Donald Trump and the Political Economy of Real Estate Tax in the US: Q&A With Professor Edward Kleinbard

Edward Kleinbard from the University of Southern California explains how Donald Trump was potentially able to lose nearly a billion dollars of his investors’ money and use that loss to avoid paying federal income taxes for almost 20 years. 

 

Edward Kleinbard
Edward Kleinbard

Even before the recent allegations of sexual harassment derailed his presidential campaign, Donald Trump faced another scandal earlier this month, following a bombshell New York Times exposé that showed that Trump declared a $916 million loss in his 1995 tax returns. Such a loss, the Times report estimated, “could have allowed him to legally avoid paying any federal income taxes for up to 18 years.”

 

According to the report, the loopholes, exceptions, and provisions in the U.S. tax code could have allowed Trump (if he were so inclined) to turn the huge losses his businesses accumulated in the early 1990s into a tax asset that would shield him from federal income tax for many years.

 

Whether or not Trump paid his taxes is impossible to determine without viewing his full tax returns (which, unlike other presidential candidates, Trump has so far refused to release). When he was accused by Hillary Clinton of not paying any federal income tax during the last presidential debate, Trump made it a point of pride and said: “that makes me smart.”

 

In order to understand how it is possible to turn a loss into a personal tax asset, we recently spoke to tax expert Edward Kleinbard, the Ivadelle and Theodore Johnson Professor of Law and Business at the University of Southern California Gould School of Law and former chief of staff of the Congress’s Joint Committee on Taxation. In his interview with ProMarket,1)The following interview has been edited and condensed for length and clarity. Kleinbard explained how Trump and other real estate developers have been able to lose other people’s money, yet still use the tax code to avoid paying federal income taxes.

 

Q: How can Trump lose other people’s money and create a personal tax asset?

 

Edward Kleinbard: We know that Trump was and is addicted to debt. He said so in a book he wrote at the time. We know it from news articles at the time that said his empire had $3.5 billion in debts, of which over a billion was forgiven by the lenders. The reason the lenders forgave that large amount of debt was that he had no prospect of him paying it back, because he had made terrible investments.

 

The fundamental, political economy story is that Trump lost nearly $1 billion of other people’s money, but was able to flip that into a tax asset of his own in the form of the net operating loss (NOL) carryover, which saved him from paying tax for many years thereafter.

 

Q: If Trump companies defaulted on their loans and paid only a fraction of the debts because of huge operating losses–wasn’t that supposed to create off-setting capital gains?

 

EK: That’s a very good question, and there are a couple of overlapping, competing theories. My theory on that is that first of all, he [Trump] had about $800 million of full recourse personal debt, of which $700 million was forgiven, and the rest was non-recourse. Then basically what happened was that he transferred a large fraction of his real estate portfolio to lenders at a loss. That loss would be ordinary, not a capital loss, because of the magic of Section 1231, which is a rule principally relevant to real estate. The rule has been around since World War II, and says gains from real estate are capital gains and losses are ordinary losses.

 

Assume you lost a billion in value, and on the other hand, the lenders absorb that by forgiving debt. You would think those two would offset, but the debt forgiveness was not treated as taxable income for one of two technical reasons: the first is that you are not required to include discharge of indebted income as taxable income, to the extent that you are insolvent. And it was quite possible that that the Trump empire was insolvent at the time.

 

That would be one way to avoid having an offsetting income charge. The other, which came into law in 1993 as a new special rule designed to benefit the real estate industry, would apply to a debt discharge. It says that forgiving real estate debt does not give rise to discharge of indebtedness income. So either way, if you were insolvent, you would rely on the insolvency exception.

 

In either case, there’s a cost to not having the taxable income charge, and the cost is that you have to give up tax basis in other remaining assets. If you don’t have investment, you don’t have tax basis, and therefore have nothing to depreciate. So it is much better to have an NOL than 39 years’ worth of future depreciation deductions, because you can use the NOL as quickly as you have income.

 

The low basis in the remaining real estate is not terribly painful from the point of view of running your business, thanks to the magic rules of real estate.

 

One thing you never do is sell for cash at a gain. You can flip to some other real estate by doing a so-called like-kind exchange. You can roll it into whatever other kind of real estate you want tax free, and borrow against appreciated real estate so if it goes up in value and you want the cash out. You don’t sell, you just borrow against it, for whatever you want. And the borrowing is not a taxable entity. So you can cash out the appreciation in the building. And, of course, when you die, you get the tax free step-up at death.

 

That’s my theory. The other theory is even more complex, and would permit the creation of the loss without the offset of lower tax depreciation on other assets. I don’t think this story fits the facts that we know from business articles circa 1992-1993. But either way, you end up with what everyone agrees is a loss of other people’s money.

 

Q: What is the political economy background that enables Trump to use losses incurred by his highly leveraged company to offset his own future income tax payments?

 

EK: Real estate has always been heavily favored in the tax law. Every district in the country, congressional district, is full of real estate, and therefore, it’s full of real estate developers and speculators who are often prominent members of the community. So the real estate industry has the good fortune to be everywhere, and therefore has always been very active in tax politics, and has always been treated with great consideration.

 

During the ’70s and early ’80s, there was real risk that the entire tax system was going to fall apart through highly artificial tax shelters. The joke at the time was that there was no orthodontist in America paying income tax, because they were engaging in crazier and crazier tax shelter deals with no economic substance behind them.

 

And so a fundamental part of the Tax Reform Act of 1986 was to clamp down very heavily on tax shelters. And it did, and it was quite effective at that. It removed tax shelter partnership buyers from the real estate market, and that created major dislocations in the market, because all of a sudden, this large population of buyers who were really quite price indifferent were suddenly removed by virtue of their entire business model being banned.

