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To be sure, more than most other groups, the real estate industry has had success at the national level in preserving incentives in the federal tax laws for real estate. For commercial residential real estate, like-kind exchange rules have allowed transfers of commercial property without taxation. Some commercial real estate companies and managers benefit from the low income housing credit and tax-exempt bond financing. Despite these spoils of the annual tax battles, a tax system based on income seriously disadvantages commercial real estate. The disadvantages far outweigh any advantages under current law. There are, of course, the problems germane to all taxpayers. Our tax laws are complicated and waste literally hundreds of billions of dollars in compliance costs. The growth of the economy is slower than need be. Commercial property, however, is disadvantaged in unique respects. The "income" tax system is irreparably flawed since it effectively taxes property owners multiple times: from investment, to operation to final sale. Interest rates are higher than need be because of the taxation of savings and interest as income, and economic growth is stifled by a system that penalizes savings investment. Any income from rentals are taxed when received. What remains, if reinvested into capital improvements, must be depreciated over a term of years rather than deducted as an expense. If commercial real estate is sold, "capital gains" are taxed again although the capital gains tax really represents double taxation of a higher future income stream and its capitalization and is a tax on inflation. Finally, death taxes often result in a government-orchestrated leveraged buy-out of the property. Fierce competition for housing tax credits has driven more developers to apply for ax-exempt bond financing. Because of intense demand for the bond allocations, even the tax-exempt bond allocation process has become very competitive and political. The FairTax™ holds out the promise of being simple, inexpensive, understandable, administrable, visible, equitable and respectful of privacy rights. The FairTax™ would replace all income taxes and all payroll taxes with a simple national retail sales tax. The plan would also provide a rebate, monthly in advance, to each household of sales taxes paid on spending up to the federal poverty level. Under the FairTax™ plan real estate income and the underlying asset's capital gain will be taxed only when spent at retail establishments to finance consumption. The plan would not impose any tax whatsoever on income, savings and investment. This will enhance "after-tax" returns both on the rental income and on capital gains. When the income tax system is abolished and taxes on rents are removed, profit from rents and from capital gains will increase. Moreover, the value of real estate will increase with economic growth. The FairTax™ will also enhance returns by lowering interest payments by an estimated 200 basis points partly because of the huge tax incentive to save and partly because the interest income will not be taxed to the financial institution. Finally, the FairTax™ will lower tax compliance costs by more than 90% and the removal of these costs will force prices down even lower. Let us take a specific factual scenario to answer the question: "how will existing owners of commercial properties be affected?" To determine this, let us propose a specific factual scenario that lists the following salient factors.
It is useful, for purposes of this example, to compare the FairTax™ to the current law. Current Law Under current law, the rents received, in the amount of $3,067,000 would be realized gain that would be offset in part with depreciation of the capital assets and expenses. The expenses would include those permitted under section 162 of the Internal Revenue Code, including payroll at $177,000, repairs and maintenance at $207,000, property taxes at $339,000, the utilities, interest expense and miscellaneous expenses (identified as other). Under the example, the total allowable expenses are $2,236,000 before depreciation. For a net income before depreciation of $831,000. With depreciation of $425,000, the net income is $416,000. How much in taxes was paid under current law for the rental of the building depends on a couple of factors. First, since we assume that $177,000 was paid in payroll, we might also assume that at least the employer share of 7.65 percent was paid by the owner. Hence, at least $13,540 was paid in payroll taxes. We do know that $416,000 was income, and we can assume from this that the taxes on the income might have been in the order of 30 percent, or $124,800. If these were all the taxes paid, our combined total would be $145,457 by the apartment owner. However, our analysis would be deficient in two major respects. First, because much of the income was "deferred" by operating and depreciation expenses, we were able to transfer some of the income as appreciation to be taxed upon sale or exchange as opposed to current earnings presently taxable. We already know, for example, that