State and Local Tax Receipts Continue to Improve

Property taxes are the largest single source of state and local tax receipts, according to NAHB tabulations of the Census Bureau’s quarterly tax data. At 40.3%, property taxes represent a significantly larger share than the next largest sources: individual income taxes (28.1%) and sales taxes (27.2%). From the second quarter of 2013 through the end of the first quarter of 2014, approximately $494 billion in taxes were paid by property owners. This was a small increase from the previous trailing four-quarter $492 billion.

Overall, state and local revenue in the first quarter of 2014 increased $7 billion over the first quarter of 2013. There were increases in all four of the major revenue sources; property tax, state and local individual income tax, corporate income tax, and sales tax.

State and local government individual income and sales tax revenue continue to experience the largest increases. From the second quarter of 2013 through the end of the first quarter of 2014, approximately $345 billion in individual income taxes were paid. This represents an increase in individual income tax revenue of nearly $20 billion or 6% from the one year ago. The increase in sales tax revenue for the same period was approximately $16 billion or 5%.

Although house prices experienced healthy increases over the last two years, one should not expect property tax collections to increase significantly. Instead, lagging assessments and the ability of local jurisdiction to make annual adjustments should lead to only modest increases. The S&P/Case-Shiller House Price Index – National Index grew by 2.5% on a not seasonally adjusted basis in the fourth quarter and 10.3% last year.

Property tax collections are not as prone to cyclical fluctuations as sales or income tax collections. Annual adjustments to tax rates and lagging property assessments smooth collections across business cycles. The relatively low volatility is reflected in steadily increasing nominal property tax collections.

* Data footnote: Census data for property tax collections include taxes paid for all real estate assets (as well as personal property), including owner-occupied homes, rental housing, commercial real estate, and agriculture. However, housing’s share is by far the largest when considering the stock of both owner-occupied and rental housing units.

 

Working at Home: Who Claims the Home Office Deduction?

Often cited as a “red flag” for audits, the home office deduction is in fact a legitimate business deduction with particular importance for certain careers and small business owners. Moreover – from the housing economics perspective – IRS data concerning the deduction, along with Census data reporting who works at home, can shed light on an important and growing role for homes: workplaces for business owners and telecommuters.

There’s no doubt that the practice of working at home is on the rise. According to data from the Survey of Income and Program Participation, in 1997 7% of workers (9.2 million individuals) reported working at home at least one day a week. By 2010, that total had grown to 9.4% (13.4 million), an increase of more than four million or 35%.

The geographic distribution of those workers who primarily work at home (most days) shows interesting geographic clustering. Using data from the 2012 Census Bureau American Community Survey, the map above charts the share of the workforce (age 16 and over) who report working at home. The highest shares are found in the West, the Northwest, the Upper Midwest and New England. The state of Vermont has the highest share (7.1%), followed by Montana (6.5%), Colorado (6.5%), and Oregon (6.3%). Louisiana has the lowest share at 2.3%.

The reasons behind this geographic distribution are not immediately clear. Potential explanations include the geographic distribution of jobs that are more likely to include or allow at-home employment, weather, age/education differences in the workforce, and less quantifiable differences in workplace culture across states. Regardless, the growth of working-at-home represents a business opportunity for both remodelers and builders to help accommodate homes for this growing purpose.

The most recent industry-specific IRS data available (2010) for the home office deduction for independent contractors and sole proprietorships (Form 8829) (not telecommuters) provides a sense of who is using space in their home for a dedicated office.

Not surprising, workers in industries that involve more individual independence or technology tend toward greater use of the deduction. For example, educators, the information technology sector, professional services (lawyers, accountants, architects, etc.), and those in the arts and entertainment sectors are all more likely to claim the home office deduction. The real estate sector is in the middle category, with many Realtors reporting home office expenses. Home office deductions are less common in the construction sector, although many small construction firms do have home office expenses.

Specific sectors with high levels of home office deduction use include textile producers, electronics producers, nonstore based retailers, publishers, video/audio producers, broadcasters, internet based workers, certain financial workers, real estate brokers, appliance and video rental services, CPAs, architects, engineers, drafters, building inspectors, designers, science and business consultants, advertisers, marketers, business administrators, educators, doctors, social workers, actors, and religious and professional organization workers.

