion draft, one of a series of such drafts that set forth possible options for tax reform, was focused on cost recovery and tax accounting issues.

The Finance Committee draft included several proposals that would, if enacted, have serious negative effects on the investment in and ownership of commercial real estate.  These include proposals to:

Increase the depreciable life of all real property to 43 years (the current tax law provides a depreciable life of 39 years for non-residential property, 27.5 years for residential property, and 15 years for qualified leasehold improvements*).

Repeal the provisions in section 1031 of the Internal Revenue Code, which allow owners of real property to exchange it for like-kind property on a tax-deferred basis.

Change the tax rate of gain on sale of real property that represents depreciation recapture from the current-law rate of 25 percent to ordinary income tax rates.

In short, the letter argues that the Committee’s cost recovery and accounting tax reform discussion draft could have a severe, widespread, and chilling effect on U.S. real estate activity.  By creating an arbitrary and discriminatory cost recovery system that is disconnected from the economic life of actual structures, the proposed reforms would reduce real estate investment and development, result in lower real estate values, and stifle the real estate industry’s ability to continue creating new jobs as the economic recovery picks up steam.

The following is a summary of the 17-page comment letter:

The letter focuses on four main elements of the tax reform proposal:  (1) the extension of the cost recovery period to 43 years for all real property; (2) the repeal of like-kind exchange rules; (3) the increase in the tax rate on recaptured depreciation; and (4) the retroactive application of all three of these proposals to preexisting investments.
We see a strong a parallel with the unintended consequences that the sweeping reforms enacted in the Tax Reform Act of 1986 had on real estate in the late 1980s and early 1990s, when retroactive tax changes ushered in a real estate depression and led to the taxpayer bailout of savings and loan institutions.  In many respects, the proposals in the discussion draft go beyond the prior reforms by raising taxes on sound and economically motivated real estate transactions.

First, modernizing cost recovery rules to accurately measure business income would require reducing, not lengthening, the depreciation schedules for real property.  Today’s depreciation system is less favorable for real property investment than at any time in the last 40 years.  Unfortunately, the depreciation estimates underlying the discussion draft rely on outdated studies from the 1960s and 1970s.  Recent research by a broad range of economists, academics, and government agencies has shown how technological change, transformations in the workplace, and other factors affect the useful life of structures.  Without constant capital improvements, buildings become obsolete faster than ever.

Second, the deferral of gain on like-kind exchanges is a bedrock principle of tax policy and the statutory rule is nearly as old as the income tax itself.  Rather than raising revenue, the proposal in the discussion draft to repeal like-kind exchange rules would have the undesired effect of “locking up” real estate assets in the hands of current owners.  It would deter the transfer of real estate to owners with the resources to invest in job-creating building upgrades and improvements, undermine land conservation efforts, and deprive states and localities of much-needed tax revenue.

Third, by treating all recaptured depreciation in real estate transactions as ordinary income, the discussion draft would raise the tax rate nearly 60 percent on a significant share of the income from real estate transactions.  The proposal would reverse the longstanding Congressional policy of applying different depreciation recapture rules to long-lived, capital-intensive real estate assets, where gain is more likely to reflect inflation than excessive depreciation.

Fourth, in applying all of these provisions to preexisting real estate investments, the discussion draft would penalize taxpayers who relied on well-established tax rules when committing their capital and sweat equity to a long-term investment.  The retroactive application would undermine confidence in the tax system and raise doubts about future “rules of the road” for capital-intensive property investments.

The signatories are also concerned  with the proposed repeal of the energy-efficient commercial buildings deduction, section 179D, which helps address a failure of the market to accurately take into account the value of energy-efficiency improvements to commercial buildings.

We recognize that the discussion draft is a first effort, the issues are complex, and the tradeoffs are significant.  As mentioned, we are very grateful for the transparent and open process the Committee has created.  With the right tax and regulatory policies—reforms that treat the industry consistently with other types of businesses, assure predictability for long-term investment, recognize the economically useful life of assets, and encourage capital formation—we believe real estate could create millions of new, middle-class jobs while also contributing to a more efficient and productive domestic economy and workforce.

The comments represent the collective and unified views of the real estate industry on the issues and proposals raised in the draft, and the letter has been signed by 19 real estate-related trade associations.  The signatories include:

The Real Estate Roundtable
American Institute of Architects
American Land Title Association
American Resort Development Association
Appraisal Institute
Associated General Contractors of America
Building Owners and Managers Association International
CCIM Institute
Institute of Real Estate Management
International Council of Shopping Centers
NAIOP, the Commercial Real Estate Development Association
National Apartment Association
National Association of Home Builders
National Association of Real Estate Investment Trusts
National Association of REALTORS®
National Multi Housing Council
Real Estate Board of New York
REALTORS® Land Institute
Society of Industrial and Office REALTORS®

(* The provision allowing a 15-year depreciation period for qualified leasehold improvements expired at the end of 2013.)

Comment Letter to Senator Baucus