This article provides insight into the destruction of a property’s original earning power by the taxation of inflation on its resale.
Uncle Sam creates his share
An investor decides to sell a parcel of real estate he bought for $440,000 twenty years ago. His broker has located a buyer willing to pay $900,000 for the property.
During his ownership of the property, the investor took $100,000 in depreciation deductions. Consequently, the investor’s adjusted basis in the property is $340,000 ($440,000 original cost minus $100,000 depreciation).
The investor does not plan to reinvest his net sales proceeds by acquiring replacement property in an Internal Revenue Code (IRC) §1031 reinvestment plan.
Consequently, the broker informs the investor the profit on the sale will be $560,000 ($900,000 sales price minus $340,000 adjusted basis). The investor is also informed his profit will be taxed at a 25% rate on the $110,000 in recapture gains for the depreciation he has taken and at a 15% rate on the $450,000 in long-term capital gains which represents the balance of his profit. (Sales costs and the net sales price are not considered here.)
However, the investor is not satisfied with the broker’s analysis since the broker did not consider the fact the property’s price increase was solely due to inflation. Thus, the purchasing power of the property’s net operating income has remained unchanged over the 20-year period of ownership.
Price inflation (and the loss of the dollar’s value) is measured by the government by the use of the Consumer Price Index (CPI). The most common CPI figure used in real estate to maintain its purchasing power is the CPI-U, called the CPI for urban consumers.
The CPI is published nationally and regionally. The most relevant index is the regional index. There are three regional indices in California: Los Angeles-Long Beach, San Francisco-Oakland and San Diego. Regional indices reflect local economic conditions affecting retail pricing.
Since the CPI has doubled during our investor’s 20-year holding period, a dollar held on the date of the investment is only worth half as much today. It now takes twice as many dollars for the investor to purchase the same goods or services.
Put another way, it now takes twice as many dollars to purchase the same amount of labor and materials to build (or buy) the very property the investor now desires to sell.
The conditions surrounding the property which affect its value have not changed – but the dollar has!
The investor feels it is unfair to pay tax on his receipt of inflated dollars from a sale – especially since the dollar’s value has decreased under the monetary policy of the government doing the taxing.
The investor claims the tax should be based on his real economic profit, which is the actual sales price less the original cost basis after it is adjusted for inflation produced by the decline in the dollar’s purchasing power since his acquisition of the property, called an inflation adjusted basis.
Since the property is located in Riverside county, the investor calculates his real (inflation-adjusted) profit by using the same consumer price index (CPI-U) figures for Los Angeles which he uses to adjust the rents he charges his tenants:
- 370.4 (Current CPI-U)
- / 185.2 (Original CPI-U at time of purchase)
- X $440,000 (Original purchase price)
- $880,000 (Original purchase price in today’s dollars)
Thus, $440,000 of the current price is created solely by inflation of the dollar, not appreciation in the value of the property.
The investor determines his profit on the sale to be $220,000 ($900,000 resale price minus $680,000, his CPI-adjusted remaining cost basis of $340,000).
The IRS disagrees and claims the profit is $560,000 ($900,000 resale minus the $340,000 remaining cost basis – unadjusted for inflation).
Does the investor have to pay taxes on the $440,000, which consists solely of inflated dollars and is included in his net proceeds from the sale (a 100% CPI increase since purchase)?
Yes! Taxes are based on the nominal profit, which is based on the actual dollars received on the sale of the property. The real profit received by the investor on his original investment is of no concern to the government – even though it must be of concern to a prudent investor and his broker. [Hellerman v. Commissioner (1981) 77 TC 1361]
Controlling the shrinking dollar
In the preceding example about the taxation of the hedge against inflation received by an owner of real estate, the investor who sells his real estate bears the brunt of the lost purchasing power of the dollar occurring after his acquisition.
The culprit? Price inflation without gradually declining capital gains tax rates for longer holding periods to offset the decline in the purchasing power value of the dollar.
Inflation is the rise in the general price level of everything people buy using U.S. dollars. Thus, the price of goods and services (including property) reflects the loss or erosion of the U.S. dollar’s buying power. As dollar prices rise, it takes more dollars to buy the same goods and services (property).
Just what role does the government play in controlling inflation?
Inflation is controlled mainly through the Federal Reserve Bank, called the Fed.
