Just Taxes Blog by ITEP

Biden Proposes to Fund Child Care and Elder Care by Shutting Down Tax Breaks for Real Estate Investors         

Biden Proposes to Fund Child Care and Elder Care by Shutting Down Tax Breaks for Real Estate Investors         

July 21, 2020

Steve Wamhoff
Steve Wamhoff
Director of Federal Tax Policy

On Tuesday, Democratic presidential candidate Joe Biden announced a $775 billion proposal to expand care options for children and elderly people, suggesting that the cost would be at least partly offset by paring back tax breaks for real estate investors.

Bigtime real estate investors are simply unaccustomed to operating without government subsidies provided through the tax code. These subsidies take many forms. For example, special breaks make it possible for real estate investors to avoid reporting profits to the IRS. At the same time, other breaks allow them to claim losses more easily than other types of business investors can. The net result is that many real estate investors pay little or nothing for years at a time. During the 2017 debate over the Trump-GOP tax law, ITEP published a report describing the many tax breaks that benefit wealthy real estate investors like the Trumps and Kushners.

It is not clear what Biden would do, but his campaign has called out at least two of these breaks: like-kind exchanges and special rules allowing real estate investors to claim losses more easily than other businesspeople.

How Real Estate Investors Avoid Reporting Profits to the IRS: Like-Kind Exchanges

Like-kind exchanges are an example of the first type of tax break, which allows real estate investors to avoid paying taxes on their profits. Most of us earn income by working, and we pay income taxes on those earnings each year. For real estate investors, the main source of income is often capital gains, the profits from selling property. Real estate investors can avoid tax on this income if, instead of selling an appreciated property, they trade it for another property and then report to the IRS that no sale technically occurred so there is no income to tax.

Like-kind exchanges were originally intended for situations in which two farmers trade land or livestock. If, for example, livestock is exchanged but no money changes hands, it may have seemed reasonable to waive rules that would normally define this as a sale and tax any gains from it. This was a minor accommodation in the tax code that also made the rules easier to administer.

But this tax break has turned into a multi-billion-dollar loophole that corporations now use as well as individuals. The term “like-kind” has been stretched beyond all recognition. For example, in one case, a trade of Midwestern farmland for a Florida apartment was considered a like-kind exchange.

How Real Estate Investors Claim Losses

In 1995, Donald Trump reported losses of $916 million, which he likely carried forward to avoid paying personal income taxes for several years. Trump likely never invested $916 million of his own money. Investors in other types of business are subject to stricter rules barring them from claiming losses that exceed what they really invested—what they have “at risk.” But real estate is subject to looser rules to determine what constitutes “at-risk” or a “passive loss.”

The general rule is that a taxpayer cannot claim losses that exceed the amount she has “at-risk” in the business, which can be thought of as “skin in the game.” However, a special rule allows taxpayers to claim losses on an investment even if all they invested is money borrowed from others, in situations where the only collateral for the loan is real estate purchased with the loan.

Another set of rules was introduced in the 1986 tax reform to block investors from using passive losses to offset income that is not passive. Very generally, if a person owns part of a business but puts no work into it, her income or losses from that business are considered passive under tax rules. The 1980s saw an epidemic of taxpayers claiming business “losses” that existed only on paper and using them to offset other income and avoid taxes. Congress dealt with this, effectively for the most part, by baring taxpayers from using passive losses to offset income that is not passive.

Income and losses from a rental business are inherently passive. Rental income is not generated from work but from the asset being rented. The passive loss rules therefore specifically define passive activity to include rental activities. However, in response to intense lobbying, an exception was added to the code in 1993 for any “real estate professional,” which is defined in a way that probably includes most real estate investors.

By the way, Trump himself was part of the effort in the 1990s to undo the 1986 reforms or at least create exceptions for the real estate industry. Whereas most tax experts view the loophole-closing 1986 act as a model of tax reform, Trump testified before a Congressional committee that the “tax act was just an absolute catastrophe for the country and for the real estate industry.” So, it’s no wonder that his own tax overhaul, when it was enacted in 2017, left in place and even expanded tax breaks for the real estate industry.