With federal tax reform legislation heading for its final set of Capitol Hill hoops -- a Senate-House conference after the July 4 recess -- American real estate owners can begin to plot their strategies for the balance of the year and for 1987.
Discussions with congressional committee tax experts here last week offered clues to how the bill will shape up in the month-long conference coming soon. Here's what experts said, and what it means if you're a small-scale investor or the owner of a first or second home.
The odds are good that the conference will not impose a limitation on the ability of homeowners to borrow against their equity to finance consumer purchases such as cars, vacations or investments.
Although there is what one staff member terms "significant concern" in the House and Senate tax-writing committees that first and second homes constitute "gaping revenue-loss loopholes, particularly for the well-to-do," most policy makers doubt whether any new restrictions on the use of equity-backed borrowing could be policed effectively by the Internal Revenue Service.
Under the Senate's tax bill, interest on loans taken out for consumer purchases no longer would be deductible.
Under the House tax bill, consumer interest deductions would be limited to $10,000 ($20,000 for joint returns) beyond net investment income.
Both bills, however, permit unlimited deductions for interest on mortgages for owner-occupied first and second residences.
This politically sacrosanct provision does create a huge potential loophole. Prohibited from deducting the interest on new auto loans, revolving charge accounts and investments, what would taxpayers be able to do under the new tax rules?
Many homeowners have figured out how they would handle it. They'd sign up later this year for one of the numerous line-of-credit, home-equity plans offered by banks and finance companies.
They'd use an expandable second mortgage on their homes to continue producing deductible interest, even though the ultimate expenditures would be for consumer purposes that otherwise wouldn't qualify for deductions.
The interest rate on such loans would be fixed or would float month to month at one to two percentage points over the prevailing bank prime rate. At the end of the tax year, homeowners would tote up the interest charges from their first, second (and even third or fourth) mortgages on their primary and secondary residences, and continue doing what they did in the pre-reform era: use those dollar deductions to offset their federal tax liabilities.
A move to clamp limitations on this loophole for homeowners failed in the Senate. Given continuing concern on the part of tax reform advocates, don't be surprised if the issue surfaces again in the July conference. At the moment, committee insiders say the inherent enforcement problems associated with new limitations from the IRS appear to tip the scales in homeowners' favor.
How would a mortgage lender, for instance, be able to certify to Uncle Sam that refinancers or second-mortgage borrowers did not use part or all of their loan proceeds to finance a consumer purchase? How could the dollars be traced?
"As long as first- and second-home mortgage financing remains untouchable," said one staff tax expert, "any consumer interest deduction bans are going to be Swiss cheese" for tax policy purposes.
Here are other areas affecting homeowners and investors that will arise in the July conference between the Senate and House: Look for some relaxation in the most controversial real estate issue in the Senate tax bill -- the so-called "passive loss" provision. The Senate's legislation seeks to ban deductions of a wide variety of real estate-related losses, including "paper" deductions (such as depreciation) as well as actual economic losses sustained when rents are lower than the bona fide costs of maintaining an income-property investment.
The House-passed bill contained no such limitations. Although House Democrats like the general concept of restraining the ability of real estate investors to write off losses, staff experts say they balk at prohibiting write-offs of true economic losses.
"Real estate shouldn't be treated in a punitive manner under the tax code," said a House staffer. "It should be treated like any other investment area, which means artificial losses should be controlled, but actual business costs should be deductible." Anticipate a stretch-out of the Senate's current five-year phase-in for its real estate passive loss provisions, possibly to seven years. Look, too, for relief to those investors whose realty partnership holdings would be hit retroactively by the 1986 passive loss restrictions. Expect a compromise on capital gains taxation, particularly if the top individual rate bracket goes beyond the Senate's 27 percent. The House bill raises the maximum capital gains levy to 22 percent, up from the present 20.
The Senate bill does away with favorable capital gains treatment altogether, in effect making the maximum rate 27 percent.
Any substantial upward movement in the 27 percent individual rate -- to 30 percent or above, for example, as advocated by some Democrats -- "will necessitate a return to lower capital gains" for real estate and other investments, predicted a Senate committee member who will sit in on the proceedings.