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Michael Hudson

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Michael Hudson and Kris Feder: Real Estate and the Capital Gains Debate

2 Depreciation and Capital Gains
3 How Mortgage Debt Converts Rent into Interest
4 Capital Gains Taxation in Real Estate
5 Government Statistics on Real Estate Asset Gains
6 The Political Context of Real Estate Taxation
7 Policy Conclusions


What is missing from the discussion is a sense of proportion as to how capital gains are made. Data that is available from the Department of Commerce, the IRS, and the Federal Reserve Board indicate that roughly two thirds of the economy's capital gains are taken, not in the stock market -- much less in new offerings -- but in real estate.

This policy brief seeks to elucidate the role of real estate in the capital gains issue, indicating the quantitative orders of magnitude involved.. We offer two main observations.
  • First, generous capital consumption allowances (CCAs) greatly magnify the proportion of real estate income taken as taxable capital gains. Capital gains accrue not only on newly constructed buildings, of course, but also on land and old buildings being sold and resold. Our tax code allows for properties to be re-depreciated by their new owners after a sale or swap, permitting real estate investors to recapture principal again and again on the same structure. When CCAs have been excessive relative to true economic depreciation, as they were during the 1980s, capital gains have been commensurately larger than the actual increase in property prices. As Charts la and lb illustrate, capital consumption allowances in real estate dwarf those in other industries.
  • Second, very little of real estate cash flow is taxable as ordinary income, so the capital gains tax is currently the only major federal levy paid by the real estate industry. CCAs and tax-deductible mortgage interest payments combine to exempt most of real estate cash flow from the income tax. This encourages debt pyramiding as it throws the burden of public finance onto other taxpayers.
A central conclusion of our study is that better statistics on asset values and capital gains are needed -- or, more to the point, a better accounting format. The economic effects of a capital gains tax depend upon how the gains are made. The present GNP/NIPA format fails to differentiate between wealth and overhead; between value from production and value from obligation. In particular, theory and measurement should distinguish real estate from other sources of capital gains -- aid, within the category of real estate, distinguish land from built improvements. Markets for immovable structures and for land have distinctive inherent features and are shaped by distinctive institutional constraints.

Our second major conclusion is that, at least until re-depreciation of second-hand buildings is disallowed, a capital gains tax cut would be unlikely to stimulate much new investment and employment from its largest beneficiary, the real estate industry. Depreciation allowances and mortgage interest absorb so much of the ongoing cash flow as to leave little taxable income. Mortgage interest payments, which now consume the lion’s share of cash flow, are tax-deductible, while CCAs offset much of what remains of rental income. On an industry-wide basis, in fact, NIPA statistics reveal that depreciation offsets more than the total reported income. As Charts 2a, 2b, and 2c illustrate, real estate corporations and partnerships have recently reported net losses year after year.

The result is that real estate corporations pay minimal income taxes -- some $1.3 billion in 1988, just one percent of the $137 billion paid by corporate America as a whole. Comparable figures are not available on non-corporate income tax liability, but the FIRE sector (finance, insurance, and real estate) reported negative income of $3.4 billion in 1988, out of a total $267 billion of non-farm proprietors’ income.These three symbiotically linked sectors thus were left with only capital gains taxes to pay on their cash flow.

The central point for capital gains tax policy is that taxable capital gains in real estate consist of more than just the increase in land and building prices. They represent the widening margin of sales price over the property’s depreciated value.  ...

Excessive depreciation allowances thus convert ordinary income into capital gains. Moreover, capital gains are the only point at which most real estate income is taxed  ...

While it is often true that the prospect of earning capital gains is what induces new investment to be made, applying further rate cuts to real estate gains cannot be expected to spur much new construction activity under present fiscal institutions. Clearly a “capital” gains tax cut cannot cause the production of more land; land (as distinct from capital improvements) is made by nature, not by the landowner.  ...

