The economic stimulus package offered less-than-hoped-for help for home builders, and the tax provisions in President Obama’s budget proposal offer a similar mixed bag.
Here’s a summary of pro and con initiatives for builders included in the proposed budget and a recap of items within the stimulus package that could impact home builders.
PRO:The proposed budget allows a five-year carryback of net operating losses against profits that would give builders, as well as other companies that have had losses recently and gains in past years, tax refunds that could bolster their balance sheets at a time when cash is badly needed.
This provision has had PR problems in the past. Last spring it was snatched out of legislation because it was labeled a corporate give-away. It was included again in the most recent stimulus package but was seriously watered down at the last minute to allow only small businesses, those with $15 million or less in receipts, to receive it.
Publicly, the NAHB set aside lobbying for that provision, instead asking for programs that would directly stimulate buyer demand. Privately, many businesses other than home builders have been pushing for the extension.
CON:The budget includes a tax increase that would affect private builders, as well as any other small businesses, whose corporate earnings or losses flow through to their personal tax refunds because they are incorporated as partnerships or S-corps.
If the taxpayer earns more than $250,000 a year, the tax rate would increase from 33% or 35% to 36% or 39.6%, the tax rate during the Clinton administration.
That change would raise taxes on 45 to 55% of small business income, according to a study by Tax Foundation, a non-profit, non-partisan tax research organization based in Washington, D.C.
Roughly 35% of business taxes are paid as a “flow through” to the owners’ personal income tax refunds, said Robert Carroll, vice president for economic policy for Tax Foundation.
While the tax increase applies to all tax payers with income of $250,000 or more, obviously not all are reporting business income. But Tax Foundation calculates that about half of the $30.1 billion in higher taxes would come from business income.
That could have a negative impact on the entire economy since small businesses create between 60% and 80% of new jobs, employ half the labor force, and generate more than half the nation’s gross domestic product, Carroll said.
“High income tax rates reduce the investment spending of entrepreneurs and the likelihood that they invest at all, discouraging growth or expansion of small businesses,” Carroll said.
Of course for small builders, the effect of the tax increase probably wouldn’t have much if any impact at all right now since most small builders likely have no or little profits to tax anyway. However, it could dampen reinvestments as the market starts to trend upward.
Still, taxes for partnerships and S-corps can be significantly less than they would have to pay if they were incorporated as C-corps, which have income taxed twice, first at the corporate rate and then a second time as income to the share holders.
CON:Proposed limitation of the amount that higher-tax-bracket home buyers can deduct for itemized deductions, including real estate taxes and mortgage interest, to 28%. Now those in higher tax brackets can receive a deduction at the same rate at which they pay their taxes by as much as 35%.
The worry is that this would dampen demand by lessening the advantages of homeownership. How much of a real impact it would have is debatable. Seventy-five percent of tax payers don’t itemize anyhow.
“This is a bigger deal in higher-taxed states,” says Steve Friedman, national director of home building services for Ernst and Young. “The Realtors think this is a big deal,” he continued. “At the end of the day, my suspicion is that anything that has a negative value on the asset that is purchased is bad. At a time when homes have suffered dramatic declines in value, why would you contemplate passing legislation that further affects those values.”
Toll Brothers CEO Robert Toll, whose high-end homes are sold to those in the tax bracket that would be affected, is less worried.
“As soon as this was announced we got the pencils out and cranked some numbers,” he says. “Surprisingly enough, there’s a slight difference. It’s not as bad as it sounds. It seemed like it was going to mean quite a bit.” But after consideration, “we don’t think it has as much of an effect on sales.”
Besides, he says, since it’s linked in a reduction in deductions for charitable contributions as well, “It may not pass.”
POTENTIAL CON:For builders who are setting up joint ventures, a proposed provision designed to target shareholders of hedge funds and private equity funds could have an impact, says Friedman.
In the past, partners in a business who have carried interest (the right to receive a share of a company’s profits earned by a business without contributing a corresponding share of the venture’s capital) have had their income taxed at a long-term capital gains rate. The proposed change would tax that income at the substantially higher ordinary income rate.
This proposed change has been squashed in Congress during the past few years, but it has the potential to pass with the larger Democratic majorities.
PRO:The already approved stimulus plan offers all companies, including builders, a new tool that could help some restructure their balance sheets by allowing them to defer paying taxes on loan forgiveness.
Here’s the way it works. If a company manages to cut its debt, either by buying back its bonds at less than what it sold them for or by convincing its bankers to accept less to repay a loan, the difference between the amount of the original debt and the new debt is taxable at a corporate rate of 36%.
Under a new provision in the stimulus plan, the taxes on that forgiven debt may be deferred until 2014 and then paid back in 20% yearly installments ending in 2019 if the debt is bought back in the two years between January 1 of this year and December 31, 2010.
This would allow a company with bond debt that is trading for less than the company paid for it to defer any tax consequences from buying back the bonds at a lower price for four to five years.
Private builders theoretically could also take advantage of the tax code change to lower their debts by persuading their bankers to take less than the full value of a loan. If that loan happened to secure property, the builder could then sell the property for less than the loan and generate much needed cash with deferred tax consequences.
But taking advantage of the debt forgiveness clause can have costs of its own.
It takes cash to buy back the bonds and bank debt. For builders who have been focusing on hording cash to hold them over until the market turns around, that’s a disadvantage.
Learn more about markets featured in this article: Washington, DC.