What Do We Want From Tax Reform?
Today is tax day, when millions of Americans are rushing to meet the deadline for filing their federal income taxes. Around this time, we usually hear about the excessive complexity of the tax code, the compliance burdens on individuals and on businesses, and the costs to our economy in lost productivity. Politicians talk about the need for comprehensive tax reform. In that regard, today is also the deadline set by the Senate Finance Committee for industry comments on reforming our tax system. NAIOP submitted its comment letter last Friday.
The major points in our letter are explained below. Before getting to that, however, we need to put tax reform in the right context. NAIOP members are a patriotic bunch. They understand that simplifying the tax code involves tradeoffs, with some provisions benefiting specific industries needing to be discarded for the greater good. Few want to pay higher taxes without a compelling reason, but all would pay their fair share for the good of the nation. The message that tax reform will lead to lower taxes and economic growth, with only the “special interests” losing out, has a very strong populist appeal, and is the go-to rhetoric for elected officials.
The problem, as you may have guessed, is that the people hearing that message – including NAIOP members – assume “reform” will result in positive changes from their perspectives. When NAIOP members learn that some tax changes would treat tenant-build-outs on five-year lease space as lasting for more than four decades, they respond by saying, “Oh, no, they can’t really believe that.” When they hear that some in Congress want to take away capital gains treatment from real estate partners who get a “promote” or “carried interest,” saying that it should be treated as if it was a guaranteed salary, our members think, “Don’t they know the many risks developers take?” Once these proposals see the light of day, our members take seriously the cliché that “the devil is in the details.”
Tax changes driven more by short-term budgetary goals rather than long-term pro-growth policies can have unintended and negative consequences. These aren’t idle concerns; we have historical experience. The 1986 Tax Reform Act caused severe economic disruption for the industry. Changes to partnership “passive loss” rules, applied retroactively, caused a drop in valuations and a market downturn. This contributed to the savings and loan crisis and an eventual taxpayer bailout. Afterwards, a “credit crunch” plagued real estate for years. Clearly, these aren’t the types of outcomes you want from comprehensive tax reform.
Our letter responding to the Senate Finance Committee’s request for input recommends a set of organizing principles which, if followed, should lead to positive reform:
Promote economic growth and support capital formation. We need to encourage entrepreneurship and responsible risk-taking. A lower tax rate for capital gains than ordinary income is critical to reward entrepreneurs who take long-term risks. Congress should refrain from eliminating those aspects of our code that facilitate the efficient allocation of capital among real estate. Tax deferral on like-kind exchanges under current Section 1031 helps this function. Eliminating them would increase the chances that owners unable to invest needed capital for repairs are “locked-in,” unable to transfer a property to a willing investor due to the tax liability. Carried interest compensation should be taxed as capital gains – it is a reward for undertaking development risk and is not guaranteed ordinary income salary.
Recognize the true economic life of assets for cost recovery purposes. Depreciation should accurately reflect the true economic lifespan of assets. Leasehold improvements customarily last for the length of the average lease: about 5-10 years. Fifteen-year leasehold improvement depreciation should be a permanent feature of the tax code.
Provide stability and predictability, creating a more favorable investment environment. Congress should not rely on short-term extensions of expiring tax provisions that are good tax policy. Make them permanent.
Support investments that help achieve broadly-supported public policy goals. In a few instances, economic realities, upfront costs and return on investment calculations prohibit businesses from achieving broadly-supported societal goals, such as advanced levels of building energy efficiency. If the goals are important enough and widely shared, incentives such as Section 179D need to be maintained.
Provide for adequate transition rules. The 1986 Tax Reform experience is important. If you change the rules, you need to give the markets enough time to adjust. As much as possible, the impact of tax policy changes should be prospective, not retroactive.
We will work with elected leaders on a fairer, simpler tax system. Getting tax reform right is incredibly important to the future of our industry. We need to look beyond the appealing message of tax simplification, and understand that unwise tax reform could do serious harm.