Sound tax policy requires an understanding of the fiscal assumptions which underlie our tax code and the mythical world of national income accounting. Far from being a potent stimulus to new investment, a general capital gains tax cut would preferentially benefit owners of already depreciated buildings speculators in already seasoned stocks, leading to further deterioration of economic health. It cannot be expected to raise the volume of capital gains declared by enough to increase the total tax revenue generated.

Depreciation and Capital Gains
Much of the statistical measurement problem derives from the fact that capital gains in real estate differ from those in other industries. While all investors presumably would prefer to take their income in non-taxable forms and to defer whatever tax obligation is due, the tax benefits to the real estate industry have no analog in manufacturing, agriculture, power generation, transportation, wholesale and retail trade, or other services. Corporations in these sectors pay taxes on their net incomes. Out of their after-tax earnings they then pay dividends, on which stockholders in turn must pay income tax. By contrast, little or none of the rental cash flow received by real estate investors is taxable, because generous capital consumption allowances are treated as costs and deducted from the net income reported to the IRS.

The effect of calculating capital gains for real estate on the basis of depreciated book values may be illustrated by the following example. A building bought in 1985 has probably been fully written off today, thanks to the generous CCAs enacted by the 1981 tax code that remained in place through 1986. For a parcel bought in 1985 for $100 million and sold today for $110 million, the recorded gain is not merely the 10 percent increase in market price, but the entire value of the building, perhaps $65 million based on the real estate industry’s average land-to-building assessment ratios.

Industrial investors must pay tax on their accruals of unsold inventories as they mount up, as if they were sold for cash. ...

Thus the putative beneficiaries of cutting capital gains taxes -- direct investors  -- suffer less from high capital gains tax rates than from the treatment of much of their capital gain as ordinary income, which is taxed at higher rates. In real estate, on the other hand, depreciation effectively converts much of ordinary income to capital gains.  ...

The greatest accounting distortion for the real estate industry occurs in the case of re-depreciation of buildings that already have been depreciated at least once. This redepreciation occurs following ownership transfers; the CCA is attached not to the physical asset, but to the change of ownership. As the building is resold at rising prices, investors are allowed to re-depreciate them again and again -- and to write off these CCAs against their income, as if they were suffering an erosion of wealth. Thus, most capital gains in real estate represent “repeat gains” over unrealistically written-down book values. This accounting fiction enables real estate investors to continue indefinitely to take their income in the lightly taxed form of capital gains.

Landlords already deduct from earnings as normal business expenses their maintenance and repair expenditures, undertaken to counteract the wear and tear of buildings. A rule of thumb in the real estate industry is that such expenditures typically consume about ten percent of rental revenue. More importantly, although nearly all land gains are made fully taxable, there is little reason to assume that physical deterioration should be compensated by a special allowance to enable the landlord to recover his capital investment within a given number of years.

... Significantly, today these buildings have been fully depreciated and therefore are probably about to be sold, at least for book-keeping purposes -- owners may buy their own buildings under different partnerships, or swap them for similar buildings with other owners. Their new owners can begin to depreciate them all over again, after duly paying capital gains taxes on the buildings’ increase over their near-zero book value. If they do not sell and re-depreciate their buildings, the owners will have to begin paying income taxes on their operating cash flow that hitherto was sheltered by depreciation allowances that have now run out. This lends a renewed note of urgency to the persistent campaign to cut capital gains tax rates.

Because excessive depreciation allowances favor real estate speculation relative to industrial production, they discourage new direct investment and employment. To reduce the capital gains tax -- the only significant remaining source of federal revenue from real estate -- would divert even more savings into the purchase and sale of existing buildings.

How Mortgage Debt Converts Rent into Interest
Depreciation rules are not the only reason why the real estate sector declares little taxable income. Out of their gross rental income, landlords pay state and local property taxes, a tiny modicum of income tax, and interest on their mortgage debt. A large proportion of cash flow is turned over to lenders as mortgage payments. Since the early 1970s, interest paid by the real estate industry has been much larger than the figures reported for net rental income....

Most cash flow now ends up neither with developers nor with the tax authorities, but as interest paid to banks, insurance companies and other mortgage lenders. In fact, mortgage interest now absorbs seven percent of national income, up from just one percent in the late 1940s. ...