 

Then in 1990 we had a major recession, and the combination of the two meant that real estate was really hurting. So the real estate industry went to Congress in the early 1990s and said, “You turned the screws too hard on us in 1986. You’ve got to do something for us.” And in 1993, Congress passed a package of giveaways for the real estate industry, including the rule that I mentioned about debt discharge of real estate debts, and several other nice giveaways.

 

The political economy backstory of the real estate industry is that it has always been treated favorably to the extent that there was a period of time in which real estate found itself in distress.

 

Q: Nothing here is specific to Trump, other real estate entrepreneurs do the same.

 

EK: Right. It’s the norm in tax planning for real estate developers to pay very little tax. The joke in real estate is that if you’re close to paying tax, buy another building. And the reason is you get depreciation deductions, you get interest deductions.

 

Real estate is also special in the pure economic sense, beyond the political economy story. Real estate is special because it is a very long-lived asset. It is a real, tangible asset. It is an asset that financial institutions and entrepreneurs have had centuries of experience at how to value, and so it is in fact possible to borrow very large sums of money against the security of real estate. That is why it’s quite difficult to run a leveraged lemonade stand, but running a leveraged real estate business is quite normal, because the lender has something to look to that the lender can value by way of security.

 

In the real estate industry in particular, interest deductions and depreciation mean that a very small sliver of equity can claim ownership of a very large property that is primarily financed through debt. And the tax law treats the equity owner as the owner of 100 percent of the property, even though the bulk of the financing and therefore the second tranche of risk is all with the lenders.

 

Q: So in real estate, when you’re highly leveraged and lose a lot of money, you can also use it to profit at the expense of taxpayers?

 

EK: Yes. Let’s assume that you don’t screw your bond holders, that in fact you service your debts. It’s nonetheless the case, simply by virtue of the fact that a very small amount of equity can control a large property using borrowed money. The tax law treats the equity owner as owning 100 percent of the property, therefore the equity owner for a small investment is getting depreciation deductions and interest expense deductions in respect of a very large amount of financing.

 

Q: Some might say that it’s ok because–as long as you’re servicing your debt–the lender is incurring income from interest, and he’s paying taxes…

 

EK: Right, except of course that it’s not true, because in the modern world the lenders are usually tax exempt institutions: pension plans, insurance companies.

 

Q: Is the real estate lobby in the U.S. more powerful than other lobbying industries?

 

EK: It is a very powerful lobby, because as I said earlier, every district in the country turns out to have a lot of real estate. The life insurance lobby is powerful for the same reason. 

 

When you look to see how much of the U.S. capital stock is held in real estate, it’s a lot more than you would expect in a world without taxes. Of course, when I say that I’m including personal residences, because they’re tax subsidized.

 

Q: Were there any political attempts in the past to remove those exemptions?

 

EK:  In the period of 1986-1993, there was a lot of excitement. The ’86 Act clamped down on tax shelters. After ’93, things have settled down. The ’93 Act stretched out depreciation to somewhat more rational levels, but loosened the screws on some of the anti-tax shelter rules to enable the real estate industry to survive.

 

Q: Is there any chance that this might change in the future?

 

EK: Yes. I believe that business tax reform is going to happen in 2017. When business tax reform happens, the numbers just don’t work without coming to grips with the over-leveraging of America. The tax system today has a tremendous debt bias, and so I believe that when you sit down and look at the numbers, and you think about the problem of the debt bias in the current law, the most straightforward solution to that will be new limitations on the deductibility of interest expense generally.

 

As an individual taxpayer, you can’t deduct your credit card interest expense, and there’s a cap on your home mortgage interest expense. What I’m arguing is that businesses will find themselves in a similar position.

 

Q: Going back to Trump, he incurred most of his losses in real estate, but in the last 20 years most of his income probably came from brand licensing and TV deals. He was able to use losses that were created in one area, real estate, to offset income that he got from becoming a lifestyle brand.

 

EK: Absolutely. No question about it. There’s no question about that. The NOL is not limited in its use to income from the same kind of business.

 

Trump’s whole business model really pivoted at some point. Over the last 15 years certainly, his business model has pivoted from being a real estate developer, subject to the risks of blowing up during recessions as in 1999, to being a lifestyle brand name licensor and brand name manager. 

 

That’s the bulk of his income now—most of the Trump real estate properties that you see around the world are not actually owned by him. He does not have an ownership stake. He has a license arrangement.

 

Q: Donald Trump’s career can be divided into the following stages: in the first stage, he gets a loan from his father and achieves success in real estate. Then he loses billions for his bond holders. Then in 1995 he has a large equity IPO of his casino operation and loses most of the money. By that time he had already built himself, so although he lost money, he is able to create his brand. 15 years later, he is still able to use his real estate losses to get a tax free income from all his branding, licensing businesses. What is the lesson we should take from this?

 

EK: The point I’ve been trying to make to people is that the technical tax details are not really important, except to a handful of tax nerds.

 

What is important, what we know to be true, is that he lost other people’s money, over a billion dollars, and that he emerged with a very large tax asset from losing other people’s money, which then leads to his repurposing of those tax assets through his pivot from real estate ownership to lifestyle brand management.

 

Q: In response to the revelations regarding his 1995 tax return, Trump and his surrogates claimed he had a “fiduciary responsibility to his business, his family, and his employees to pay no more tax than legally required.” Would you say that’s the case?

 

EK: No. It’s a preposterous, almost incomprehensibly incoherent claim. No one has a fiduciary duty to himself first, that’s a meaningless concept. To create a tax loss for himself is not an exercise in a fiduciary duty, and nobody has a fiduciary duty to lose a billion dollars of other people’s money.

 

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.

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1. The following interview has been edited and condensed for length and clarity.