Overall, according to IRS data for tax year 2011 $9.8 billion in home office expenses (insurance, rent, repairs and utilities) were claimed on IRS Form 8829. The deduction is split into two classes: direct expenses related to the actual officer and indirect expenses that apply to the home as whole and are only partially deductible. Approximately 6 out of every 7 dollars claimed as a deduction originate from this indirect class. An additional $1.3 billion in home office related depreciation deductions was claimed in 2011.

Taxpayers who are likely to claim the deduction, including small business owners (builders and remodelers) and Realtors, should be aware of the rules. The IRS has a good summary page on the deduction. More details can be found in IRS Publication 587, which includes the following useful flowchart regarding qualifying.

From a tax law perspective, two key changes are worth noting. First, in 2013 the IRS provided a simplified method for claiming the deduction, which can save taxpayers time in filing the required form. Under this approach, taxpayers may claim a $5 per square foot of home office space (up to a maximum of 300 square feet), other expenses such as mortgage interest and real estate taxes are claimed on Schedule A, and no depreciation deduction (or future recapture) is allowed.

Second, for those who have often heard about strict tests connected to the deduction, do keep in mind tax law changes made in 1997 that went into effect in 1999. Under the Taxpayer Relief Act of 1997, a residence can qualify as a principal place of business when it is used to conduct administrative or management activities if there is no other fixed business location. This change clarified a lot of uncertainty regarding the deduction for many classes of workers. However, for all taxpayers (homeowners and renters), the office space must be exclusively used for business purposes.

Telecommuting employees are less likely to be able to claim the deduction (they must itemize for example), and should consult IRS Form 2106 for additional detail.

Tax Policy and Housing

Tax policy plays a key role in shaping housing demand, determining business conditions and deterring or fostering economic growth. Housing-related tax policy is of such significant importance that it has been selected as a primary issue for NAHB’s 2014 legislative conference, “Bringing Housing Home,” which takes place March 17-21 as home builders and other members of the residential construction industry meet federal lawmakers. As part of this event, yesterday we examined labor issues and tomorrow we will look at the future of the housing finance system.

The mortgage interest deduction (MID) is a cornerstone of housing tax policy. Deductions for mortgage interest have been permitted since the establishment of the income tax in 1913. Broadly claimed, the deduction facilitates homeownership by reducing the after-tax of purchasing a home with a mortgage. The MID also creates parity with other forms of investment for which interest expense is deductible.

According to 2012 data from Congress:

• The MID benefitted 34.1 million homeowning households for a total savings of $68.2 billion in that year alone
• Two-thirds of the tax benefit was collected by households earning less than $200,000 in economic income
• For households earning between $100,000 and $200,000 (e.g. married couple each earning $55,000), the average tax savings was more than $2,000 for just a single year

Historically more than 85% of mortgage interest paid is claimed as a deduction on Schedule A. That is, most people paying a mortgage are in fact itemizing taxpayers. And the largest benefits as a share of household income, are typically for younger households, who are paying mostly interest in the early years of a mortgage.

The rules for second homes are also critically important for homeowners who change principal residences within a tax year, traditional seasonal residence markets, and custom home construction in which the eventual homeowner takes out a construction loan. This broad use of the second home MID rules is illustrated by examining the geographic distribution of the second home housing stock.

Public opinion polling consistently reports that homeowners and renters – prospective homebuyers – favor retaining present law rules concerning the MID and defending our nation’s commitment to homeownership. For example, a 2013 United Technologies/National Journal Congressional Connection Poll asked respondents to rate the importance of various tax rules. The results indicated that 61% of respondents said that it was ”very important” to keep the MID, with 86% of individuals saying it was either “very important” or “important.” This placed the MID second in their list, falling behind only tax preferred retirement accounts, such as 401(k)s, which scored a 63% “very important” ranking.

Recent economic research has linked the use of the MID with intergenerational income mobility. And macroeconomic modeling by the Tax Foundation found that repealing the MID to lower-income tax rates would reduce GDP growth.

Another important tax program on the rental housing side of the industry is the affordable housing credit or LIHTC. Created as part of the last major tax reform effort in 1986, the Low-Income Housing Tax Credit (LIHTC) replaced previous policies with a successful private-public partnership that ensures the development of housing for low- and moderate-income Americans. Since its inception, the program has financed the construction of more than 2.5 million affordable homes.

The LIHTC allows equity investments to be raised at lower cost, which makes the production of affordable housing possible. The LIHTC sustains 95,000 new full time jobs per year across all U.S. industries—generating $2 billion in federal tax revenue. No other housing program has been as successful as the LIHTC in producing safe, high quality, affordable rental housing. While the program has been producing approximately 75,000 new homes a year, the need for affordable housing remains strong given rent burden levels across the nation.