Real estate is pledged to mortgage lenders as collateral in case the promised interest payments fail to materialize. Capital gains have been collateralized into new and larger loans decade after decade, increasing the mortgage burden that transforms rental income and depreciation allowances into interest payments. Ultimately, the financial rentiers end up with most of the cash flow which landlords -- and government tax collectors -- relinquish.

... The result is that the FIRE sector as a whole has been subsidized at the expense of direct industrial investors and consumers. ...

Chart 5 tracks the relative growth of the finance, insurance, and real estate sector using Labor Department employment figures. It shows that what the classical economists called “productive” labor has remained constant since 1929, while virtually all growth has been in government (mainly state and local) and private sector services -- mainly in the FIRE sector. Tax subsidies may largely explain why the FIRE sector has been the most rapidly growing part of the economy over the past half century. This is the conceptual context in which we should view the NIPA statistics.

5. Capital Gains As Reported to IRS - 1985, as Percentage of Total Capital Gains (Billions of Dollars)

Total Capital Gains
Estimated Land Gain
Land $16.4
Business Real Estate & Partnerships 41.2
Rental Real Estate 24.5 50%
Principal Residences 39.5
Corporate Stocks & Securities 70.7 20%
Other Assets 15.6 0%
Source: IRS

The effective rate is further reduced by numerous exclusions and exemptions.  ...

No capital gains duties are levied on estates passing to heirs. Indeed, inheritors of real estate may begin re-depreciating their income-yielding buildings afresh at the new (typically higher) transfer price. The estates bequeathed by the richest one percent of the population (over $600,000 in value) are now taxed at a 55 percent rate if not sheltered, but of course these are the estates most likely to shelter inheritance and gift bequests. For instance, assets given as gifts are taxed only at the time they come to be sold.30 If the capital gains tax were reduced or abolished, the deferral would become permanent. ...

Most capital gains reaped by business partnerships accrue to real estate firms, which shelter personal income by avoiding incorporation. IRS statistics ranking capital gains in terms of how long the assets were held show that many of these gains represent quick “flips." Often these are land that has been rezoned from a low-value to a high-value use. Retaining the capital gains tax would have little effect on deterring such speculation.

Reported capital gains in real estate were understated as a result of exclusions. On the other hand, much direct investment included the cost of land, commercial buildings, and plant and equipment. Taking this into account, we estimate that roughly 70 percent of the capital gains calculated by the IRS for 1985 probably represent real estate. Even this estimate may understate the role of land and real estate. In 1985, anticipating the planned 1986 tax reform which would raise the capital gains tax rate from 20 to 28 percent, many investors sold their securities that had registered the largest advances. Some 40 percent of the capital gains reaped by selling these stocks probably represented real estate gains. A major spur to the LBO movement driving up the stock market was an awareness that real estate gains were not being reflected in book values and share prices;36 as land prices leapt upward-funded in part by looser regulatory restrictions on S&L lending against land -- raiders bought publicly traded companies and sold off their assets, including real estate, to pay off their junk-bond backers. In effect, not only were rental income and profits being converted into a flow of interest payments; so also were capital gains. ...

Economic policy should distinguish between activities which add to productive capacity and those which merely add to overhead This distinction elevates the policy debate above the level of merely carping about inequitable wealth distribution, an attack by have-nots on the haves, to the fundamental issues. What ways of getting income deserve fiscal encouragement, and how may economic surpluses best be tapped to support government needs? Policies that subsidize rentier incomes while penalizing productive effort have grave implications, not only for distributive justice and social harmony, but also for economic efficiency and growth.

The Lies of the Land: How and why land gets undervalued
Turning land-value gains into capital gains
Hiding the free lunch
Two appraisal methods
How land gets a negative value!
Where did all the land value go?
A curious asymmetry
Site values as the economy's "credit sink"
Immortally aging buildings
Real estate industry's priorities
Its cost to citizens   Its cost to the economy

Turning land-value gains into capital gains

YOU MAY THINK the largest category of assets in this countrly is industrial plant and machinery. In fact the US Federal Reserve Board's annual balance sheet shows real estate to be the economy's largest asset, two-thirds of America's wealth and more than 60 percent of that in land, depending on the assessment method.

