Abolish PAL Rules & Accelerate Depreciation

by David Arthur WalterS

Miami Beach, Florida

(Senator Martinez' office has not responded to this December 17, 2008 proposal to
ameliorate the housing crisis and lower rents, nor has the mainstream media taken
any interest in the proposal)

December 17, 2008

SENATOR MEL MARTINEZ

356 Russell Senate Office Building
Washington, D.C. 20510

Re: Housing Rescue – Abolish PAL Rules & Accelerate Depreciation

Honorable Senator Martinez:

Abolishing the passive activity loss (PAL) rules of Internal Revenue Code Section
469 in respect to residential rental real estate, and providing for the
accelerated depreciation of same, will provide investors with considerable
incentive to invest in the flagging housing market including foreclosure
properties and new construction. I would virtually restore the tax shelter
residential real estate investors once enjoyed, which allowed them to accelerate
depreciation charges at 175% declining balance over 18 years, instead of the
current straight-line depreciation method over 27.5 years, and to apply passive
losses from such real estate investments to both passive and non-passive sources
of income, thus reducing their income tax liability.

Eliminating the PAL rules for residential real estate would not only provide an
incentive for purchasing foreclosed houses and renting them out, whether to the
current occupants or to other tenants, but would also make investment in
multifamily apartment houses more attractive even at lower rents than those that
currently prevail.

As you know, the tax shelter that investors once gladly exploited was provided by
the government in the 1960s to increase the supply of apartment houses, which had
become relatively unprofitable with the advent of low-interest FHA and VA
mortgages with low or nil down payments, which made it cheaper for people to buy
homes in the suburbs. By the mid-1950s, the cost of building apartments was rising
more rapidly than the cost of building single-family homes; new apartments
amounted to less than 10 percent of housing starts in America. A political
decision was made to provide a tax shelter for multifamily housing investors to
help advance urban renewal – which of course is a pressing concern today. [1]

Another political decision was made, embodied in the Tax Reform Act of 1986, to
eliminate the tax shelter. The passive activity loss rules were instituted and
accelerated depreciation for real estate eliminated. Since the 1986 Act as
conceived was expected to decrease the supply of rental housing for the poor, the
Low-Income Housing Act was added to it, whereby developers can take a Business
Credit over ten years, subject to stringent qualifications and restrictions. The
Tax Reform Act of 1986 otherwise favored investment in owner-occupied housing over
rental housing. The PAL rules enacted and the elimination of accelerated
depreciation played a leading role in the largest real estate downturn in U.S.
history, excepting of course the one we presently suffer.

The main reason Congress cited for the change was that “it had become increasingly
clear that taxpayers were losing faith in the Federal income tax system. This loss
of confidence resulted in large part from the interaction of two of the system’s
principle features: its high marginal rates (in 1986, 50 percent for a single
individual with taxable income in excess of $88,270), and the opportunities it
provided for taxpayers to offset income from one source with tax shelter
deductions and credits from another.” [2] That is, the high marginal tax rates had
led a so-called tax-motivated real estate shelter boom largely enjoyed by the
wealthy class.

The tax preferences afforded to people who did not even participate in an industry
appeared to harm those who did participate, giving the former an unfair
competitive advantage over the latter. This encouraged “a flow of capital away
from activities that provided a higher pre-tax economic return, thus retarding the
growth of the sectors of the economy with the greatest potential for expansion.”
[3] Besides, why allow passive investors who hold real estate to depreciate it
every year and take the losses against other kinds of ncome when similar write-
downs are not afforded to shareholders on their shares as long as they hold them?
Therefore Congress decided that passive investors, those who did not materially
participate in the trade or business activity invested in, could only deduct their
passive losses from income gained from similarly passive investments until the
investment was disposed of. In other words, investors could no longer deduct
passive investment losses from active income (salaries, self-employment income,
etc), nor from portfolio income (interest, dividends, capital gains, etc).

But now that the tables have been turned and the nation is in the midst of a
housing crisis, almost everything that was said against the residential real
estate tax shelter can be said for it. For instance, investors who have income to
shelter are more likely than not to be qualified to leverage the equity they
advance with mortgage loans for the purchase of foreclosed properties, for those
at risk of foreclosure, and for new construction, and to let them out at
competitive rents while profiting by applying losses to other sources of income.
Whether or not certain investors materially participate in the ventures is
irrelevant since the merit of legislation is the greater social benefit achieved,
and what is wanted here and now is a significant incentive that will boost the
housing market with some of the trillions of dollars parked on the sidelines. That
is what an appropriate tax shelter is for. The Joint Committee on Taxation stated:

“Congress viewed the question of how to prevent harmful and excessive tax
sheltering as not a simple one. One way to address the problem would have been to
eliminate substantially all tax preferences in the Internal Revenue Code. For two
reasons, however, this course was determined by Congress to be inappropriate.
First, while the Act reduces or eliminates some tax preference items that Congress
decided did not provide social or economic benefits commensurate with their costs,
there were many preferences that Congress concluded were socially or economically
beneficial…. Second, Congress viewed as prohibitively difficult and perhaps
impossible, the task of designing a tax system that measure income perfectly….
Even to the extent that rules for the accurate measure of income could
theoretically be devised, Congress decided that such rules would involve undue
complexity from the perspective of many taxpayers…. However, Congress concluded
that when the tax system permits simpler rules…opportunities for manipulation are
created…. The question of what constituted a tax shelter that should be subject to
limitations was viewed as closely related to the question of who Congress intends
to benefit when it enacts tax preferences. For example, in providing preferential
depreciation for real estate….” [4]

Wherefore Congress strives to balance interests towards the greater good,

sometimes giving limited preference to certain interests to that end. The balance
is a moving one as long as the nation lives, and the movement of the political-
economic wheel in an advancing civilization is progressive as well as cyclical.
Sometimes the time and place dictates that what was done should be undone. Hands
that were tied before must be untied to do what they do best. It is with that in
mind that I suggest, with all due respect, that the passive activity loss rules in
respect to residential real estate be undone and depreciation thereon accelerated.

Sincerely,

David Arthur Walters

[1]“At this point, an investor can be got interested in building and owning an
apartment house even though he earns little or nothing on his investment: the
government in effect gives him his ‘profits’ by excusing some of his other income
from taxes, ‘The apartment house business,’ tax lawyer Adrian Thiel told an upbeat
meeting on multifamily housing in 1969, is ‘an adjunct business and shouldn’t be
the main business of builders, or the main business of anybody else. It’s an
ancillary, incidental thing to making money elsewhere and then sheltering it.’ The
Joint Committee on Internal Revenue Taxation reported to Congress in 1976 that in
soliciting partners for real estate ventures, ‘it has become common practice to
promise a prospective investor substantial tax losses which can be used to
decrease the tax on his income from other sources. There is, in effect,
substantial dealing in ‘tax losses’ produced by accelerated depreciation in real
property.’” Mayer, Martin, The Builders, W.W. Norton, New York: 1978.

[2] Congress believed that the shelters eliminated “gave rise to a number of
undesirable consequences, even aside from their effect in reducing Federal tax
revenues. Extensive shelter activity contributed to public concerns that the tax
system was unfair, and to the belief that tax is paid only by the naïve and the
unsophisticated.” General Explanation of the Tax Reform Act of 1986, Joint
Committee on Taxation, U.S. Government Printing Office, Washington: 1987

[3] Ibid.

[4] Ibid.