For these reasons noted above, the future of the MID, the LIHTC, and other housing related tax provisions should be watched carefully in any future tax reform effort. A recent discussion draft of a comprehensive tax reform proposal from House Ways and Means Chairman Dave Camp would, for example, make significant changes to these and other tax rules.

Tax Reform Discussion Draft: What the Housing Industry Needs to Know

Chairman Dave Camp of the House Ways and Means Committee published a discussion draft of a comprehensive tax reform proposal on February 26th. The 979 page legislative draft adopts the policy strategy of broadening the tax base, while lowering income tax rates. These changes are approximately revenue neutral according to the Joint Committee on Taxation.

In practice, this approach means the elimination or modification of many deductions, credits, exemptions, exclusions and other rules in exchange for lower income tax rates. While there is approximately no net revenue change for the government and little change for average taxes paid by all income classes of taxpayers, there are many winners and losers within those classes in terms of changes in tax liability due to the many changes involved in the proposed reform.

NAHB is examining the proposal in its entirety to evaluate its impact on the housing industry, including home builders, multifamily developers, remodelers, and homeowners and homebuyers. Some changes represent negatives for housing, while others may offer benefits.

What follows is list of proposed changes to existing federal tax law that should be of interest to the greater housing and real estate industry. In the weeks ahead, we will quantify the impacts of many of these changes as part of an effort to evaluate the economic impact of the draft. For example, our next post on this tax reform draft will examine the dynamic (macroeconomic) analysis produced by the Congressional Joint Committee on Taxation, which indicates the impact of this comprehensive tax reform proposal on jobs, GDP, and the business capital stock.

Individual Taxpayer Issues and Pass Thru Entity Rules

Income Tax Rates

The existing tax rate system would be replaced with, effectively, a three tier tax rate system: 10%, 25% (beginning at $71,200 for joint returns), and 35%, which is made up of the 25% rate and a 10% surtax on AGI amounts in excess of $450,000 ($400,000 for single returns).

The 10% rate is phased out for AGI in excess of $300,000 ($250,000 for single returns).

The additional 10% surtax would allow deductions for the calculation of that excess for a number of items including charitable deductions for itemizers and “qualified domestic manufacturing income,” which includes receipts derived from construction of real property. This definition does not, however, include receipts from residential rental activity.

It is important to keep in mind that individual income tax rates are business tax rates for pass thru entities, such as S Corps and LLCs, which make up most real estate related businesses.

Capital gain and dividend income would be subject to ordinary income tax rates, although allowed an above-the-line deduction equal to 40 percent of that income. As the 3.8% net investment income tax remains in place in the draft, with the 40% exclusion, the top capital gains tax rate would be 24.8%.

Future tax bracket dollar thresholds would be determined by chained CPI, rather than CPI-U as under present law.  This would reduce the inflation adjustments and lead to lower bracket thresholds in the future relative to present law.

The individual Alternative Minimum Tax is repealed.

Itemization

To claim the mortgage interest deduction, taxpayers must itemize – that is, have total Schedule A deductions in excess of the standard deduction. The draft proposal would raise the standard deduction significantly to $22,000 ($11,000 for single taxpayers). However, the standard deduction is phased out for taxpayer’s with AGI in excess of $513,600 ($356,800 for singles). Such taxpayers would also have their itemized deductions phased out.  This phaseout would replace the present law Pease phaseout of itemized deductions, which acts as a marginal tax rate increase.

More fundamentally, the significant increase in the standard deduction amount would reduce the number of taxpayers who itemize from 30% to approximately 5%. Due to other proposed changes, the mortgage interest deduction and the charitable deduction, which itself is proposed to be subject to a 2% AGI floor to claim the deduction in the draft, would effectively be the only remaining itemized deductions allowed for most taxpayers. For homeowners to itemize, these two sources would need to sum to an amount greater than the standard deduction.

Personal Exemptions

For 2014, taxpayers may claim personal exemptions for members of their household in the amount of $3,950 per qualified person. These exemptions would be repealed and replaced by the larger standard deduction.

Child Credit

The child tax credit increases from $1,000 to $1,500, in part to make up for the loss of the personal exemptions for qualified children.

