Abolish Pal Rules By David Arthur Walters

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 writedowns 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.