FIN 183: A Blast from the Past Spoiled by the 1986 Tax Law Change

Before the 1986 tax law change, the tax shelter benefits of real estate were huge. Two benefits do not exist today were found in its prior form.

First, before 1986, the IRS allowed accelerated methods of tax depreciation for real estate improvements. From your accounting class you might recall methods with cool names like double-declining balance or sum-of-the-years digits. With accelerated forms of deprecation, investors could shelter a lot of taxable income in the early years of an investment. Since 1986, real estate investors have generally been limited to straight-line (S/L) depreciation.

Second, before 1986, real estate investors could use any negative taxable income from a real estate investment, shown as “paper loss,” to offset any other income. This made commercial real estate investment attractive to anyone with a good income. Many professionals, including accountants, lawyers, and doctors, formed partnerships to invest in commercial real estate. Real estate was almost a no-brainer investment. If the real estate investment made money, the investors made more money. If the real estate investment lost money, the losses provided a tax shelter and a lower tax bill for these high-income investors. You really could not make a bad real estate investment until the 1986 tax law change.

The 1986 tax law changes created two forms of income, active and passive. Active income is your primary income from employment. Passive income is income from passive investments such as stocks, bonds, and real estate. The new rules stated that you cannot use tax losses from passive investments to offset active income. These partnerships of high-active-income investors could no longer shelter income from any real estate losses.

With less tax shelter benefits after 1986, the demand for commercial real estate declined. Around the same time, the supply of commercial real estate on the market was cresting as the government tried to dispose of real estate assets from failed savings and loan associations. With demand down and supply up, the late 1980s and early 1990s were essentially the Great Depression for commercial real estate.