Saturday, February 13, 2010

Should We Get the Taxpayer Out of the Real Estate Business?

This post was also featured on The Reformed Broker. The TRB now has a weekly stocktwits TV show.

The taxpayer is more deeply involved in the real estate business than most people realize. I think it is time we pull the plug on the on-going blatant give-aways that go from our tax money to various constituents in the real estate business. So let's look at some of the known and lesser-known ways the real estate complex has been leeching for years. You can answer for yourself whether this is fair or not.

Multiple instances of preferential taxation
(1) At the corporate level, REITs are "special" in the eye of the taxman. REITs, unlike other perfectly good businesses, do not pay corporate-level income taxes so long as the income is derived from real estate operations and mostly paid out in dividends. Additionally, a substantial percentage of these dividends might not taxed at all as they are considered "return of capital." Just like this, the tax code has created a chosen sector, while "regular" companies pay income taxes and their owners pay taxes again on the dividends. (please no comments about BDCs, LPs, "c"'s, etc.: I am talking about regular mainstream businesses)

(2) RE developers also get local tax breaks for new construction in certain areas. Is this fair to the businesses providing jobs constantly in the area that do not get any breaks? I do not think so.

(3) There are breaks at the personal level as well. The big one is the mortgage interest deduction. Of course, you are fooling yourself if you think you are getting deal. If I were the seller and you were the buyer, and we both thought that a market price of X made sense, we'd transact at X. However, if I know that because of the tax break, you can actually afford X+20, guess the new market price? It is X+20. I will keep the surplus to myself while you think you're getting a deal on your taxes. For tax breaks to really work, they have to be private. Otherwise, in a large marketplace, the price will migrate up to where the sellers (the real estate industry) will capture the entire surplus.

(4) Another personal tax break are the very generous exemptions from what are in essence capital gains taxes. No other assets are exempt: short-term stock wins are even taxed at the high personal income tax rates. In other words, the tax payer encourages investment in largely non-productive assets with high carrying costs, while discouraging potentially appreciating, income-producing investments, such as stocks. Think about whether this makes sense.

(5) A loosely similar situation exists with 1031 exchanges of properties. In short, they allow sale and purchase of separate properties without taxes on any appreciation if the transactions happen within a certain time frame. Again, do you get a tax break if you sell a stock and buy a new one? No. The taxpayer is supporting a certain asset class over another for no good reason, in my view.

In addition to the taxation situations listed above (I am sure there are more but I am neither a tax nor a RE guy), the taxpayer is deeply involved in the real estate financing business whether the taxpayers want it or not. Let's look at some of the ways. Just remember that secured real estate lending is a mainstay of banking so banks have a vested interest in having collateral that receives preferential treatment.

(1) The taxpayer is the ultimate backstop for the FDIC. The FDIC insures deposits even in the most questionable banks. This (a) removes a source of discipline for the bankers and (b) perpetuates the lowest-cost funding for these questionable operators. Now, what do these questionable operators do? Well, they go out and lend to.... the real estate industry! If you look at most of the bank blow-ups since the "crisis" started, you will notice that they have been giving far too many mortgages and C&D loans to buccaneers who rolled the dice with little equity, or to johnny-come-lately's who knew little about the business.

(2) The taxpayer is on the hook for unlimited support for the "mortgage giants" FNM, FRE (+ the FHA). Remember that the news was released on the day before Christmas in the afternoon because the Nation's #1 TurboTax User (TM) was hoping that people would not notice? Anyway, what has been happening with these folks? For many years, under the guise of "making homes affordable", they have been interfering with the mortgage market and transferring value from the taxpayers to the real estate industry, in addition to being beacons of political cronyism. Now that the chickens have come home to roost, who gets stuck with the losses? You guessed it, the taxpayer.

(3) The taxpayer is also paying for VA program mortgages. Since we have a 100% volunteer army, why is the taxpayer subsidizing the career choices of other people by giving them money to give to the real estate complex?

(4) Let's not forget the current programs such as the housing purchase tax credit (another blatant giveaway to the industry), the various financing facilities from the Fed (only $1 tril in support of MBS), etc. Much is written on those (and not enough on the basics, so I am focusing on the often-overlooked latter).

So, the taxpayer is subsidizing both the industry via various tax breaks and its financing structure. Nice job if you can get it. But there are some other ways in which the taxpayer gets hit.

(1) Public housing and housing vouchers. The taxpayer, in addition to providing for his/her own shelter, is also providing for the shelter of many other people. Setting aside the discussion whether housing is a "right", lets look at some of the effects. (a) Voucher programs, such as Section 8, cover the difference between "market" rent and income, so the rent levels are artificially propped up. Also, there is a direct benefit to working as little as possible as any increase in income would go for rent. Not bad of a deal. (b) Public housing. "Projects" are now being widely demolished as a failed experiment. Is someone going to reimburse the taxpayer for the construction and demolition costs, along with the maintenance, policing, etc. costs that were associated with the projects? I doubt it. In places like Manhattan, vast swaths of the island are occupied by public housing thereby reducing supply and driving the market price up for the "regular" taxpayers (there are other factors in that price, of course, such as rent controls, being on an island, etc.). So the taxpayer has paid for the construction, maintenance, current housing AND has to pay higher rent because of the restricted supply. Makes no sense. Who benefits, besides the direct beneficiaries? The holders of the remaining housing stock, who can now sell high-priced condos and/or charge the highest rents in the country.

(2) Eminent domain abuse. Some cases in recent memory: the Kelo case up in New London, where a developer forced people out of their homes for a private project. Second, the Atlantic Yards project in Brooklyn (involving the participation of a Russian nouveau riche oligarch and Acorn- to hand out the "affordable units" allocation), the developer there is trying to squeeze some holdouts again for a private development (condos, office, retail and a new center for the New Jersey Nets). Also, Columbia University, a private entity, trying to expand its campus by steamrolling over the local property owners through incessant court battles, as well as through letting its own buildings in the area rot in order to create an appearance of "blight" and anoint itself as the savior. In all three cases, the developers are getting tax breaks to violate eminent domain principles. Big Pharma cannot confiscate your organs to do experiments, Big Oil cannot drill in your back yard, the local transit authority cannot confiscate your van to add to their fleet, and yet Big RE can defacto take your property against your will (the whole "has to pay a market price" argument is weak, there is no market price if the other side simply does not want to sell).

To summarize, the taxpayer has been too involved in subsidizing the operations and financing of the RE industry. This has lead to untold amounts of malinvestment and to widespread personal financial ruin for underwater home "owners." The taxpayer involvement should stop. Will it happen? Realistically, I doubt it: hoping it would happen is about as futile as trying to convince yourself that all children are above average. But, like Dexter's blog on suspicious trading, I am doing the SWPL thing here: "raising awareness."

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)

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