Mortgage Interest Deduction (MID)

The present law $1 million principal cap for a first and a second home is reduced over four years to a new cap of $500,000 (not indexed to inflation). The new cap would not apply to existing mortgages, just new purchases. Refinancings of existing mortgages would be governed by the $1 million cap, provided the refinancing did not increase the amount of principal owed. Home equity interest deductions are disallowed, although home improvement loans would continue to qualify as acquisition indebtedness, similar to present law AMT rules. Additional IRS reporting requirements would apply, including the amount of outstanding principal and the date of origination.

Real Estate Tax Deduction

The deduction for property taxes paid on owner-occupied homes would be eliminated, along with other state and local income, sales, and personal property tax deductions.

Capital Gain Exclusion for Principal Residences

For the purposes of the $500,000/$250,000 gain exclusion for the sale of principal residence, the draft extends the ownership and use period test, from two years out of five (as under present law) to five years out of eight. The exclusion can only be used once every five years. And finally, the exclusion is phased out by income dollar for dollar for AGI in excess of $500,000 ($250,000 if single).

Residential Energy Credits

The proposal would retain the sunset or eliminate all housing related energy efficiency tax credits, including the section 25C energy-efficient remodeling credit, the 25D residential power credit (for solar, wind turbines, etc, which expires at the end of 2016), the 45L $2,000 new energy-efficient home tax credit, and the 179D commercial and multifamily retrofit deduction.

Net Earnings from Self Employment and S Corps/Partnerships

Under the proposal, self employment income for FICA taxes would now include an S Corporation shareholder’s (or partnership equivalent) pro rata share of income. Individuals with no material participation would continue to exclude the income from self employment tax, with participation defined by similar rules as the tax code’s passive loss rules. All other shareholders could claim a deduction equal to a share of the income, with the share determined by the lesser of 30% of the sum of the relevant pass thru income and wages from the S Corporation or pass-thru net earnings from self employment. This share is intended to capture the historical portion of U.S. GDP due to non-labor income.

Moving Expenses

The above-the-line deduction for moving expenses, when relocating for a new job, is repealed.

Repeal of the Exception to the 10% Penalty for IRA Withdrawals

The ability to withdrawal some funds from a tax preferred retirement account for a first-time home purchase is repealed.

Corporate and Other Business Tax Reform Issues

Low Income Housing Tax Credit

The legislative draft retains the LIHTC, but makes several changes to the affordable housing credit. Credits will now be allocated by cost basis, rather than credits as under present law. Next, the 130% basis boost option is repealed. The national unused housing credit pool would be repealed. A significant change involves extending the 10 year credit claim period to 15 years, which will reduce syndicated credit prices. However, the 70% present value formulation is adjusted to remain 70% over the 15 year period. The draft repeals the 30% present value credit (the 4% credit).

Like Kind Exchanges

The nonrecognition of capital gain due to like kind exchanges is repealed for all transactions, with the exception of certain binding contracts entered into during 2014.

Private Activity Bonds

The legislative draft eliminates the tax exemption for PABs, including multifamily rental bonds and mortgage revenue bonds.  The draft also eliminates the mortgage credit certificate option.

C Corporation Tax Rate

The proposal lowers the C Corp tax rate to 25% after tax year 2018. The lower rate is phased in between 2014 and 2018.

Carried Interest

The proposal requires treating certain capital gain income due to a carried or promoted interest as ordinary income for tax purposes. However, capital gain income due to a carried interest associated with real estate (i.e. section 1231 property) retains its character as a capital gain.

Contributions of Capital

All contributions of capital are included in gross income, other than contributions of money or property for exchange of stock or interest in an entity. Under present law, contributions in aid of construction are taxable, with the exception of certain water and sewer items. Under the proposal all such contributions would become taxable.

Depreciation

Residential rental real estate is subject to a 27.5-year depreciation life. The proposal would extend the depreciation period for newly developed real property to 40 years. An inflation adjustment would be allowed, that would increase depreciation deductions somewhat.  The Treasury Department would be instructed to develop depreciation periods for other forms of tangible property.

Completed Contract Accounting

The tax code’s long term accounting rules require use of the percentage of completion method of tax accounting for contracts lasting more than one tax year. A notable exception to this rule is the home construction contract rule, which the home building industry obtained after the 1986 reform effort to prevent builders from having to finance tax payments as part of the development process. The draft repeals this exception, but leaves in place the small construction contract exception for businesses with gross receipts of less than $10 million (three year average, not indexed for inflation).

Advertising

Under the draft, 50% of advertising expenses must be capitalized and thus no longer available for immediate write off. The capitalized expense would be amortized over a ten year period. Taxpayers with less than $1 million in advertising in a given tax year would be exempt from the capitalization requirement.

