Stephen Ashley isn’t sure how much his company will benefit from a 116-word tax break for residential property owners slipped into the omnibus and coronavirus relief package late last month.
But the Rochester, N.Y., apartment developer thinks it will be worth more than the $540,000 his company spent lobbying for what he describes as a technical fix to the 2017 tax code overhaul.
Ashley, whose company owns about 3,000 apartment units in upstate New York, and other real estate developers will benefit from a tweak to the 2017 tax law that had resulted in higher taxes for the more heavily indebted owners of residential rental property.
The fix in last month’s spending package allows certain owners of apartments built or bought before Jan. 1, 2018, to depreciate their investments over 30 years instead of 40 years. The Joint Committee on Taxation estimates the provision, buried on page 2,452 of the massive omnibus package, will cost $3.3 billion over 10 years.
Ashley and others familiar with the 2017 law’s drafting said it wasn’t lawmakers’ intent to subject residential property owners to the longer depreciation period. But the law’s text was clear enough that the Treasury Department couldn’t regulate property owners out of the crosshairs without new legislation, Ashley said in an interview.
“When you sit down and explain the facts to legislators they say, ‘That doesn’t make sense. That wasn’t the right thing to do,’” said Ashley, a former Fannie Mae chairman who knows his way around the Capitol. He says he personally lobbied lawmakers for the fix, and Senate records show he also deployed lobbyists from DLA Piper LLP’s Washington office to work the issue.
Ashley’s hometown congressman, Rep. Joseph D. Morelle, D-N.Y., a member of the powerful Rules Committee elected in 2018 after a 27-year stint representing Rochester in the state assembly, was the lead House sponsor of standalone legislation to enact the fix.
Ashley, who calls Morelle a “longtime friend,” was among the lawmaker’s top contributors to his first run for Congress, according to data compiled by the Center for Responsive Politics.
The industry also won big-name support from South Dakota Sen. John Thune, his chamber’s No. 2 Republican and a member of the tax-writing Finance Committee, who introduced the Senate version.
“It’s a pure benefit for people who are already in this situation” of depreciating their property over 40 years, said Michael Wiener, a Los Angeles attorney who advises clients on complex real estate transactions.
The hope, Wiener said, is that the Treasury Department can quickly come out with guidance on how residential rental businesses can apply for refunds by amending their 2018 and 2019 tax returns.
Based on the JCT’s score of the omnibus bill, during the fiscal year ending Sept. 30, 2021, alone, property owners and developers could benefit to the tune of about $1.2 billion from the Treasury, including refunds.
'Pay the piper'
Before the 2017 tax overhaul, residential rental property owners generally could deduct all of their business interest expenses from their taxes, even if they were so highly leveraged that interest costs outweighed income.
Meanwhile, they used what’s known as the general depreciation system which allowed the cost of a residential rental property to be written off over 27.5 years. So, besides interest expenses, owners could also deduct 3.6 percent of a property’s value every year from their taxes.
The tax overhaul changed both of those deductions for rental property owners.
To help offset a big corporate tax rate cut, the law limited how much interest expense businesses could write off to 30 percent of taxable income.
"Congress said, ‘You got to pay the piper'" if you're a debt-laden business, said Jason D. Dexter, managing director of certified public accountant KPMG’s Washington National Tax Practice.
That would have been a tough blow for owners of smaller housing properties like duplexes and four-unit buildings that are constantly borrowing funds to fix roofs, replace windows and the like, Ashley said.
So the law also gave businesses a way around the interest deduction limits, if they were willing to operate under what’s known as the alternative depreciation system — which for commercial and residential property owners is typically a 40-year depreciation schedule. That’s the equivalent of a smaller 2.5 percent annual deduction than under prior law.
The 2017 law’s drafters decided that residential rental property owners should take less of a hit than commercial real estate firms, however, so they wrote into the legislation a more generous 30-year depreciation schedule for residential properties.
But lawmakers didn't specify that the 30-year schedule would apply to all apartment properties; instead, older apartment complexes became subject to the depreciation provision's general effective date of Jan. 1, 2018. For developers with properties "placed in service" before that date, the change amounted to a large tax increase.
Real estate industry groups described the harsher treatment of pre-2018 rental properties as a “drafting oversight,” reasoning that Congress did not intend to make one depreciation rule for older properties and another for new ones.
“There are few policy arguments for requiring real estate firms” to depreciate older properties over a longer period, several industry associations wrote in a letter thanking Thune, Morelle and Rep. Brad Wenstrup, R-Ohio, a cosponsor, for introducing the fix. “Congress seems unlikely to have intended such a drastic change.”
The Dec. 6, 2019 letter, a day after the bills were introduced, was led by the National Multifamily Housing Council and signed by industry powerhouses including the National Association of Home Builders, National Association of Realtors and Real Estate Roundtable.
The injection of cash into a particularly troubled sector could be timely. The squeezed supply of rental housing, particularly for lower-income renters, was reaching crisis levels before the pandemic, according to lawmakers and experts.
According to 2019 census data, nearly 40 percent of renters spend 35 percent or more of their income on housing, a key measure of unaffordability. Unemployment rates have since nearly doubled, leaving millions of tenants facing eviction and landlords in dire financial straits.
Morelle said in a statement the 2017 law had “endangered our nation’s already critically low affordable housing supply” and that the 30-year depreciation period will “alleviate financial pressure placed on tenants and multi-family home owners, who are now under even greater strain due to the COVID-19 crisis.”
Matthew Berger, who handles tax policy for the National Multifamily Housing Council, said the omnibus provision corrects a flaw in the tax code that "unnecessarily disrupted cash flows and increased the tax liability" of apartment developers. The result was less money to invest either in older assets or to develop new properties, Berger said.
'Technical' fix or not?
It’s not entirely clear why the fix for older residential properties wasn’t included in the original 2017 tax law.
It's possible it was just a "drafting error," as Berger put it, exacerbated by the breakneck speed with which Republicans wrote and passed the complex tax overhaul.
It’s also possible the drafters had their eye on costs, given their budget reconciliation instructions to keep the deficit impact to no greater than $1.5 trillion over a decade. And it's possible some wanted to ensure the benefit was an incentive for new construction and investment.
But the fix wasn’t merely “technical” enough for the JCT to assign zero cost to it, as the revenue scorekeepers did with a depreciation fix for retail stores and restaurants they said would simply align the law’s text with their own understanding of lawmakers’ intent.
In any event, Ashley thinks industry lobbyists simply dropped the ball in the 2017 negotiations. “Their focus was entirely on preserving carried interest,” he said.
That’s a reference to the more generous capital gains tax treatment real estate and other investment partnerships can claim on their share of a fund’s profits from asset sales. The final 2017 law increased the asset holding period needed to qualify for lower capital gains rates from one to three years, costing investment partnerships an estimated $1.1 billion over a decade — far less than critics of carried interest treatment wanted.