DON WILLIAMS, managing partner of Trammell Crow Co., has a problem. On one hand, he has been a long-time backer of Ronald Reagan. On the other, he is one of the nation’s leading developers and head of the National Realty Committee, a group comprising major developers, lenders and other key players in the real estate industry. In the latter capacity, Williams has found much to fault in President Reagan’s No. 1 second-term cause-tax reform.
For the past several months, since former secretary of the Treasury and now White House Chief of Staff Don Regan unveiled the Reagan administration’s first-draft tax reform proposal, Williams has been crisscrossing the country with an ominous message: If enacted, the proposal would all but put the real estate development industry out of business. He has been interviewed by Dan Rather and a host of national business publications, and has carried his concerns to scores of congressmen and senators.
Whether Williams’ efforts will bear fruit remains to be seen. Most developers believe Reagan’s Treasury Department’s second stab at drawing a tax reform measure, one drafted under the watchful eye of the politically pragmatic current Treasury secretary James A. Baker III, is significantly better than Regan’s effort, but still devastating to their industry.
And the Democratic Party’s alternative tax reform package, drafted by Dan Rostenkow-ski’s House Ways and Means Committee staff, is considered by Williams and his organization to be even worse than the Reagan plan. “We had hopes Rostenkowski would see the effects we believe many of these so-called reforms would have on the millions who hold jobs in industries related to development, but so far it seems we are wrong.”
Actually, Williams is not completely opposed to the basic idea of simplifying the nation’s tax laws; he just feels the president’s current proposal fails to achieve any goals the president set forth for tax reform, while doing considerable harm to important national industries. “The president told the nation he wanted a plan that would make filling out a tax form easier, and one that would provide a level playing field for economic interests,” explains Williams. “I can understand the desire for those reforms and even the need for them, but I don’t think that’s what we’re getting.”
What Williams believes the country is about to get is a reordering of the playing field in which some existing economic interests will benefit considerably and others will lose, also considerably. “Both the president’s plan and the House staff plan clearly and consciously make the policy determination that real estate investments are simply not as economically productive for the country as other types of investment, and therefore, the plans set out to alter the tax structure to steer capital, both debt and equity capital, away from real estate,” says Williams.
Rostenkowski generally bears out Williams’ accusations. “I think there is considerable feeling in Congress and throughout the country that an enormous amount of capital has gone into buildings that need not have been built, that are standing empty and will stand empty for some time, and that this capital could and should have gone for a more productive purpose.”
Rostenkowski also echoes the oft-stated argument that real estate development is simply a tax dodge for the very well-to-do. “There is a feeling among many members that there are those in the real estate industry who make large profits because of the tax laws, yet who have little or none of their own capital at risk and who perform little or no useful economic function.” Rostenkowski seems well aware of Texas’ famous land flips in which a piece of property is sold rapidly from one group of speculators to another with substantial increases in value per sale, but with no underlying economic reason.
Doubtless, many Dallasites, even those with a personal interest in the health of some sector or another of the real estate development industry, feel some sympathy for the Chicago Democrat’s position. Driving about Dallas and spying out the so-called “see-through” buildings (buildings without tenants) one can believe the tax system, or some system, has moved considerably more capital into the industry than is needed.
Interestingly, Williams does not disagree. “I have no doubt the accelerated depreciation adopted by Congress in 1981 added to the overbuilding problem. But most of us in the industry didn’t ask for that tax break. Many even opposed it as unneeded and potentially harmful to the industry for the very reasons its opponents point out.” However, Williams believes the abuses of tax shelters have been mitigated by recent amendments to the tax code.
THE REAL CULPRIT in overbuilding, in Williams’ opinion, is the deregulation of financial institutions and other industries, especially the telecommunications industry. “When the government turned savings and loans loose to invest in whatever they thought looked good, you lost all discipline in the marketplace. You had people with little or no expertise in real estate and construction investing and loaning massive sums to anyone who could stack two bricks on top of one another,” Williams says. “At the same time you had Ma Bell splitting up, and that brought hundreds of companies across the nation, from manufacturers to retailers, into the telecommunications area-and they were all looking at space. This created a bubble of high, probably badly over-inflated, demand projections.”
What Williams, the Dallas lawyer turned businessman, and Rostenkowski, the Chicago pol and protege of the late Mayor Richard Daley, do have in common is a fear of the impact of tax reform on the millions of workers who depend on the real estate development industry for employment. “When you stop to think about what all goes into the development of real estate, be it industrial warehouses, retail centers, housing or office buildings, you begin to see just how many people could be hurt if the industry falters,” worries Williams. “Among the industries that would be hit are basic industries-industries already in deep trouble-such as steel, forestry products and furniture manufacturing.”
Williams carries his argument further. “If all this money were going down the drain, it might be worth the pain to redirect the capital to more worthy recipients. But in the information society we are becoming, the office building is the factory. In fact, if you want to get really futuristic you can say that with more and more people using their homes as offices, the home itself is a factory of the future. We really do need to change our way of thinking about these things,” he says. Williams admits, however, that his argument equating factories and office buildings hasn’t found a ready audience in Washington.
Williams and Rostenkowski tend to agree that no plan currently on the table does much to simplify things for the average taxpayer, but does much to complicate things for those who already use tax attorneys and accountants. “Just switching from the current status to whatever is adopted will cost a great deal of money,” explains Williams. “But many of the provisions, including one that would have developers switch from cash to accrual accounting, would be a windfall to the accounting industry. It would cost our industry hundreds of millions of dollars. Would that money be economically productive?”
