Write-Off Loss Feared : Tax Reform: Hot Resorts Feel a Chill

It is an odd kinship. The poor Virginia families who labor in the Shenandoah Valley’s Nelson County earn less in a year than many affluent Palm Springs property owners make in a single week.

But the two communities are fighting side by side against a common enemy: tax reform.

Since late November, when the Treasury Department delivered to President Reagan a plan to cut tax rates in exchange for eliminating most deductions and diluting others, including many for second-home ownership, prospective vacation-home buyers have stopped shopping around, stopped buying and even canceled deals struck before the tax-reform plan was unveiled.

‘Verge of a Disaster’

Second-home cities “could be sitting on the verge of a disaster,” frets Palm Springs builder William Bone.

Sales in virtually every second-home hot spot in America have weakened. In Palm Springs, large condominium builder Sunrise Co. saw January sales tumble 80% from the previous year. And Southern California builder Raymond Watt’s desert sales are down an estimated 20%.

At Virginia’s Wintergreen resort, the skiing business was at its highest level ever in January and February. But its condo sales were down 79% in December from a year earlier and were nonexistent in January, normally one of its strongest months. February bounced back slightly, with three condo sales.

Colorado’s Snowmass--the third-largest U.S. ski resort, after Vail and Mammoth--figures it has lost as much as one-fourth of potential business because of tax uncertainty.

33% Drop in Sales Seen

And Florida developers estimate a 33% year-to-year drop in second-home sales.

“Interest rates were falling and we were seeing an uptick in condo sales last year,” said John Fitts, chief executive of Colony Resorts Inc., a Sherman Oaks company that manages resorts and hotels in Hawaii, Utah and South Carolina. “And then here comes the flat tax proposal--which conveniently surfaced after the election, you’ll notice--and now people are backing off of purchases and sales are falling.”

What scares investors is the prospect that the tax advantages of owning real estate will be watered down.

Property taxes, the favorable treatment of capital gains and accelerated depreciation of property, all big incentives for owning property, would come under the Treasury’s tax-reform ax. But it is the threatened loss of part of the interest-expense deduction that has the industry up in arms and prospective buyers shying away.

“People are on the sidelines waiting and wondering what to do,” complained Bone, chairman of Sunrise Co. “They’re so confused they aren’t doing anything.”

Mortgage interest on a principal home would remain fully deductible. But all other interest--deductible in full under current law--would be subject to a yearly cap of $5,000 plus an amount equal to the taxpayer’s net investment income, after an adjustment for inflation. Any excess interest expenses could be carried forward for use in other years.

For example, a taxpayer with $20,000 in home mortgage interest expenses, $10,000 in interest expenses from a car loan and a mortgage on a second home, and $2,000 in interest and dividends from stock and money-market accounts would be able to deduct the full $30,000 now.

Often Misinterpreted

Under the proposal, he could continue to deduct full interest on his principal residence. But he would be allowed to deduct only $7,000 of the additional $10,000 in interest expenses: the $5,000 that is allowed everyone and an additional $2,000--equal to the interest and dividends--to offset his investment income.

The proposal is complicated and often misinterpreted.

“I can’t tell you how many people I talk to who think the only interest they’ll be able to deduct if this thing passes is interest on their principal home,” said Bone, who hired several tax specialists to analyze the complex, 262-page proposal and has organized builders from resort cities nationwide in an effort to counteract the tax uncertainty. “That is simply not true.”

Even so, fear, confusion and uncertainty--not reality--are dictating the market. “Someone needs to point out to decision makers that it was very irresponsible to put on the table a proposal of this nature and then allow it to sit there,” UCLA economist Werner Hirsch said. “It’s like getting you to first base and then calling the game for several months.”

Even investors familiar with the proposals are putting off buying property and backing out of deals.

‘Some Hard Thinking’

One middle-age couple who were actively searching for a second home in the Southern California desert, for example, consulted their Los Angeles financial adviser after announcement of the Treasury plan. Assured that a large share of their interest write-off would remain, they called off the search anyway. “This made us do some hard thinking about why we wanted to buy a place there,” the husband said. “We decided it was mostly a tax decision.”

Equally squeamish are investors and lenders who finance second-home construction. “We are seeing investors starting to drag their feet on deals; they’re re-evaluating their arithmetic and thinking twice about what project to go into,” Bank of America economist Michael Salkin said.

Bowen H. McCoy, a managing director in the Los Angeles office of the New York investment firm Morgan Stanley & Co., said that investor syndicates nationwide began backing out of every real estate deal they could immediately after the Treasury’s announcement. Those that were binding, he said, they put up for sale.

To entice investors back into the marketplace, McCoy said, syndicators are crafting new types of contracts, with guarantees to protect returns on investment in the event of a tax law overhaul.

