Tax Sux

A couple thoughts about the president’s tax returns.

First, the only crime committed here is the unlawful disclosure of Donald Trump’s tax returns. See Title 26, section 7213 of the United States Code. Somebody should be in a lot of trouble. 

Second, and more importantly, you cannot determine the character of a tax filer by looking at a tax return.

There are two kinds of income under the tax code, ordinary income and capital gains. Most of us are familiar with ordinary income. We make wages. The government takes them.

Capital gain is income that comes from the sale or other “realization” of assets. 

Gain is the difference between what one paid for the asset versus what one got when it was sold or “realized.” As day traders know, income from short-term gains on buying and selling assets, such as stocks, is treated as ordinary income. Income from gains on buying and selling assets held for more than one year is treated as long-term capital gains.

Now, suppose there are two people, A and B. A has a good job making $120,000 a year. A’s friend, B, owns real estate.

Specifically, B owns three buildings. B paid $10 million for each of these three buildings some years ago. Each building generates $450,000 of rental income per year, and operating expenses for each of these buildings runs at $50,000. B also spends about $360,000 a year per building to keep them updated, repaired, and in good order.

A year passes with A earning his wages and B managing his buildings. A has cash flows of $120,000 and taxable income of roughly $120,000.

B’s return is complicated. B pulls in about $1.2 million after expenses, but maintaining his buildings, replacing plumbing, roofs, elevators, etc., he spends about $1,080,000. So from a cash flow perspective, he takes home about $120,000 a year, just like A. From a tax perspective, however, B gets to deduct about the same amount in depreciation for his buildings, so his taxable income is also about $120,000. At an effective rate of roughly 20%, A and B each pay roughly $24,000 in federal income tax. 

Suppose after four years, on December 24, B borrows $5 million against one building and guarantees it on a “bad boy” basis (i.e., if you file the building for bankruptcy or take certain other prohibited actions, you are on the hook; otherwise the bank looks only to the real estate) as is the practice in real estate markets. B also decides that he will use the proceeds of the loan to prepay all the expenses of the financed building for the next year.

On the same day, B sells the two other buildings, one for $5 million, and another for $11 million. B had a capital loss of $5 million on one building and $1 million in capital gains on the other, for a net capital loss of $4 million. B had $1.2 million of ordinary income but after deductions for depreciation that is reduced to his usual taxable income of $120,000. What’s more, B prepaid $50,000 in expenses, so after deducting that amount, B’s taxable income is now $70,000. B also has a “tax attribute,” a carry-forward capital loss of $4 million from the low sale.

B’s net worth is down to $26 million. B has lots of cash (around $21 million) but only $5 million of equity in real estate. As consolation, at an effective tax rate of roughly 15 percent on $70,000, B’s tax bill is in the neighborhood of $10,500.

As he does every year, A pays the IRS $24,000. A is not loving it. But that’s A’s problem; he is not seeing what is going on.

What if on January 1 of the following year, B purchases two new buildings for $10 million, each of which has the same rent and expense features of the buildings B sold a few days before? Now suppose almost a year later, the next December 24, B sells his oldest building for $14 million, pays off the $5 million debt with the proceeds of this sale, and sells one of the new buildings for $9 million.

On January 1, B now has at least $18 million in cash, $10 million in a building, and no debt. He has a book net worth of $28 million, so he is up $2 million from the prior year but down overall. Given that the performance of the buildings was the same, B had $120,000 in income from the buildings after expenses and depreciation. 

B’s $4 million gain on the old building is offset by the matching $4 million carry-forward of loss on the building B sold the prior year, and B had an ordinary income loss on the sale of the new building of $1 million. So B has no taxable income and an ordinary income loss of $890,000 to carry forward into the next years. 

B goes out and gets an appraisal of his remaining building and the appraiser comes back with $15 million. B paid St. James prices for Boardwalk. It happens. B has a paper gain of $5 million (which is not a realization event and so is not taxable), a paper net worth of $33 million, and $890,000 of his future ordinary income is sheltered. 

A pays the IRS another $24,000. 

B is not the bad guy. B just owns real estate. Tax sux.

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About Jay Whig

Jay Whig is an adjunct fellow of the Center for American Greatness. Whig practices law in New York and a resides in Connecticut, specializing in insolvency and restructuring. Opinions are his own.

Photo: (Photo Illustration by Scott Olson/Getty Images)