Most capital gains are land-value gains. The big players do not want their profits in rent, which is taxed as ordinary income, but in capital gains, taxed at a lower rate. To benefit as much as possible from today's real estate bubble of fast rising land values they pledge a property's rent income to pay interest on the debt for as much property as they can buy with as little of their own money as possible. After paying off the mortgage lender they sell the property and get to keep the "capital gain".

This price appreciation is actually a "land gain", that is, it's not from providing start-up capital for new enterprises, but from sitting on a rising asset already in place, the land. Its value rises because neighbourhoods are upgraded, mortgage money is ample, and rezoning is favorable from farmland on the outskirts of cities to gentrification of the core to create high-income residential developments. The potential capital gain can be huge. That's why developers are willing to pay their mortgage lenders so much of their rent income, often all of it.

... Today borrowing against land is a path to getting rich -- before the land bubble bursts. ...

... The Financial, Insurance and Real Estate (FIRE) sectors seem to have adopted a kindred philosophy that what is not quantified and reported will be invisible to the tax collector, leaving more to be pledged for mortgage credit and paid out as interest. It appears to have worked. To academic theorists as well., breathlessly focused on their own particular hypothetical world, the magnitude of land rent and land-price gains has become invisible. But not to investors. They are out to pick a property whose location value increases faster rate than the interest charges, and they want to stay away from earnings on man-made capital -- like improvements. That's earned income, not the "free lunch" they get from land value increases.

Chicago School economists insist that no free lunch exists. But when one begins to look beneath the surface of national income statistics and the national balance sheet of assets and liabilities, one can see that modern economies are all about obtaining a free lunch. However, to make this free ride go all the faster, it helps if the rest of the world does not see that anyone is getting the proverbial something for nothing - what classical economists called unearned income, most characteristically in the form of land rent. You start by using a method of appraising that undervalues the real income producer, land. Here's how it's done.

PROPERTY IS APPRAISED in two ways. Both start by estimating its market value.

The land-residual approach subtracts the value of buildings from this overall value, designating the remainder as the value of land. ...
The building-residual approach starts by valuing the land, and treats the difference as representing the building's value.  ...

Note that the Fed's land-residual appraisal methods do not acknowledge the possibility that the land itself may be rising in price. Site values appear as the passive derivative, not as the driving force. Yet low-rise or vacant land sites tend to appreciate as much as (or in many cases, even more than) the improved properties around them. Hence this price appreciation cannot be attributed to rising construction costs. If every property in the country were built last year, the problem would be simple enough. The land acquisition prices and construction costs would be recorded, adding up to the property's value. But many structures were erected as long ago as the 19th century. How do we decide how much their value has changed in comparison to the property's overall value?

The Federal Reserve multiplies the building's original cost by the rise in the construction price index since its completion. The implication is that when a property is sold at a higher price (which usually happens), it is because the building itself has risen in value, not the land site. However, if the property must be sold at a lower price, falling land prices are blamed. ...

THE DRIVING FORCE behind the anomalies is the political lobbying eager to depict real estate gains simply as "protecting capital from inflation." In reality, it helps land owners and their creditors get a free ride out of land asset-price inflation -- that is, The Bubble. ...

... The Fed's statistic would be dismissed as a comic exercise showing how economists tend to lapse into otherworldly speculation. But in this case the motive is all too worldly. Looking beneath the surface, one finds the not-so-invisible hand of self-interest by the real estate industry and its financial backers.

To give the Fed economists their due, they evidently came to the conclusion that their statistics were fatally flawed. The September 1997 balance sheet estimates made a start along new lines by including a calculation reflecting the original (historical) cost of buildings. This gave land a positive value. But nationwide totals were no longer compiled. No longer was there a line labeled "land," nor does the Fed publish a residual number for market value less the historical cost (or even the replacement cost) of buildings. Instead of making better land estimates, the Fed has dropped what had become a political and statistical hot potato. 1994 is the last year for which it has estimated economy-wide land and building values.

