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The Effects of Tax Reform on Real Estate: Some Empirical Results
This paper uses data on publicly traded real estate firms to examine the effects of two major tax reforms. Specifically, we analyze the effects of the 1976 and 1986 Tax Reform Acts (TRAs) on the risks and returns of real estate investment trusts (REITs) and other real estate firms, using intervention analysis. Since REITs have been a dominant force in the real estate equity markets, and since they are treated differently for tax purposes than corporations investing in real estate, we examine the two groups of firms separately.(1)
While there exists much popular press literature which discusses the impact of tax reform on real estate, little empirical work has directly examined the market's response to these changes.(2) Most previous work undertaken to examine the potential impact of tax changes has used simulation modeling to estimate the effects on real estate firms' values (e.g., Fisher and Lentz 1986; Hendershott, Follain, and Ling 1986). A review of the simulation literature is presented in Follain and Brueckner (1986). Turning away from the simulation technique, Nourse (1987) uses appraisal data to empirically estimate how the 1976 and 1981 tax laws affect capitalization rates (i.e., net income divided by value) for real estate. In contrast with the existing literature, we use market data to evaluate the empirical effects of the 1976 and 1986 law changes. The empirical results provide insights into the interaction between tax laws and the market for real estate assets.
In the next section of the paper we discuss the historical background of the 1976 and 1986 Tax Reform Acts, emphasizing provisions influencing REITs and real estate in general. We also outline the anticipated effects of these provisions on the value of real estate assets relative to other assets. We argue that the net impact of the 1976 act on REITs and other real estate corporations remains an empirical question, in part because the rules limiting loss offsets tend to increase the value of real estate firms while the construction period capitalization rules tend to decrease the value of real estate firms relative to other entities. Our cash flow model also predicts that the major loss offset limitations and depreciation changes in the 1986 act tend to decrease the value of real estate corporations relative to other entities. Finally, we also argue that the REIT specific provisions of both tax acts may result in a difference in the response of REITs relative to other real estate corporations.
We describe the data and methodology in Section III and present the empirical results in Section IV. We find a positive and significant market reaction in the returns for both REITs and other real estate firms to the 1976 TRA. Response to the 1986 TRA by both groups of firms is negative and significant. Evidence of significant shifts in the systematic risks of REITs and real estate corporations are found for both tax acts. Section V contains our conclusions.
II. TAX REFORM AND REAL ESTATE: OVERVIEW
Both the 1976 and 1986 tax acts were extremely complex and contained special provisions affecting several industries. Since this study focuses upon the effects on real estate assets, it is important to note that the methodology to be employed abstracts from general market-wide effects and measures only the differential effect upon real estate versus the rest of the market. In this section we review the basic changes in taxation brought about by the two acts and anticipated impacts on real estate asset values. All formal derivations are relegated to the Appendix.
A. The 1976 Tax Reform Act
The 1976 tax act contained many changes that influenced the real estate industry. The major changes affecting real estate in general dealt with the following: the requirement to capitalize, rather than expense, construction period interest and property taxes; implementation of depreciation recapture on residential income properties; tightening of the minimum tax requirements; extension of the capital gains holding period from six to nine months; and further tightening of the investment interest limitation. The major goal of legislators in drafting the 1976 TRA was to limit the availability of various tax shelters that were considered to be abusive. Much of the debate that continued throughout the legislative process dealt with the issue of which types of investment activities should be targeted by the act. One of the most important features of the final act was that real estate investments were made exempt from the "at-risk" restrictions imposed on other forms of investment such as oil drilling and exploration, farming, movie and television production, and equipment leasing.(3) These "at-risk" restrictions essentially prevent the taxpayer from using tax losses in excess of the investment actually at risk to offset taxable income from other sources.
As the Appendix demonstrates, exempting real estate from the at-risk provisions tends to enhance real estate asset values relative to those assets used in activities subject to at-risk while subjecting real estate to construction-period-interest capitalization (instead of expensing) tends to have an offsetting impact on relative asset values. These two provisions alone, then, reveal that the 1976 TRA impact on real estate cannot be predicted a priori and can only be determined empirically.
There were also several provisions in the act that applied specifically to REITs and therefore are expected to prompt a differential REIT response. Although the real estate trust form of ownership originated in the early 1800s, the present form of taxation of REITs was not established until 1960. At that time an amendment to the 1952 Internal Revenue Code defined the term "real estate investment trust" and established that, as long as certain tests were met, such entities be given the same "conduit treatment" for tax purposes as Regulated Investment Companies.(4) This meant that essentially all income earned by a REIT would be passed through to its owners without being taxed at the firm level. In order to qualify as a REIT, and thus avoid taxation at the firm level, the firm must meet four separate tests on a yearly basis. These tests concern organizational structure, sources of income, nature of assets, and distribution of income. Briefly, to qualify as a REIT the firm must be an arrangement for the pooling of funds for investment in real property from which passive (versus active) income is substantially passed through to shareholders on a current basis. Although REITs enjoy a tax advantage relative to real estate corporations, they are subject to numerous operating restrictions which real estate corporations are not.(5)
With the exception of provisions regarding foreclosure property, the 1976 TRA was the first major tax reform to affect REITs since the tax code amendments of 1960.(6) The REIT provisions of the 1976 TRA represent the culmination of efforts to reform the taxation of REITs which began in 1973. While the 1976 TRA did not change the basic principles of REIT taxation, certain structural …