The Fed is the government’s central bank. Technically, the Fed is independent of the government. Yet, its chairman and board of governors are selected by the President under the advice and consent of the Senate.
The Fed provides cash and credit for the private banking industry.
Banks must have sufficient dollars to properly fund borrowers’ needs. If not, the business, industrial and trading markets of the nation will constrict and reduce the ability of consumers and investors to purchase property or other goods and services.
The private banks using the Federal Reserve System must keep reserves on deposit with the Fed to cover bank obligations to depositors. By controlling the amount of these reserves, the Fed controls the money supply available to businesses and consumers.
For example, when the U.S. economy is sluggish, businesses and consumers are slow to buy goods and services. To bolster the economy and encourage purchases, the Fed will increase the money supply available to consumers.
To increase the availability of loan funds for industry and consumers, the Fed buys government securities (T-Bills) in the open market at a higher-than-market price with cash. Since the banking industry is heavily invested in government securities, the Fed’s purchases place extra funds in the banks and at the same time reduce interest rates. Thus, the Fed increases the banks’ desire to lend money since the banks now hold cash which is non-interest bearing.
The role of the Fed
When the Fed buys the securities, it credits each bank’s reserve account. The banks now have more money in their reserve accounts than the minimum they must deposit with the Fed.
Rather than let the money sit at the Fed without earning interest, the banks withdraw the money to lend to consumers and businesses. This puts more money into the system, lowers interest rates and perks up the economy (if the consumer actually begins to borrow).
In turn, the additional supply of money initially tends to drive interest rates down. At this point, businesses and consumers generally are paying less for their purchases of goods and services. Consequently, sales activity picks up (since the price and interest rates are perceived to be right) and the economy is said to be on the rise. A change in public sentiment is sought by the interest rate move.
During periods of inflation driven by increasing consumer demand, the Fed reverses the flow of funds, selling federal securities at higher interest rates to withdraw money from the system and reduce the reserve accounts of banks. The banks now have less to lend, which also tends to drive interest rates up. This conduct by the Fed reduces business and consumer purchasing enthusiasm. Over time, sales activity begins to slow.
The Fed’s job is to predict where the economy is headed. If the Fed guesses incorrectly, higher inflation and less economic growth, or even a deflationary recession, could result. Any bias by the Fed is toward inflation, not recession, in order to keep the economy from falling into a deflation in prices.
Inflation and taxes
Unfortunately, the government’s raising revenue, through its income and profit tax system, does not respond to the malfunction (or bias) of the national banking system. When inflation occurs, investors taking profits must pay taxes on any profits created by the inflated dollars, dollars the investor must accept at the time of sale.
In our example, the investor must pay taxes on the actual dollar amount of the inflation profit, not the inherent economic value he receives with these dollars which might even reflect a real profit, which our example does not.
There are two reasons the tax system ignores inflation so completely.
First, the U.S. dollar’s primary function is to act as a uniform medium of exchange. This is the dollar’s “legal value.” The dollar is the unit of exchange the U.S. has established to pay all public and private debts, including the payment of taxes. [Norman v. B & 0 Railroad Co. (1935) 294 US 240]
As a medium of exchange, inflated dollars affect all of us. Not only do we receive inflated dollars, but we pay with inflated dollars. Therefore, our investor will have to pay higher taxes, but the adverse impact is partially diminished since he pays with inflated dollars.
Also, during the time the investor held the property, hopefully rents increased to cover the increased cost of goods and services.
The second reason for taxing inflated dollars is based on our common understanding of profit.
When we think of profit we count up the actual dollars we receive on a sale. Ordinarily, we do not factor in such things as the toll taken on the quantity and quality of goods and services by inflation when we seek to pay “last year’s” prices.
The test of profit in a real estate transaction is whether we receive more dollars on a sale than what we paid for the property. In this sense, the tax is on the increase in actual dollars we receive. Yet, if the inherent value of the real estate declines due to depreciation or obsolescence, the property’s value in current dollars may fail to keep up with inflation and actually fall in terms of real value.
For example, our investor bought his property 20 years ago for $440,000. He took $100,000 in deductible depreciation. What if the current resale price for the property is $500,000 – an 11% actual increase in dollars during his holding period?
Here, the investor would have a $160,000 taxable profit ($500,000 resale price minus his $340,000 remaining basis).