Small Business Expensing

Section 179 small business expensing would be made permanent for a maximum of $250,000, which is reduced by the amount that the qualified property investment exceeds $800,000. Both amounts are indexed to inflation.

Installment Sales

Installment tax accounting is permitted for certain dealer dispositions of timeshares and residential lots under present law. The legislative draft repeals these exceptions to the more general prohibition against installment sale accounting to report gains income.

Brownfield Expensing

The rule allowing brownfield expenses to be expensed would be repealed, although over a number of years.

Exit Tax (section 1250 gain)

Under the proposal, a taxpayer must recapture the gain on disposition of section 1250 property as ordinary income to the extent of earlier depreciation deductions taken. Recapture of depreciation attributable to periods before January 1, 2015, is limited to the depreciation adjustments only to the extent that they exceed the depreciation that would have been available under the straight-line method.

Rehabilitation Credit

The tax credit for historic rehabilitation of rental properties is repealed.

UNICAP Rules

The draft expands the exception to the uniform capitalization rules for certain small taxpayers. Any business that produces or acquires real or tangible property with average annual gross receipts of less than $10 million is not subject to the UNICAP rules under the proposal.

Independent Contractor Status

The proposal provides a safe harbor under which if certain requirements are met. These include a written contract and certain tax withholding.

Section 199 Domestic Production Activities Deduction

The legislative draft gradually phases out the existing deduction for domestic economic activity, including construction, with final repeal in tax year 2017. The existing deduction is equal to nine percent of qualified income.

Housing-Related Tax Rules That Expired at the End of 2013

At the end of 2013, a number of housing-related tax provisions expired. Collectively, these housing and other tax rules are part of a set of policies known as “tax extenders,” which have traditionally been extended every year or so.

While there is growing support for extending most, if not all, of these provisions, a potential debate on comprehensive tax reform may delay any Congressional effort to extend these rules. If such a delay carries through until late 2014, perhaps in a lame duck session after the election, then it is possible that a future extension may not be retroactive for 2014. In the past, Congress has enacted retroactive extensions, but such actions cannot be relied on for the future.

Thus, homeowners, builders, remodelers, and other real estate professionals are well advised to consider that it is possible that these provisions may not be part of 2014 tax law.

Another complicating factor for the tax policy agenda in 2014 is the news that Senate Finance Committee Chairman Max Baucus will be resigning to become the U.S. ambassador to China. While it is expected that Senator Ron Wyden will become the next chairman of the committee, what impact this transition will have on tax extenders is uncertain.

The following housing or real estate related tax provisions expired at the end of 2013:

Housing Rules

• Mortgage debt forgiveness tax relief: rule that prevents tax liability arising from many short sales or mitigation workouts involving forgiven, deferred or canceled mortgage debt.
• Deduction for mortgage insurance: reduces the after-tax cost of buying a home when paying PMI or insurance for an FHA- or VA-insured mortgage; $110,000 AGI phase-out.
• The section 25C energy-efficient tax credit for existing homes: remodeling market incentive with a lifetime cap of $500.

Business Rules

• The section 45L new energy-efficient home tax credit: allows a $2,000 tax credit for the construction of for-sale and for-lease energy-efficient homes in buildings with fewer than three floors above grade.
• The 9% LIHTC credit rate: absent the credit fix, the LIHTC program would suffer a loss of equity investment for affordable housing projects; in place for 2013 allocations.
• Base housing allowance rules for affordable housing: income definition rules.
• The section 179 small business expensing limits: offers cash flow and administrative cost benefits for small firms, with limits of $500,000 for deductions and $2 million for capital purchases.
• The section 179D deduction: provides a deduction for some energy-efficient upgrades to multifamily and commercial properties.
• New Markets Tax Credit: no new allocations of this community development tax credit.

Senate Finance Staff Discussion Draft: Energy Tax Incentives

Last week saw the release of yet another discussion draft from the staff of the Senate Finance Committee concerning tax reform. Following draft proposals concerning depreciation/accounting and other business expenses (such as advertising), the most recent draft proposes changes to the tax code’s rules concerning energy production and energy-efficient improvements.

Under the draft proposal, most existing energy tax incentives would be eliminated or otherwise allowed to sunset and replaced by two credits.