This leaves in limbo the macro-economists and business analysts whose business is to explain the finance, insurance and real estate (FIRE) sector's dominant role in the economy. According to the land-residual appraisal technique, high-rise buildings seem to have the lowest land values. Real estate interests argue that this is realistic, because at least in New York City the higher a building is, the more of a subsidy its developers need, given the economics of space involved for elevators, surrounding air space and so forth. The land itself is assigned a negative value as a statistically balancing residual reflecting the difference between the building's high construction costs and its lower market value.

On this basis much of New York's most highly built-up land would seem to have a negative value, including the World Trade Center even before its Sept. 11 destruction. While a low-rise building might be built on this site without subsidy, a skyscraper would need a subsidy, implying a negative land value.

... My research has shown that the Fed's methodology undervalues land by as much as $4.5 trillion. ... My estimates based on historical values suggests that land rather than buildings represents two thirds of the nation's overall real estate value -- $9 trillion, leaving building values at just half this amount. ...

One obvious problem with the land-residual approach is that many buildings would not be rebuilt in their existing form. ...

The commercial loft building in which I lived rose in price from $40,000 in 1986 to $120,000 in 1980 and $4,000,000 in 2000. This sharp increase cannot be explainable by rising building costs. The building itself steadily deteriorated. All that increased was its site value. ...

IF THE APPRAISAL controversy is framed in terms of business cycle analysis, then the statistician finds no reasonable alternative to seeing that when the cycle rises and falls, the difference must be in the land, not buildings. What people are buying are not reproduction costs, whose fluctuations over the course of the credit cycle are relatively minor. They are buying site value, which is in limited supply, akin to a natural monopoly. Most of all, real estate investors and homeowners are buying the right to resell their property as prices are bid up by what they expect to become an increasingly affluent economy fuelled by an abundant supply of mortgage credit.

The land-residual approach appears to work as long as a fairly constant proportion of land to buildings is maintained. Statistically, this can occur only when property prices are rising at about the same rate as commodity prices and wages. But business cycles snake around the economy's basic trends, rising steadily and then plunging sharply. This fluctuation is what causes the most serious problems for statisticians.

In a thriving real estate market appraisers typically use a rule of thumb in allocating resale prices as between land and buildings to reflect their pre-existing proportions. Buildings typically are assumed to account for between 40 percent and 60 percent of the property's value. As a result, building values are estimated to grow along with a property's overall sales value. ...

Site values as the economy's "credit sink"

TO CLARIFY MATTERS it may help to think of "land" in the broad sense of comprising all elements of property value that cannot be explained in terms of capital investment and its profits. This category includes the site's locational value. Site value is the essence of long-term planning by real estate developers at the local level. But an examination of the economy-wide figures shows property prices to be determined by broad macroeconomic factors, headed by the availability of mortgage credit. Real estate is the major recipient of bank credit, and price waves or cycles are determined largely by the supply of mortgage loans and their interest rates. ...

In sum, just as real estate lending fuels land speculation, so the withdrawal of such credit leaves property markets to decline, sometimes with a crash, as occurred in Japan after 1990 when its financial bubble burst. Should this rise and fall be attributed to buildings or to land? It seems to me that inasmuch as the price rise and fall is homogeneous, applying to parking lots as well as to skyscrapers, we should attribute it to land. This achieves the logical symmetry of applying to the downturns as well as upturns in the real estate cycle. ...

Immortally aging buildings

INCOME TAX LIABILITY may be minimized in two ways.

