The tax bill of l986 may well be the most important legislation of this session of Congress. But it is far too soon to predict whether it will be judged to be the major reform that its supporters claim. Offsetting the bill’s many good features are less obvious ones that introduce unexpected consequences and new distortions that may be just as harmful as those that were eliminated.
There probably is no better example of those unintended consequences than the bill’s effect on apartment rents. Simply put, most low- and moderate-income renters will end up worse off than they would have been without the tax reform bill. The primary effect of the changed rules for depreciating new rental housing will be an increase in rents that will more than offset reduced taxes for low- and moderate-income renters.
Under current law, allowable depreciation exceeds the actual decline in the value of buildings. This favorable treatment was designed to encourage improvements in the available stock of housing. The new bill approximately halves depreciation allowances in the first year. For example, a new apartment that would rent for about $500 per month costs about $50,000 to build. Current law produces a tax deductible depreciation allowance of about $300 per month in the first year. The new legislation will cut that allowance back to less than $150 per month. So in order to cover net-of-tax costs, the owner would have to charge an extra $150 per month in rent.
Even if the effect of the new law will be to reduce interest rates by a full percentage point, as many economists expect, that only can offset a fraction of the higher cost of providing rental housing. A 1% reduction in the interest rate on a mortgage of $50,000 would save $500 in the first year, or about $40 per month. That saving would offset less than one-third of the increased cost due to the depreciation loss.
This simple approximation has ignored other considerations, such as the higher tax rate on capital gains when the building is sold, the loss of investment tax credits on the appliances and other equipment in new buildings, and the lower personal rates for the real estate investor. But it dramatizes a result that is only too likely when all the various factors are considered.
Consider a married taxpayer with the median income of about $25,000 a year. Under the new bill this taxpayer is expected to save only about $20 per month in taxes. Such a typical taxpayer who rents pays about $500 per month for housing. If rents rise by about 10% to 15% as they probably will with the new depreciation rules, this typical taxpayer’s rent increase will swamp the meager reduction in taxes.
The driving force in the increase in rents will be the reduction in the supply of new apartments. The change in depreciation rules for new apartments reduces the profitability of additional construction at today’s rent levels and therefore cuts back the overall supply of apartments. Rents have to rise to balance the demand with the reduced supply.
Although the new real estate depreciation rules apply only to new construction, the effect of the reduced supply of apartments and the increased competition for space will inevitably bid up rents across the board. That means that all the existing apartments, including small buildings and owner-occupied, multiple-family units will be affected. So a tax change aimed at eliminating a tax advantage for certain real estate investors will become a force that will increase the cost of housing throughout the economy.
As with any increase in price, there will be secondary effects as the market adjusts over time. Some renters will adjust by consuming less housing--renting smaller or older apartment units with fewer amenities.
Other renters who can afford it will shift toward purchasing their own home, since home ownership will still retain all the special tax breaks that it now enjoys.
There are some ironies here. One of the intentions of the tax reformers was to create a “level playing field” among different types of investment. While the incentive to consume less housing in general may be an example of what they wanted to accomplish, the new law actually exaggerates the distortion toward overconsumption of owner-occupied housing.
The tax reformers probably did not intend to provide a windfall capital gain as a result of the depreciation change. But the main beneficiaries of the induced increase in rents will be the landlords who own the existing apartments. The depreciation rules do not change for these units.
To enlist public support for the tax proposal, certain red flags have been flown to highlight inequities in the current system. There has been much emphasis on real estate tax shelters that provide large losses, which the investors have then used to reduce their tax bills on salaries and professional incomes. But these tax shelters have been primarily based on special tax rules for low-income housing that have given especially favorable depreciation treatment. The changes in these special depreciation rules and the new minimum tax rules that will preclude using losses on such low-income housing investments to offset other tax liabilities will effectively dry up the supply of new housing for the very poor.
There is little doubt that this tax bill will not be the last effort at reform. A few years down the road, a new tax bill will provide an opportunity to correct some of the unintended consequences of this year’s bill and to make some new mistakes as well. We predict that the depreciation of new and low-income housing will be one of the first areas to be revisited.