The first would be a tax credit for the production of clean energy, with the value of the credit determined by the amount of greenhouse gases produced during production – greener production, more credit. The credit could be claimed either as an energy production credit or an investment credit of up to 20% based on installed qualified equipment. The credit would become effective for new power production facilities after January 1, 2017, although after 2016 a 20% credit would be available for existing facilities that retrofit to capture at least 50% of carbon dioxide emissions. The credit would phase out when U.S. electricity production emits 25% less in greenhouse emissions.

The second credit would reward the production of any transportation fuel that is 25% cleaner than conventional gasoline. The maximum credit would be $1 per gallon, with the actual credit determined for the fuel relative to gasoline. The credit would begin in 2017. Alternatively, an investment credit would be available based on 20% of the value new, qualified production facilities.

In turn, the draft proposal would eliminate or phase out almost all existing energy tax incentives. For housing, this means:

• The section 25C tax credit for energy-efficient improvements to existing homes would sunset permanently at the end of 2013
• The section 45L $2000 tax credit for the construction of new energy-efficient homes would sunset permanently at the end of 2013
• The section 179D credit for commercial and multifamily energy-efficient improvements, as proposed in the cost recovery draft, would be eliminated

The section 25D 30% tax credit for residential solar, geothermal, wind turbines, and fuel cells would remain under present law, but the December 31, 2016 sunset would be enforced.

It is estimated that these changes on net could raise $75 billion in tax revenue over ten years.

A number of general principles are embodied in this proposal, with negative consequences for housing and real estate measured against present policy.

First, the proposed approach would clearly favor energy production over energy conservation and retrofitting. Improving existing buildings, or constructing energy-efficient properties with long-run benefits for potential future owners, is an approach that is rewarded under the existing tax credit system.

Second, the proposed tax benefits for energy production appear to exclude homeowners and perhaps some rental housing and commercial real estate owners. The proposed legislative drafts indicate that for a taxpayer to qualify for the investment credit (as homeowners can do now under the 25D credit), the installed property must be eligible for depreciation. Homeowners do not claim depreciation deductions, so it appears power produced by an owner-occupied home would not be eligible. Furthermore, to qualify for the first tax credit noted above, any electricity produced on site must be sold to either an unrelated party or metered and monitored by a third-party. This rule may exclude some apartment and commercial real estate owners from the proposed tax rule for on site power production.

If this preliminary analysis is correct, excluding on-site power production is a policy mistake given such production does not suffer from transmission losses. According to the Department of Energy’s Energy Information Administration (EIA), “annual electricity transmission and distribution losses average about 7% of the electricity that is transmitted in the United States.”

NAHB will continue to review the proposal, which could be included in future comprehensive tax reform proposals, and submit comments to the Senate Finance Committee in January. In meantime, discussion is beginning to pick up concerning energy tax extender items, including the section 25C and 45L credits, which expire at the end of 2013.

Advertising Expenses – On the Tax Reform Radar

Comprehensive tax reform is guided by a simple formula that masks a complex process that produces winners and losers. The formula is broaden the base, lower the rates. This means increasing what most taxpayers report as taxable income, but taxing that larger number at a lower marginal tax rate.

To broaden the base, tax policymakers must curtail or eliminate many deductions, credits, and other tax rules. The most common set examined are the annually reported set of tax expenditures, which include broadly claimed and popular deductions like the mortgage interest deduction.

However, as part of business tax reform, other rules not necessarily considered tax expenditures could also be weakened in order to broaden the tax base. One such item included in a recent legislative draft from the Chairman of the Senate Finance Committee is the deduction for advertising expenses.

Under present law, advertising expenses are deductible as ordinary and necessary business expenses. However, under the legislative draft a business would be required to capitalize and amortize 50% of advertising expenses over a five-year period. The remaining 50% could be deducted in the year of the expense. The net effect of this proposal would be to increase the after-tax cost of advertising compared to other business expenses.

To examine the industry impact of this proposal, we thought it would be interesting to use recent IRS data to examine how important advertising is for various sectors. The following graphs use 2010 (the most recent available) IRS Statistics of Income data for businesses who file Form 1120, which includes C Corporations and some S Corporations.  The data exclude a number of kinds of firms, including sole proprietorships and partnerships, so the information is not a complete accounting of business activity, but rather a useful sampling to examine sector differences.

It is immediately clear that construction ranks fairly low in terms of advertising use, at least as measured in terms of total advertising dollars as a percent of annual business receipts. As a sector, the construction industry spent 0.34% of total 2010 receipts on advertising. This compares to 0.98% for all industries. The highest shares tend to be in industries like entertainment and information services where economies of scale produce more intense national completion. Taxable educational business had the highest overall advertising spending in 2010 at 5.78% of receipts.