However, under the real economic profit analysis, our investor would have an inflation-adjusted loss of $180,000 ($500,000 resale minus $680,000, his CPI-adjusted remaining cost basis).
Editor’s note — For the property to maintain its original purchasing power of $440,000, the investor would have to net $880,000 (less the depreciation deduction of $100,000) on his resale – after the payment of any profit taxes.
Can our investor report a loss on the sale?
No! The profit is again measured in actual dollars received – even though the real estate’s price (and its basis) has not kept pace with price inflation brought about by the Federal (mis)management of the money supply. [Spurgeon v. Franchise Tax Board (1984) 160 CA3d 524]
This applies to both state and federal taxes. California definitions of income and profit are the same as federal definitions. [Calhoun v. Franchise Tax Board (1978) 20 C3d 881]
Losses due to inflation’s devaluation of depreciation deductions are subject to the same money value rules – the use of nominal (actual) dollars received without any adjustment for inflation. [New Colonial Ice Co. v. Helvering (1934) 292 US 435]
Cutting its share
By taxing the actual amount of dollars received as profit on a resale instead of the real economic value of the dollars received, the government cuts itself a share of the investor’s real estate on any resale at a price greater than the investor’s remaining cost basis.
To see how government (equity) sharing works, it is important to recognize the economic fact that, other things remaining constant, improved real estate tends to follow the CPI over time. Thus, the earning power of improved, income-producing real estate generally remains constant. Rents simply increase to meet (or create) inflation.
When both real estate values and the CPI increase at the same pace over time, the real economic value of the real estate remains constant. Thus, real estate is a “hedge” against inflation.
However, the government taxes inflated dollars when the owner sells his real estate. Thus, the inflation allowed by the management of money cuts for the government a share in the owner’s original ownership interest in the real estate. The share is paid at the time of sale.
The government would receive much less in revenue from taxation than it does now if profits were not increased by inflation, since “profit” would lack the inflationary increase.
For example, an investor bought real estate for $500,000 ten years ago.
Today, the property’s value is $1,000,000. But, if the CPI doubled, the property would be “worth” the same as it was ten years ago in real terms.
Should the investor sell the property for $1,000,000, he will have a $500,000 profit on property which has merely maintained its original worth. The profit is net long-term capital gain currently taxed at 15%.
Editor’s note — Profit resulting from depreciation, called unrecapture gain with its current 25% tax rate, is not considered here.
Thus, the government has cut itself a 7.5% share in the current dollar value of the property.
However, the investor has no real economic profit. Yet, the government will take for itself a share in the present worth of the investor’s original cost of the real estate without itself making any investment – at the expense of the investor’s losing 1/13th (7.5%) of his original purchasing power.
The investor is economically worse off for having sold than had he retained the property – not good news for brokers encouraging owners to sell what they have collected.
Investors must keep a close eye on the CPI trends and cyclical fluctuations in prices to maximize annual rent increases and profits on a sale. It is said, the three most important words in real estate are location, timing and price. Here we are addressing the analysis of timing and price.
The investor should consider the timing of any sale to occur when the property’s increased value (due to market cycles) exceeds the percentage change in the CPI since acquisition. If the value increase exceeds the increase in the CPI figures, which usually occurs during times of economic prosperity, the investor will experience a real economic profit on the sale.
When the value of real estate lags behind the CPI, it may be wise to hold property (and buy) until cyclical movement in values causes prices to catch up and possibly exceed inflation for the holding period. When an investor sells real estate which has not kept pace with inflation, he will have lost real money, and will still be taxed on the inflation-created profit. He will be poorer for it in the future, for failure to sell when the time was right.
Inflation and income
The tax system not only fails to adjust sales profits for inflation, but also rental income received during ownership of real estate.
Specifically, this is a fixed-rate lender’s predicament – from which a long-term owner of real estate benefits. Ordinarily, when a fixed rate loan is made, the lender calculates what is referred to as the nominal interest rate on the loan, which is the actual interest rate charged the borrower, also called the note rate.
To arrive at the nominal (note) rate, say 5%, the lender implicitly determines the real rate of interest it expects to earn on the funds lent, say 3%, and adds the anticipated future inflation rate, say 2%, a “cost-plus-profit” approach to pricing the lending of money, cost being the future anticipated rate of inflation.
