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![handle is hein.taxfoundation/iretcgadv0019 and id is 1 raw text is: June 3, 1993 No. 20
THE TAX TREATMENT OF REAL
ESTATE: TWO STEPS BACK, ONE
HALF STEP FORWARD
Overlooked in much of the debate about
President Clinton's budget initiatives are two
proposed income tax changes that directly target real
estate investment. The House of Representatives
proposes to lengthen the cost
recovery period for non-
residential real property from The proposed
the current 31.5 to 39 years. treatment of r
The House also accepted a mere tinkerin
second Treasury proposal that where a comj
would relax the rules limiting order.
the deductibility of passive
losses for real estate
professionals. In terms of
reducing the current tax bias against real estate,
these changes tug in opposite directions.
Lengthening the Cost-Recovery
Period: One Giant Step Backward
The Tax Reform Act of 1986 (TRA86)
lengthened the cost recovery periods for most
capital assets. This had an especially damaging
effect on the real estate industry. By lengthening
the cost recovery period for most real estate
investments from 19 to 31.5 years and by changing
the accounting method that was used in calculating
depreciation, TRA86 significantly reduced the after-
tax return on all real estate investment. These
changes also represented a movement away from
chan
eal es
- wvit)
ilete
what sound economics urges is the appropriate tax
treatment of such investments.
The lengthening of depreciation periods in
TRA86 was based on the fallacy that, for tax
purposes, the costs of production facilities should be
deductible over the years in which the facilities
continue to be used, i.e., over their so-called
economic lives. This argument was invoked once
again by the Clinton administration to justify
lengthening the depreciation period for real estate.
As stated by the Treasury department: The
recovery period for non-residential property under
current law results in depreciation allowances that
are larger than the actual decline in value of the
property... [t]he recovery period for the depreciation
of such property should be increased.
Treasury's assessment is wrong. If tax policy
is to be efficient, i.e., if it is not to favor one kind
of investment over another, the
depreciation system should
ges in the tax insure that the present value of
tate constitute depreciation deductions per
the tax code dollar of investment is the
verhaul is inl same for all property. Tying
the cost recovery period to the
life of the property, and
limiting total depreciation
deductions to the amount paid
for the property, creates a bias against investment in
long-lived capital, i.e., capital that is expected to
be useful for a relatively long period of time, such
as real estate.
The House bill would decrease the present
value of non-residential real property tax write-offs
and, hence, increase the present value of the taxes
paid on the return on investment in such property.
The result would be a reduction in the value of non-
residential real estate. This is because, the present
value of any tax write-off is lower the more remote
it is in time. A dollar is worth more to someone
now than at any point in the future. Therefore, at
any given discount rate, the further into the future a
dollar of production costs can be deducted for tax
Institute for
Research on the
Economics of
Taxation
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