These data indicate that while changes to the tax treatment of advertising would be an issue worth exploring in tax reform, the construction and real estate sector would be relatively less affected than other areas of the economy.

A more detailed look at construction and real estate firms is presented above. Advertising in 2010 was least used by civil construction and land development at 0.17% of total receipts.  Following next are businesses who construct residential and nonresidential buildings with 0.26% of total receipts in advertising expenses and specialty construction trade contractors at 0.49% of receipts.

The only category within the real estate industry that exceeded the national average was the “real estate” category, coming in at 1.16% of total receipts. The industrial code reflects lessors of rental real estate, property managers, and those engaged in selling, buying, or appraising real estate.

Tax Accounting and Home Building: Tax Reform Impacts

Tax accounting is not the most exciting topic, even to tax geeks.  But it can be important. This is certainly the case for how federal tax law treats income due to construction contracts. Among other proposals in a recent Senate Finance Committee legislative draft is a change that would, if enacted, affect how and when home builders pay taxes for home construction. NAHB has argued in testimony to protect present law and will submit comments on the proposal described in this post.

First – present law. One of the changes made by the Tax Reform Act of 1986 required more business taxpayers to pay a portion of expected income taxes prior to completion of a contracted project.

Such long-term contracts (which includes a building construction contract not completed within the tax year in which it is entered into) must use the percentage-of-completion (PCM) method of tax accounting, in lieu of the completed contract method (CCM). Under the PCM method, taxpayers must report expected income from the contract proportional to the tax years in which construction costs are incurred, regardless of when revenue is received. The net result is that under the PCM method, home builders would be required to pay a portion of income tax prior to completion of construction and sale when home construction spans multiple tax years. This could require having to finance a portion of expected income taxes among other development costs.

Targeted at multiyear, large manufacturing and defense contracts, the 1986 change was originally intended to exempt home building. Builders considered their agreements with customers sales contracts, not construction contracts, and thus not subject to the rule. Among other differences with construction contracts, home building agreements do not typically involve progress payments, and while buyers place downpayments, such funds are generally held in an escrow account and cannot be used to cover construction or tax costs. However, in 1988 the IRS published guidance that NAHB recognized would include home building in the construction contract definition.

Recognizing the harm that IRS implementation of 1986 rule could cause to the home building sector, NAHB succeeded in having Congress enact exceptions to the long-term contact rules. The most important was the home construction contract exception, which provides an exemption from the PCM requirement for any contract for which 80 percent or more of estimated total costs are expected to be attributable to 1-4 unit home building and site improvement for such homes. Such contracts can use the CCM under which net income from the contract may be reported in the year in which the contract is completed and accepted.

A further partial exception is available for construction of 5+ unit housing, under which the taxpayer may use a 70/30 split: 70% PCM and 30% exempt from PCM. A final exception is available under the heading of “small construction contracts.” Under this rule, contracts expected to be completed within two years and performed by a taxpayer whose average annual gross receipts for three prior tax years is no more than $10 million may use the completed contracted method.

Under the Senate Finance Committee Chair draft proposal, the home construction contract exceptions noted above would be repealed. The small construction contract exception (the $10 million rule) would be retained, and it would be indexed for inflation. The result of these changes would be to add complexity and financial burdens on many home builders, particularly in high cost areas.

In the final analysis, the proposal repeals a fix made to the 1986 Act that was widely recognized as placing an accounting burden on small businesses. Given that many builders will fall into the definition of a “long-term contract” because construction can span across two tax years (even if taking less than 12 months in total), the proposal is clearly anti-growth and investment. While imposing financing challenges on builders, it is also only a revenue gainer for the government in the sense that it is a timing change. For these reasons, NAHB will oppose any changes to the home construction contract rules in the tax code.

Finance Chair Tax Reform Draft: Impacts for Builders and Multifamily

This week saw the release of a number of tax reform drafts from Senate Finance Committee Chairman Max Baucus.  Coming after drafts concerning international tax rules and tax administration, the final release of the week involved depreciation and accounting issues.

A number of these proposals would have negative impacts for home building, multifamily, and real estate in general.  It should be noted that, in part, the intent of these proposals is to provide funds to pay for base broadening tax reform, which would lower corporate and individual income tax rates. However, a proposed rate structure has not yet been unveiled.

