The Real Estate Investor Versus the Stock Market Investor
Cherry-picking theory debunked.
November 15, 2007
by Lester Snyder, JD/LLM
This article has been excerpted from Lester Snyder’s book, Double Take: Unequal Taxation of Equals, (Vandeplas Publishing, 2007). Reprinted with permission.
The cherry-picking theory is that taxpayers might otherwise abuse the system by electing to sell their loss stocks in years most beneficial to them. However, studies show that many taxpayers have long periods of capital losses, without gains to offset these losses. Vera is a good example of one who did not cherry-pick.
Vera is a retired high-school principal (age 68) who had accumulated $1.5 million in her pension fund. She was advised by her investment counselor to take the money out of the fund at her retirement, pay income taxes of $500,000, and invest the remaining $1 million in stocks and bonds (public and corporate). In the years 2000-2002, she had capital gains on stock trades totaling $50,000; in 2003, 2004 and 2005 she had net capital losses (no capital gains) totaling $100,000 on four stocks in corporations which were showing reduced earnings on loss of government contracts. Vera had no real control on when to sell. She was advised to sell these stocks before they declined any further. In 2006, she had no capital gain or loss; her only income for 2003-2006 was derived from taxable interest on corporate bonds, in the amount of $40,000 each year.
Vera can only deduct $3,000 of her $100,000 capital loss, in each of the years 2003-2006. The remaining $88,000 of loss can be carried over to future years and deducted only against capital gains, on any sales in those years. If there are no capital gains, she’s limited to the annual $3,000 deduction. Unlike other types of taxpayers whose losses are in a “business” or other special groups, Vera cannot carry-back her capital losses to her 2000-2002 capital gains.
Thus, over a six-year period Vera has $50,000 in actual net investment losses; but nevertheless she is required to pay an income tax of $10,000 on her fictional $50,000 of gains.
Three theoretical reasons are often stated by tax law scholars for the restriction on deduction of capital losses: (1) the “cherry-picking” myth- choosing the best year, tax-wise, to take one’s losses; (2) parity- since one’s capital gains get favorable treatment, her capital losses ought to be restricted; and (3) revenue loss to the treasury.
She did not deliberately choose to sell at a loss; she had to protect her investments against predicted imminent losses in those securities.
The data discussed below indicates who the victims of this rule really are, and, as we believe, refutes all three reasons for this punitive treatment for many taxpayers in this country.
The most telling statistics on capital gains and losses, as reported in the Internal Revenue Service Bulletin, reveal that for the year 2003, more than 75 percent of the capital gains are shown for those with incomes over $200,000, while the same income group incurred only 20 percent of all capital losses. Even more revealing: those with income over $1,000,000 (just under 100,000 taxpayers) realized 50 percent of the capital gains ($162 billion), but incurred only about one percent of the capital losses. Thus, 80 percent to 90 percent of taxpayers with capital losses are being penalized for the low-tax rates on capital gains realized by a different group of taxpayers. This is troubling in many ways. All three reasons for restricting the deductibility of capital losses are flawed and exaggerated. First, the data calls into question the cherry-picking theory. Those with losses, like Vera, are mainly in the middle-income class, with less sophisticated advice available to them. Second, the parity theory that capital losses should suffer from the tax largesse bestowed on those with gains, is virtually destroyed by the IRS’s own analysis showing the gains and losses realized by two different groups of taxpayers. Third, the revenue loss theory- allowing deductions results in tax revenue loss to the Treasury, fails to take into account the hundreds of billions of real revenue loss caused by a nearly 50 percent reduction in rates for capital gain in the recent past. In Vera’s case, there would be no net loss of tax dollars to the government if she were allowed to fully deduct her capital losses in the years they were incurred; the part of her invested capital that she lost had already been taxed at 35 percent as part of the $1.5 million she received a year or two earlier.
It is an understatement that the capital loss rules need to be revised, including the $3,000 limit, which has not been increased for decades. To the extent that the capital gain rates are intended to serve as an incentive for people to invest in risk-oriented ventures, not allowing more liberal treatment of capital losses flies in the face of, and is counterproductive to congressional incentives for people to save or invest more. One wonders why so-called tax law experts have not talked about this inequity. Most of the consumption-type taxes, as discussed in chapter 7, would do away with this inequity by, among other things, eliminating the need for the present capital gain and capital loss rules.