Decline in Construction

The foot-dragging is already noticeable in housing statistics. In California, December housing starts fell 13.9% and single-family construction declined 22% from the previous month. Salkin, who believes that the declines are at least partly attributable to the uncertainty over tax reform, is “waiting with great interest” to see whether the trend continued in January. Those figures are due out shortly.

The numbers have construction officials and managers of resort cities worried about potential ripple effects.

“There is no question that the tourist economy of Coachella Valley, and particularly the upper end of that market, could be quite threatened,” said Norman King, Palm Springs city manager.

“It could depress the whole market, primary homes included,” Palm Springs builder Bone said. “And where does that leave the construction worker and the guy who makes toilets? Without jobs.”

That prospect is particularly troubling to one-employer locales like Nelson County, Va., a resort popular with residents of northern Virginia and Washington, D.C.

Resort Employs 700

The county’s Wintergreen ski resort employs about 700 workers and does enough construction work to keep another 300 workers in jobs, making it “the largest employer in what is a very poor county,” Wintergreen general counsel Stuart Sadler said.

So, “it worries a lot of people around here,” he said, that Wintergreen condo sales were abysmal in November, December and February and nonexistent in January.

“I can’t tell you how concerned we are here that, as a result of this tax-reform talk, people are going to start dumping condos on the market,” said county administrator Russell Otis, who has appealed to his congressional delegation. “And if that happens, our property values will erode and cause a tremendous reduction in our local revenues.”

Alternatives Devised

Such concerns have prompted some financial planners and tax advisers to devise ways around the possible lost deduction. One recommendation that is gaining popularity is for a taxpayer to refinance the mortgage on his primary residence and use the money to pay off or pay down a second-home mortgage, capitalizing on the belief that primary mortgage interest will always be sacrosanct even if other interest isn’t.

Others urge caution in buying second homes this year.

‘Too Many Questions’

“I’m not sure I would propose to someone to go buy a home in Palm Springs right now,” said Barbara Stark, a tax and financial planning specialist with Los Angeles-based Security Pacific Bank, a big lender in Palm Springs and other desert communities. “There are too many questions.”

One of the big questions is how the government would handle the transition between the old law and the new. The promise of a liberal transition, many believe, would go a long way toward ending what Rep. Richard A. Gephardt (D-Mo.) calls the “chilling effect” that the specter of tax reform is having on business transactions.

“I hear an awful lot of talk about tax reform and I have to believe it’s going to come to pass,” said Bank of America economist Salkin. “But it is not going to land on us like a big aircraft out of the night. It will be a slow, liberal phase-in.”

To curb the near-hysteria among some real estate sales groups, builders have organized tax seminars, appealed to their congressmen, crafted unusual loans to outsmart the politicians, stepped up their advertising and hired econometric forecasters to study the possible damage in the event that the next alteration of the U.S. tax code is a sweeping overhaul of the system rather than the kind of piecemeal changes to which Americans have become accustomed.

Zero-Interest Loans

In Los Angeles, the big construction and financial services company Kaufman & Broad Inc. dusted off a zero-interest loan offering that had few takers when it was first presented a year ago. Lured by an ad that warns “the Treasury Department is suggesting legislation that will eliminate tax deductions for interest on your second home,” fully half of the buyers of Kaufman & Broad’s Casablanca project in the California desert are opting for a no-interest loan, spokeswoman Donna Hughes said.

Unlike the terms of a conventional mortgage--20% down and 30 years to pay--the no-interest loan calls for one-third down and five years to pay off the principal. On the sale of a typical $112,990 second home, the buyer would put $37,664 down and make 60 monthly payments of $1,255, the builder said. Since the builder gets his money out of the project so quickly, he’s willing to forgo interest.

The Kenneth Leventhal accounting firm recently conducted a tax-reform seminar in Palm Springs to allay the fears of real estate salesmen who “had a concern that the desert would become a ghost town,” said Richard Shapiro, a partner in the firm. Believing that most second-home owners would actually fare better under the proposal than they do now because of the plan to sharply reduce tax rates, Shapiro advised seminar participants to “go to your synagogue, temple or church and pray that the new tax law passes.”

“What does it matter if you lose part of the deduction if you more than make up for it with a lower tax rate?” he asked.

Shapiro, who favors a crackdown on tax dodges, also thinks it “wrong to isolate real estate and not look at how competing investments would be affected.”

Favored in Tax Laws

“Real estate,” he said, “has always been favored in the tax laws . . . and there’s no reason to believe real estate won’t remain a more attractive investment than others.”

Bank of America’s Salkin agrees. “Say you have a $250,000 house in California financed conventionally. And in the early going it dropped 10% or 15% in value because the tax laws are changed. I’m not sure you’d think you were better off. But if you wait a year or so, you may find that housing is the only (investment) game in town and the values could reverse.”

Some consumers, who are just barely able to scrape together enough for a down payment on a modest second home, may not be able to make their payments without benefit of the tax deduction. Fitts of Colony Resorts predicts that more of these “borderline investments” will fall into foreclosure if the Treasury proposal becomes law.