THE FINAL TAX BILL : Property : Real Estate Industry Finds Changes Devastating

The tax reform bill has the real estate development industry obsessed. “We think about it just about every waking hour,” said Stephen Jarchow, vice president of Lincoln Property Co. of Dallas, one of the nation’s largest apartment builders.

Although the bill is not yet law, its impact is already evident in real estate investment circles. At its heart is the proposal to raise billions for the U.S. Treasury by reining in tax shelters that invest heavily in income-producing property.

The bill “has immobilized anything to do with a (real estate) tax shelter,” said Sanford Goodkin, a real estate consultant in Del Mar. “ . . . It has had the most devastating impact I have ever seen in my 30 years in the real estate industry without the event actually happening.”

The bill curbs a decade of preferential tax treatment for those who invested in limited partnerships that funneled their money into apartments, shopping centers and office buildings. The favored treatment accelerated sharply in 1981 when new tax laws expanded depreciation rules.

Those rules helped pave the way for private investors to deduct large paper losses from the partnerships. As a result, billions of private investor dollars were funneled into building projects, leading to gluts of empty apartments and office buildings in cities around the country.

The impact of this tax policy is particularly evident in Texas. Houston has become notorious for its “see-through” office buildings, empty of occupants and interior walls. Meanwhile, thousands of apartments and condominiums lie empty between Dallas and Fort Worth.

Other Investments Likely

The new law sharply curtails the methods for calculating paper losses, with the expected result that private investor funds will flow into investments other than real estate.

The tax legislation has been opposed fiercely by powerful housing and real estate lobbies, which warn of dire economic consequences.

The National Assn. of Home Builders, for example, said apartment construction will drop by 50% next year as a result of the bill. The slowdown in supply will, in turn, boost rents by a total of 20%, excluding inflation, during the next five years, the association added.

Others suggested that the sharp drop in multifamily housing construction will drive an already sluggish economy into recession. New-home construction is an important economic bellwether because of the jobs and taxes it provides.

Banking Impact Feared

Some warned also of a major impact on the banking industry, where hundreds of banks and savings and loan firms are already trying to cope with delinquent development loans.

The tax bill is expected to add to those problems by reducing the values of income-producing properties by up to 20%. That, in turn, is expected to trigger foreclosures on marginal properties and force even more financial institutions into insolvency.

“The impact on the banks is going to be far worse than anyone wants to admit,” one veteran real estate syndicator said. “They are scared to death about this.”

The pessimists notwithstanding, other real estate insiders say the bill will return a measure of sanity and respect to real estate development. Future deals will have a more conservative flavor because new construction will depend on the real return on investment, not on the tax breaks it offers.

“It will make real estate a more legitimate business,” said Ken Nitzberg, president of Equitec Financial Group in Oakland. “Sometimes, you have to have a shake-up. Sometimes, when the new coach comes in, he has to cut all the old players.”

Continuing the sports metaphor, Nitzberg said: “We have to learn to run off tackle. There has been too much of the triple reverses, with a flea flicker back to the quarterback.”

“The old rules of real estate apply again,” consultant Goodkin said. “It’s location, location, location.”

The new economics mean tough times for many real estate syndicators, hundreds of whom are are not expected to survive the dislocations of the next few years.

Private real estate syndications--in which organizers gather money from investors in order to buy property--raised $4.68 billion last year but are expected to raise less than $1 billion next year.

“The private market is for all intents and purposes dead” because of the tax bill, declared Fuhrman Nettles, vice president of Robert A. Stanger & Co, a New Jersey investment advisory firm.

“There’s a very serious shakeout going on,” added Jarchow, the Lincoln Property executive. “Hardly a day goes by without reading about another syndicator in trouble.”

Raised $8 Billion

At the same time, public partnerships, which must register with the Securities and Exchange Commission, are growing in popularity, according to Nettles. These funds, which raised more than $8 billion last year, tend to be larger, more diversified and more income-oriented than private partnerships.

The private real estate syndications have been particularly popular with affluent investors who want to shelter their large incomes.

Investors who, for example, invest $10,000 in an apartment building have been able to deduct paper losses several times that amount from their real income. These paper-loss deductions result chiefly from accelerated depreciation on the building and interest expenses on the money the partnership has borrowed.

The new bill, however, cuts the heart out of these shelters because it allows investors to deduct these losses only from income from other so-called passive investments, but not against the money they earn at their primary jobs.

In addition, the bill stretches out depreciation from 19 years to 27 1/2 years for rental housing and from 19 to 31 1/2 years for commercial property.

One exception to the rule allows property owners with gross incomes below $100,000 to deduct up to $25,000 a year if they “actively participate” in managing the real estate.

Some say this may boost real estate activity in resort towns like Palm Springs and Lake Arrowhead because it encourages people to buy second homes and rent them. But the benefit is phased out and eventually eliminated as the owner’s income grows from $100,000 to $150,000.

No Grandfather Clause

Perhaps most galling to investors is the fact the bill phases out the present tax benefits over the next five years. There is no grandfather clause retaining the present benefits for those who have already invested in the limited partnerships.

“To change the rules in the middle of the game is just not fair,” said William Dockser, head of CRI, a real estate finance and development company in Rockville, Md.

As a result, some analysts warn that investors may default on billions of dollars worth of commitments in the future because their investments, minus the full tax benefits, no longer make economic sense.

“In five years,” Nettles said, “I think we’ll be Jim Dandy--if we can get that far.”