By JOHN D. MCKINNON and LAURA SAUNDERS
WASHINGTON: Racking up huge losses on a personal income-tax return, as Donald Trump apparently did in 1995, isn’t that tough if you reside at the highest levels of the real-estate world, thanks to the considerable benefits the U.S. tax code confers.
In part because of those benefits, real-estate businesses often are formed and taxed as partnerships or limited-liability companies, known as LLCs, rather than taxable corporations. That way, profits—and potentially juicy tax losses—flow directly to owners’ personal tax returns, allowing individuals to use those losses to minimize or eliminate years of future tax liability on other types of income.
Real-estate professionals also enjoy numerous exceptions to the tax rules that typically limit the usefulness of deductions tied to losses for other kinds of investors. That reflects the enduring influence the industry has in Washington, allowing it to hold on to specialized benefits originally designed to help developers and investors recover from severe downturns in the past.
Mr. Trump himself spoke of the law’s complexity, and the many ways he benefited, Monday in Pueblo, Colo. After calling tax laws unfair, he said he “legally used” those laws to his benefit. His familiarity with those laws, he said, made him “one who can truly fix them.”
Mr. Trump has proposed big changes to the tax code, but his campaign has put forward little so far that would address the enormous complexities he mentions or seek to limit the many provisions the real-estate industry enjoys.
Under some circumstances, real-estate business owners such as Mr. Trump can even take losses on properties that were highly leveraged through loans. That is despite rules that Congress created to avoid tax windfalls for business owners when their loans are written off or renegotiated.
While forgiveness of debt often counts as taxable income, experts say there are ways for sophisticated real-estate investors to postpone it indefinitely. One way is to forgo future deductions on other properties instead of owing current taxes on the forgiveness, said David Lifson, a certified public accountant with Crowe Horwath in New York who advises high-net-worth clients.
Another strategy, he said, is to avoid forgiveness of debt by shifting what is owed on a losing property to a winning one. In this way the investor can harvest losses for use against other income while continuing to own the winner.
Several experts said they believe Mr. Trump benefited from provisions allowing real-estate developers to take big losses on highly-leveraged properties.
“The leverage has to be massive, massive” in the transactions that generated his losses, said Martin McMahon Jr., a tax law professor at the University of Florida. In part, these experts said, that is because they couldn’t imagine such large losses coming solely from operating losses at his businesses.
The $916 million in net operating losses—listed on Mr. Trump’s state tax returns that were sent to the New York Times—was a remarkable 1.9% of all NOLs claimed by individuals in 1995, according to Alan Cole, an economist with the Tax Foundation.
“Losses of this magnitude don’t come from mismanaging a casino for a couple of years,” said Edward Kleinbard, a tax professor at the University of Southern California law school. Mr. Trump “generated an enormous [net operating loss deduction] for himself by losing other people’s money.”
Congress adopted changes during the 1990s that made it somewhat easier for real-estate professionals to take advantage of leveraged losses, without having to claim income from the cancellation of debt that typically accompanies write-downs of loans.
However, it is still unclear whether—and to what extent—Mr. Trump might have relied on those rules.
And all this doesn’t mean that Mr. Trump did anything illegal. The basic policy allowing deduction of net operating losses over multiple years has stirred little controversy until now. It is viewed as a way of supporting businesses through the ups and downs of economic cycles.
Because the benefits are valuable, the Internal Revenue Service scrutinizes such returns, and many taxpayers have lost court cases on these issues. “I tell clients who claim to be real estate professionals that they should expect to be audited often,” says Joseph Walloch, a CPA and former IRS agent in San Diego, Calif.
Source: WSJ