NAHB’s initial review of the draft proposal flagged the following items that would be of concern for housing and real estate stakeholders:

• Repeal of the tax rules for like kind exchanges.
• The depreciation period for structures, residential and commercial, would be extended to 43 years. This marks a large increase for residential rental property, which holds a 27.5 year period under present law. There would also be longer depreciation periods for all other kinds of assets, including building components.
• The section 179D deduction for energy efficient commercial and multifamily property improvements would be repealed.
• Recaptured depreciation would no longer be taxed at 25% for some rental property owners, but instead would be taxed at ordinary rates (proposed ordinary rates have not been published).
• The home construction contract exception, that allows builders to pay income taxes on home sales after the actual sale (the completed contract method) when the construction period spans two or more years, would be repealed. However, builders would still be able to use the completed contract method provided their average annual gross receipts for the prior three years were less than $10 million (indexed to inflation in 2015).
• Advertising expenses would no longer be immediately deductible as a business expense. Under the proposal, 50% of advertising expenses would be capitalized and claimed over a 5 year period, with the remaining 50% available for immediate write off.

On the positive side, the proposal puts into place a permanent regime of section 179 small business expensing. Business taxpayers could write off immediately up to $1 million of business related tangible personal property, with that limit phasing out beginning at levels of $2 million of business property purchased.  Section 179 expensing is a helpful tax simplification rule.

What happens next?  NAHB will continue to examine the details concerning this proposal and submit comments to the Finance Committee. This proposal represents the first legislative draft in what is expected to be a long process concerning tax reform. The Senate Finance Committee may release additional draft proposals, and it is expected that House Ways and Means Chairman Dave Camp will unveil his own comprehensive tax reform plan in the coming months.

In the meantime, we will continue to review and analyze the legal and economic implications of these tax proposals, with an eye on potential impacts for housing and construction.

Land Value Tax: An Alternative to the Property Tax

An alternative to the local property tax, the land value tax offers certain benefits over the economically inefficient property tax. However, its novelty and legal and political challenges continue to make it an elusive option at this time.

According to numerous polls, the most hated tax is the local property tax. Economists Marika Cabral and Caroline Hoxby argue that Americans are averse to the property tax because it is the most noticeable and important major tax. In addition, many economists agree the property tax is economically inefficient because it taxes the value of improvements, which acts as a tax on economic development. A tax is said to be inefficient if another system could raise the same revenue while increasing economic growth.

One proposed alternative to the property tax is the land value tax. The land value tax would allow state and local governments to maintain control over a significant source of tax revenue while addressing issues of efficiency.

Although not used extensively, the land value tax is more than a theoretical abstraction. Local governments in New York, Pennsylvania and Hawaii have used it. In addition, twenty-five nations use some form of the land value tax.

The land value tax has been implemented in two forms. In a pure land value tax system, the tax is applied to the value of the land with no tax applied on improvements. In a split-rate tax system, land value is taxed at a higher rate than improvements. For example, in Harrisburg, the 2008 tax on the value of land was 28.67 while the tax on improvements was 4.78, a ratio of 6 to 1.

In addition to being more economically efficient, proponents argue that the land value tax provides an incentive for development. The evidence to support this conclusion is limited by the availability of data within the United States. Economists Oates and Schwab in a 1997 paper find a positive association between adoption of land value taxation and building activity in Pittsburgh. In a 2000 paper, economists Plassmann and Tidemann use data from 15 Pennsylvania municipalities and find a direct, positive relationship between the tax differential between land and improvements and the number of building permits. In other words, under a split-rate system, Plassmann and Tideman find evidence that the higher the land tax in relation to the improvements tax, the more building activity occurs.

Elimination of the inefficient property tax system in the U.S. would be challenging because of the importance of the tax revenue to state and local governments. Property taxes are the largest single source of revenue for state and local governments, accounting for over one-third of all revenue. Opponents of the land value tax also argue that it encourages overdevelopment. The land value tax was largely blamed for the overdevelopment of Waikiki. Although unwanted higher density was most likely the result of poor planning rather than the land value tax, the county of Hawaii abolished the land value tax in 2002.

A recent study, Assessing the Theory and Practice of Land Value Taxation, lays out a framework for implementing the land tax. Another study, Land Value Taxation – Theory, Evidence, and Practice, includes an exhaustive discussion of legal issues that need to be overcome in each state in order to implement the land value tax. The legal and political challenges of changing the current property tax system are daunting.

In spite of these challenges, Connecticut signed into law this June a pilot program allowing three municipalities the option of implementing a land value tax. The success or failure of the program will likely determine the programs expansion within the state.