Rostenkowski agrees that the average taxpayer would have little to gain. “The average taxpayer doesn’t itemize as it is, and things aren’t all that complex if you don’t itemize.” He adds that tax questions can be rough on the small businessman, and he hopes a lifting of the tax complexity burden on small business will be one accomplishment of tax reform. What Rostenkowski seems to believe should be accomplished through tax reform is a reordering of national priorities and a shifting of tax burdens toward the more wealthy end of the scale and onto business in general-but especially larger business. And there are few businesses larger than development giants like Trammell Crow.
STILL, THERE ARE items in both bills Williams can accept. One is a provision relating to rehabilitation tax breaks: The president’s plan would do away with the break while the House staff plan would scale the plan down. “Frankly, that provision has little effect for Sunbelt-based developers. We just don’t have that much in the way of historical buildings to rehabilitate, and we have pretty much rehabilitated those we do have,” Williams points out. “Those who will benefit most are northern cities in need of total rehabilitation. That tax break means Sunbelt taxpayers are going to be subsidizing Frost-belt city rebuilding efforts.”
Williams is not overly concerned about the scaling down of accelerated depreciation. The president’s original plan, Treasury I, which would have allowed depreciation only over the real economic life of a building (a period fixed in that proposal at 63 years), was anathema to Williams and other developers. But Treasury II, which changes the current 18 years to 28 years, is reasonably acceptable, and the House staff plan, which allows a 30-year period for depreciation, seems acceptable to Williams. “This will certainly hurt the big tax shelter boys and remove a lot of the syndicated money from the game, but it will truly curb the flow of that form of equity capital into real estate.”
Another area that the real estate industry would rather avoid, but which Williams finds at least acceptable, is the change in the treatment of income from the sale of depreciable property (not land) placed in service after 1985. Under current law such income would be taxed at the 20-percent capital gains tax rate. Under Treasury II it would be taxed as regular income, or at a 35-percent rate. Williams finds the House staff plan would, through a complex formula, essentially raise the current tax to 21 percent.
THERE ARE, HOWEVER, two proposed changes that Williams and others in the development industry believe could all but put them out of business: the proposal to limit tax losses on real estate financed by non-recourse debt, and the proposal to limit the amount of interest an individual may deduct from his taxes to investment income plus $5,000.
The “at-risk” provision holds that an investor cannot deduct from his or her taxes more than the investor has at risk in a particular project. “At risk” is usually defined as the amount of equity the investor has in the project, less cash flows received, and the amount of debt he has personally guaranteed. Real estate has always been an exception to the at-risk rules because of its history of being financed by long-term non-recourse debt. The proposal, however, would disallow any losses relating to the non-recourse debt. Developers, according to Williams, would be forced to dramatically increase their personal guaranties, without any offsetting increase in the prospective rewards.
Williams believes the proper goal of at-risk should be to prevent abuses, such as the seller financing at artificially high values to create tax shelters without economic substance. He suggests the provisions as written ignore an important point. Under current lending practices the fair market value of real estate will exceed the associated amount of non-recourse debt (debt in which a project stands as the only collateral and where the borrower puts up no personal liability), so that owners are “in fact” at risk from an economic standpoint. Williams fears that debt financing of real estate and development projects will cease to be available and that equity financing alone will be the foundation of the industry. “This will basically remove all but large pension funds from the financing of large projects, and I don’t think having that few players is good,” explains Williams. He says in England, for example, where depreciation is not deductible, the real estate industry is dominated by large pension funds, resulting in a low level of competition and high rents.
The provision to limit non-business-related interest payments is intended to cure the perceived abuse called “tax arbitrage.” Tax arbitrage is achieved by permitting limited investment partners a current deduction of interest against other taxable income even though the interest was incurred on property that will appreciate substantially in value. However, William believes current law has dealt with a real problem. He believes the bottom line of the proposal will be a complete destruction of any incentive for individuals to invest in limited partnerships, which are in fact businesses. This would strengthen even more the hand of the large institutional investor in real estate finance, since such institutions as pension funds are tax-exempt.
A FINAL PROVISION in the Reagan plan (but not included in the House staff plan) that Williams finds highly objectionable is one to “recapture” some 40 percent of depreciation taken from Jan. 1,1980, through June 30,1986, in excess of what would have been taken in tax by using a 40-year life and straight-line depreciation. Most real estate industry leaders believe this provision would create dramatic and, in some cases, fatal liquidity problems. They believe these problems created by “phantom income” will depress values and, by forcing many tax-motivated sales, produce major distortions in the marketplace.
Whether the provisions encompassed in President Reagan’s Treasury II tax reform measure will ultimately find their way into law is, of course, very much in doubt. The Ways and Means staff has presented a proposal substantially different from the president’s. Exactly how many of its changes the president might be willing to buy is unknown. Indeed, it is still far from certain that Rostenkowski will even be able to corral a majority of his own committee to support a tax reform bill, and if he can it will likely be because he has made major changes in what his own staff has presented.
But even if the House Ways and Means Committee and the White House can agree on a compromise measure and Rostenkowski can muster a committee majority, the bill must gain full acceptance in a House that seems to wish the president would forget the whole thing. Most members returned from lengthy summer vacations convinced that Americans were supportive of tax reform in the abstract-but unenthusiastically so, and very opposed to specific provisions. But even if Reagan and Rostenkowski rally the House to a tax reform standard, Reagan’s own Republican Senate remains ice-cold to the concept, considering it to be little more than a firing-pin for a fratricidal GOP war.
With so many hurdles ahead, Don Williams should rest easy.