Generally, the lender wants a real return of 3%, sometimes called a margin, as in ARM loans. If the lender expects inflation in the future to average 5.5%, then the actual rate charged borrowers would be 8.5%. The lender calculates the interest rate so his principal lent will not be eroded by inflation.
However, lenders do not always accurately guess inflation trends the Fed will allow.
For instance, as a lender, which would you rather receive – 6% or 10% interest on your money? Before jumping to what at first glance appears to be the obvious answer, consider the role of inflation.
In the mid-1960s, interest rates were about 7% while inflation was 1.5%. Thus, a lender made a positive 5.5% real rate of interest annually on his loan.
By 1979, inflation was above 13% per annum. A 10% loan in 1979 (a typical rate charged) would hand the lender a negative 3% real rate of interest annually. Thus, the lender suffered a loss of purchasing power on the principal balance of the loan, despite the higher nominal interest rate compared to 1965. With such negative results at 10%, over time the lender will become broke.
Historically, the real rate of interest needs to be a positive 3% per annum for lenders to remain viable. Any greater margin between the rate of inflation and the actual/nominal rate charged a borrower makes the dollar stronger – as its purchasing power has increased – and dollar denominated assets (such as California real estate) weaker in price. Cash is said to be “king” when this economic phenomenon of a strong dollar occurs.
For example, by the early 1980s, the real rate of interest was nearly 10% – that is, 10% in addition to inflation. This excessive real yield for having held cash for investment gave us the phrase, “Cash is King.” The pricing power sellers enjoyed in the late 1970s was replaced by the power of cash which held prices down in the early 1980s.
To help combat situations that occurred in the late 1970s when fixed-rate lenders generally miscalculated the actual inflation rates, most lenders by 1982 turned to the adjustable rate mortgage or “ARM,” also called an inflation index loan. The ARM is the ultimate hedge against inflation for the lender, entirely depriving the owner of real estate of any benefits of inflated prices. In an ARM, the lender sets the real rate of interest it wishes to receive over the life of the loan, called a margin, and ties to it recovery of inflation over the life of the loan based on an index with figures that increase and decrease with changing inflationary conditions.
The lender with an ARM eliminates his guesswork, the risk of loss of the purchasing power of money he lent, due to an inflationary upturn, and the accompanying increase in the lender’s cost of funds invested in loans. By using an ARM indexed for inflation, the entire risk of future inflation has, in effect, been shifted to the borrower. Borrowers had no such variation in interest payments on their real estate loans in the 1970s when loan rates were fixed and fully assumable by buyers without modification or charge.
The lender holding an ARM loan will not profit by way of a premium price for his loan should he sell the loan when inflation falls and drives down the cost of funds. Conversely, the lender will not lose if inflation skyrockets and drives up the cost of funds. The borrower who owns the real estate securing the ARM will experience the opposite economic result, depriving the owner of the hedge in real estate ownership since the hedge was shifted to the lender in the form of increased cash payments.
By the inflation index chosen, the ARM lender simply adjusts the actual interest (note rate) – in most cases every six months, to reflect current market (and inflationary) conditions. With the indexed adjustment, the mistakes made by institutional lenders during the real estate boom of the late 1970s and again by the bond market funding fixed-rate loans at the turn of the century will not reoccur.
Since tax collectors and economists address inflation differently, it is imperative the real estate investor observe inflationary trends and closely follow changes in the purchasing power (value) of the dollar when making a loan, or buying or selling real estate. The investor must consider where the value of money is headed.
Historically, real estate has always been a good hedge against inflation. The value of a properly located and maintained parcel of improved real estate will not only keep up with inflation, but will appreciate at rates beyond the rate of inflation. The mortgage lender with an ARM loan will deprive the owner of most of that inflation.
Two leading indicators to watch which report inflation in our economy are the government’s fiscal and monetary policies.
On the fiscal side, the investor must watch projected budget deficits. When the government fails to limit spending to the amount of revenue it raises (from the taxation of income), inflation generally increases due to the precipitated high rates of employment and reduced availability of excess factory operating capacity.
On the monetary side, if the Fed keeps the money supply high (pump priming at low short-term rates) when the economy is at a high level of performance, price inflation will likely result since too much money is chasing too few products.
By watching these indicators (and many others), the investor is better able to forecast periods of inflationary and non-inflationary times, and to maximize his capital investment (purchases) and capital recovery (sales).