A Way to Curb Supply

Give investors incentives to buy excess housing.

April 1, 2008

The biggest obstacle facing the real estate market today is excess inventory. The NATIONAL ASSOCIATION OF REALTORS®’ Research department estimated that as of December of last year, there was a 9.6month supply of homes on the market. Until this inventory returns to more normal levels, home prices will continue to decline.

Yet, with homeownership already falling to 68.2 percent in the third quarter of 2007 from the historic high of 69.2 percent in the second quarter of 2004 and the tightening of mortgage loan credit in response to excesses of subprime lending, it’s unlikely that the homeownership rate will increase in the near future. When you add growing concerns about an economic slowdown that may keep even qualified buyers on the sidelines, we are left to ponder how this excess inventory will be absorbed so that we can return to a healthy real estate market.

Still Feeling Effects of ’86 Tax Act

The most effective way to stimulate new demand for real estate is by making home purchases more attractive to — and profitable for — real estate investors. Unlike buyers who plan to live in their homes, investors are less likely to shy away from a changing market, provided the deal is a good one. One very effective and immediate way to make more home deals financially attractive to investors is to revise the current limitations on tax deductions for passive losses incurred from real estate investments.

These limitations on deductible losses were set in tax legislation passed by Congress in 1986, in response to what some felt were excessive tax shelters for investment real estate. This legislation limited the amount of loss that investors who did not actively participate in the management of the real estate they owned could deduct from their taxes to $25,000 a year. In addition, the full extent of these deductions was available only to those passive investors with adjusted gross incomes of $100,000 or less. Note that this limitation doesn’t apply to most people in the real estate business.

As a result of these changes, many real estate investors took severe losses, and some even walked away from their properties.

Indexing Loss Limits

I’m not suggesting that we return to the unlimited deductions from before 1986. But I do believe that Congress needs to take another look at passive loss deductions. The problem is that the $25,000 limit on deductible passive losses and the $100,000 limit on maximum adjusted gross income were not indexed for inflation in the original law. This same failure to index limits for the alternative minimum tax has caused a political furor that Congress has temporarily addressed with an adjustment.

If the act’s limits had been indexed to the 3.1 percent annual inflation that’s been the norm over that period, the deduction for passive losses would be approximately $47,500 annually today and the adjusted gross income limit would be $189,900.

By adjusting 1986 tax rules to current levels, more investors would have the opportunity to deduct losses they incur from repairs or vacancies at their investment properties. This financial incentive would make them more willing to purchase property — including today’s excess housing inventory. Reducing the supply of housing on the market, in turn, would help stabilize home prices. Finally, as markets normalize, more buyers and sellers would gain the confidence to reenter the residential real estate market.

Investing in real estate is already an attractive way for investors to build wealth. By increasing the tax incentives for investors to reflect current income levels and costs, Congress would not only help to alleviate a short term oversupply of homes but would help ensure the future prosperity of many more Americans.