Tax Credits just don't work

Today, CNN Money confirmed what we already suspected - a double dip in home prices.  They even provided a nice chart.

This, after our government spending $15 billion on tax credits to prop up the real estate industry.  My question for you real estate pros is - how's that working out for you?  To make matters worse, SmartMoney.com reports that recipients of the credits saw their home values decrease at twice the rate of the credit. 

The entire purpose of a tax credit is to entice us to do something that we wouldn't otherwise do.  And the credit always fails.  Always. 

Here is a fresh idea - abolish all tax credits.  I know - insane, right?  What about the credit for insert-your-favorite-cause-here?

OK, I'll go first.  I like the credit for rehabilitation of historic structures.  My office is in a restored 1924 building in the middle of historic downtown Salisbury.  I love the concept of preserving beautiful old buildings.  I'm fortunate to live in a place that has such respect for history.  In fact, Salisbury is somewhat of a leader in historic rehabilitation.  But, I've found that many taxpayers who invest a substantial amount of money rehabilitating an historic structure discover that their credit is limited (sometimes to zero) by the Alternative Minimum Tax (AMT).  Without getting too technical about tax law, suffice it to say that the tax law giveth and the tax law taketh away. 

Lacking a perfect model for post-credit tax law, I offer Adam Smith's "four maxims of taxation" from Wealth of Nations, first published in 1776.  According to Smith, taxes should be:
1. Proportional
2. Transparent
3. Convenient, and
4. Efficient

How does current tax law rate according to those four concepts? 

Scott Hodge of the Tax Foundation said in his 5/2/11 testimony to the Senate Finance Committee "The proliferation of special interest tax preferences, the rising number of nonpayers, and the increasingly redistributable nature of the federal income tax all contribute toward a system that is geared more toward enacting social policy than raising revenue".

Is that what we want?

Tax Opportunity for Real Estate Professionals

The IRS recently released an important ruling affecting “real estate professionals” with losses from multiple rental activities. Revenue Procedure 2011-34 (http://www.irs.gov/pub/irs-drop/rp-11-34.pdf) allows Real Estate Professionals with more than one rental activity (property) to aggregate all rental activities into one activity. The election to aggregate activities can now be made retroactively.

Why is this important? The law states that real estate professionals must “actively participate” in rental activities in order to deduct losses from those activities. Generally, this loss deduction can offset not only passive income but also income from non-passive activities, such as salary or profits from real estate sales, to the extent of $25,000 per year. Non-deductible current losses are “suspended” and indefinitely carried forward to future years.

There are several tests to qualify for active participation, but perhaps the most onerous involves time spent on the activity. To qualify for real estate professional treatment, you are required to participate in real estate trades or businesses more than 750 hours per year, and the time spent in the real estate trade has to exceed the time you spend in any other activity. Think 14 hours per week. Unless aggregated, that’s 14 hours per week for each property. For multiple properties, the time requirement can present some obvious challenges. An inability to substantiate required time involvement can have disastrous results upon audit.

Are there disadvantages to aggregating rental activities? One potential disadvantage has to do with dispositions. If you sell a rental property which constitutes an “activity”, suspended passive losses are released in full in the year of disposition, regardless of the $25,000 ceiling on passive losses. If all activities are aggregated, a disposition of one property will release suspended losses only to the extent of gain on the sale of that property.

So, should you make the election to aggregate your real estate rental activities? As with all tax decisions, the only correct answer is - it depends. If substantiating 750 hours per activity is a challenge, the election should be seriously considered. If you have substantial suspended passive losses in an activity that you plan to sell soon, it may be better to wait.

As always, consult with your tax advisor. No tax decision should be made in a vacuum, but rather should consider your personal circumstances.