  • The most general -- and also the most economically pernicious -- is through the tax deductibility of interest. The working assumption is that interest charges are a truly inherent business expense, not simply the result of a business decision taken by investors to leverage their equity. For interest to be an inherent business expense, interest-bearing debt would have to be a factor of production, which it is not. Properties would yield their rent regardless of how they are financed. Investors choose to rely on debt rather than equity financing because the tax laws favor it, thanks to the political lobbying of institutional creditors ("the debt lobby"). Homeowners too deduct interest payments, which encourages borrowing.
  • The second way to minimize tax liability, is to depreciation the building, that is. annually deduct from taxable income part of the purchase price until it's all deducted and the building is "written off" It's the most unique tax advantage enjoyed by the real estate industry. Investors are able to depreciate their buildings based on their assessed acquisition price, regardless of the actual building costs involved or the level of economy-wide land-price inflation. Investors depreciate buildings at rising prices even when prior owners already have depreciated these structures once or even many times. For real estate owned by households and partnerships (the latter being the preferred legal instrument for holding residential apartment buildings and office buildings), the Fed has estimated much higher proportions of land to buildings, but these estimates also overvalue buildings relative to land. Every time a property changes hands at a higher price, building assessments are raised proportionally - and begin to be re-depreciated for these higher valuations, regardless of how often the buildings already have been written off! There is no limit as to how often a building can be re-depreciated. What matters is simply how often the property changes nominal hands.

This fiscal privilege has created a phantom real estate economy. Buildings acquire death-defying lives, metamorphosing time and again for the purpose of enabling their owners to avoid paying income taxes. For commercial real estate investors as a whole, the repeated depreciation of buildings has made commercial real estate investment largely exempt from the income tax. Homeowners are not permitted to charge depreciation on their own residences, but only on buildings that they rent out. ...

For real estate, however, the economics are unique. Machinery rarely can be re-depreciated, but this is not true of buildings as long as they are kept in proper repair. Maintenance and repairs typically consume about 10 percent of the rental value. For business owners, the explicit purpose of this expenditure is to maintain the building's value intact, so that it can survive year after year and avoid obsolescence while its site value rises. If a building is sold at a higher price, its assessment usually is raised. Suppose a property is sold for twice the $1 million the owner paid for it. The local appraiser is likely to say; "I see you've sold your building for $2 million. Under my rule of thumb, I appraise the land as half this value, and the building as half, so that gives you a $1 million dollar building." Under this rule, the building that was formerly priced at $500,000 can be re-depreciated at a price that builds in this $500,000 gain. In this way a substantial portion of the rise in site value of non-depreciable land is treated as depreciable building value.

... The free lunch of land-price gains is unseen as attention is diverted from the real estate bubble and land-price inflation to building costs. These fiscal considerations help to explain why it has been so hard to get Washington to produce national land value statistics. ... 

Tax favouritism for real estate was defended in Congress on the ground that it was in the public interest to provide a special inducement to the real estate industry to build more homes and office buildings. But as Adam Smith observed, every industry represents itself as serving the public interest. Can one really say that investors borrowing 70 percent of private-sector loans to ride the wave of asset-price inflation are more in the national economic interest than favoring direct investors to build new plant and businesses that employ labor rather than pricing homes, office buildings and industrial sites further and further out of reach of those who must earn their income by increasing society's productive powers? ...

Nationwide the capital-gains dimension needs to be incorporated into the rental revenue statistics to measure real estate's total returns. This sector's nearly complete success in escaping the tax collector has placed an enormous tax burden on everyone else.    Read the whole article

see also:
The Land-Residual vs. Building-Residual Methods of Real Estate Valuation, http://www.michael-hudson.com/articles/realestate/0110LandBuildingResidual.html

The Methodology of Real Estate Appraisal: Land-Residual or Building-Residual, and their Social Implications http://www.michael-hudson.com/articles/realestate/0010NYURealEstate.html

How to lie with real estate statistics: The Illusion that Makes Land Values Look Negative; How Land-Value Gains are Mis-attributed to Capital http://www.michael-hudson.com/articles/realestate/01LieRealEstateStatistics.html

Where Did All the Land Go? - The Fed’s New Balance Sheet Calculations: A Critique of Land Value Statistics http://www.michael-hudson.com/articles/realestate/01FedsBalanceSheet.html




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Wealth and Want
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