the building has an asset basis of $14 million and a fair market value of $28 million. If the building were sold for its then fair market value, the owners would have a $21 million loan liability to pay off and yet have at the same time $14 million in capital gain. Even assuming that this capital gain were taxable at a rate of 20 percent, the tax on that gain would be $2.8 million. It may be much higher due to recapture rules. In what year should we consider that capital gain to be paid? If we assume that the capital gain is really paid over the course of a thirty year period, it would result in a tax of about $93,000 per year. Looked at another way, the present discounted value of a $2.8 million capital gains tax ten years from now using a ten percent interest rate is still over $1 million. Second, we have forgotten about the death taxes. If a single owner were to die with the value of the property in his estate, a death tax of at least $7 million times 50% would result, for a tax of $3.5 million. If we also assume for the moment that this tax is payable over 30 years, the tax on an annualized basis would be $116,700. The total annual tax liability of the property, taking into account capital gains and estate and gift taxes, can therefore be roughly estimated to be $376,614. One more point should be noted. Under the income tax world we generally do not assume that the owner of the apartment is taxed on the payments for rent for a residential lease by virtue of the fact the lessee had to pay the tax with after income and payroll tax dollars. However, rents today must be paid from after-income-tax and after-payroll-tax dollars. For example, to pay $1,000 in rent a typical middle class taxpayer must earn $1,554 today. This detracts from the resources available to pay rent or make any purchase and this factor become relevant when we move to a consumption-based approach on which income is not taxed but purchases are taxed. Under the FairTax™ The FairTax™ would repeal the income tax. Thus, rents received would not be taxable to the building owner, there would be no depreciation deductions or interest paid deductions since there would be no income tax against which to deduct them, and there would be no capital gains tax since the income tax is repealed. The $416,000 net income would not be subject to tax. The FairTax™ would also repeal the payroll taxes. The $177,000 includes some employer payroll tax. If all of the owner's payroll were subject to the Social Security portion of the payroll tax, the amount saved would be $13,540. Finally, there would also be no death taxes. As a result, the building owner could be said to save upwards of $374,614. There is also the savings in compliance costs. Some of the operating expense might be attorney fees and tax reparation fees, which will reduce significantly under the FairTax™. We might say that that concludes our analysis. No taxes are imposed on the owner. Moreover, the income tax for the lessee is replaced with a tax on consumption for the lessee. There are three sales tax scenarios that need to be compared for a better understanding. The case of the commercial rent is one scenario. Although the income tax would be repealed, the commercial rent would not be subject to sales tax. If the rents were paid by businesses, there would be no sales tax imposed. The FairTax™ does not tax business-to-business transactions. Only sales to consumers are taxed. In this example, the after-tax return would go up by the amount of the income, payroll, capital gains and death taxes that the owner does not have to pay. In a second scenario, the rent is subject to sales tax since the rental property is a residence and leased to a consumer. If the rents were paid by consumers (for example, for an apartment residence) then the rent would be subject to sales tax. This sales tax would be added onto the rent and separately stated. In this case, it is quite possible that landlords will be able to add the sales tax on to the rent. In this way, the tax would fall forward or alternatively stated, the incidence of the tax would fall upon the consumer. Consumers will have much larger paychecks since income taxes and payroll taxes will no longer be withheld from their paychecks (more $1-1/2 trillion additional will be in paychecks). They will therefore have the funds to pay the sales tax and demand will remain strong. The relative price of apartments compared to all other alternative consumption goods will remain the same. Recall that rents today must be paid from after-income-tax and after-payroll-tax dollars. In the third scenario, however, we have a residential tenant again. However, market forces may require that owners of property and wage-earners take lower returns (called factor or backwards incidence). If this occurs, then the rents will remain the same, but the amount of the rent will include the taxes on the rental unit. The landlord would not pay income taxes, but would have the responsibility to pay over the sales tax on the rents. Interest rates will also be much lower and the owners can be expected to enjoy some savings, some lower interest rates. |