Now let’s go to Wilbur’s case:
Wilbur is a retired executive of a large lumber company. He had accumulated $1.5 million in his pension account at his retirement. He preferred to use that money to invest in commercial real estate (two large parcels of undeveloped land that he expected to sell eventually to shopping mall developers, and six parcels of undeveloped land that he expected to sell to developers of office buildings). Like Vera, he paid $500,000 in income taxes on the $1.5 million he received from the pension fund. In 2003, he sold the two parcels to one major department store at a gain of $50,000. In years 2004 to 2005, he sold three of the remaining six parcels to office building developers at a $100,000 loss, due to what appeared to be a long-term economic downturn in the real estate market.
The IRS accepted Wilbur’s reporting the sale of the first two parcels at capital gain rates for 2003, and, after months of haggling also accepted his reporting the $100,000 loss on the sale of the three parcels in 2004-2005 as an “ordinary” loss fully deductible against his other income from dividends, rents, and consulting fees (all “ordinary” income). The IRS initially took the position that Wilbur’s loss was a “capital” loss and only deductible against capital gains in 2004-2005. However, he had no capital gains in those years, and would have to wait until some future year to deduct all but the $3,000 the tax law allows each year.
There is considerable uncertainty in predicting the correct result. The problem is caused by extraordinarily vague words in the statute that defines a “capital” asset. It starts off by saying all “property” is a capital asset, then lists eight exceptions (which are then taxed at ordinary income rates). The first exception is for “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” The court cases trying to apply these words to a variety of fact patterns have had to come up with a number of factors to determine whether the taxpayer was holding the property “primarily” for sale or as a long-term investment. But the decisions are all over the lot. As one respected federal judge put it: “If a client asks you in any but an extreme case whether, in your opinion, his sale will result in capital gain, your answer should probably be, ‘I don’t know, and no one else in town can tell you.’” Not surprisingly, the cases are virtually impossible to reconcile.
Wilbur is lucky the IRS caved in without litigating the issue. In other words, he was deemed to be in the “business” of selling real estate. But he is as passive an investor as Vera. So Vera had a restricted capital loss, and Wilbur had a 100 percent deductible ordinary loss. Why the difference? Both investors were previously taxed on the money they invested, and both took risks and lost.
But, alas, let us remember this is the tax law we’re talking about, and if both Vera and Wilbur had gains rather than losses — presto! The tables would be turned. Let us see what would happen: Vera would be taxed at the lower capital gain rate and Wilbur would be taxed at the ordinary rates up to 35 percent if we apply the IRS decision that he’s in a trade or business. Wilbur would now shift his position and, through the process of role reversal, Wilbur would argue that he is like Vera, simply holding the land for investment and is thus entitled to capital gain treatment.
So while Congress and others continue to debate the legitimacy of taxing capital gains at a lower rate for real wealthy folks, they do virtually nothing to craft better definitions of this disguised way to help the few, while the average investors (who far outnumber the few sophisticated investors) are left to fight it out on soggy soil — leaving them at the mercy of the courts who have no actual guidance as to what capital gains really are.
This lack of coherent rules creates needless and costly litigation (although law professors love to try to distinguish these cases in their tax classes). We begin to see that the concept of “capital gain” should either be eliminated from the tax law, reducing all the tax rates, or drastically revised with a more efficient and rational set of definitions of “capital asset” providing equal incentives to all investors.
There are a number of alternative ways to resolve these inequities in the current regime. One way is to eliminate both the stepped-up and stepped-down to fair market value at death basis rules, and taxing all gains and allowing deduction for all investment losses no matter when the property is sold. Another way is to revise the present law to move closer to a consumption-type tax, where all investments would be deductible in the year made, and any gain on later sale would be taxed as personal consumption, unless reinvested, as discussed in Chapter 7.
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Lester B. Snyder, JD/LLM, is a professor at the University of San Diego School of Law. For 20 years, he was editor-in-chief of the Journal of Real Estate Taxation. He was the first professor-in-residence in the Tax Division of the U.S. Department of Justice. His new book, Double Take: Unequal Taxation of Equals, (Vandeplas Publishing, 2007) was published in June of this year and is available at Amazon.