In 1986 Congress passed a tax reform act (TRA 1986) whichin addition to simplifying the tax code, also eliminated and restricted the tax benefits associated with investment real estate.
The tax reform did three things:
1.) It limited the adjusted gross income to $100,000 for those individuals that invested in real estate and wanted to be able to depreciate the property and receive a tax deduction for doing so. The deductions were phased out and pro rated for those with an AGI between 100-150K. And for those with an AGI of greater than 150K, the losses were carried forward, indefinitely. Prior to 1986, any American was able to benefit from the tax deductions associated with investment real estate.
2.) The Tax Reform Act of 1986 also limited the annual passive losses (depreciation) associated with investment real estate to $25,000 a year. Prior to 1986, there was no limit on the number of passive losses that a real estate investor could deduct.
3.) And finally, the TRA of 1986 lengthened the depreciation scale for residential real estate investments from 15 years to 27.5 years. In other words, for those who could still qualify for the passive losses and deprecation associated with real estate, the annual tax deductions were now virtually cut in half. It would take nearly twice as long to fully depreciate a residential real estate investment.
These three changes made real estate investments literally less valuable overnight. And some would contend that it was this tax reform that contributed to the savings and loan crisis as well as the housing recession in the late 1980s.
The one exception to the first two changes was for those that met the IRS criteria of being a "real estate professional". For those that met the IRS definition, #1 and #2 do not apply. I'm not going to get into the definition, but Diane Kennedy who knows a thing or two about taxes details a definition here.
Well, here we are 22 years later and this tax code is still on the books. And there are two problems with this, first, the income and passive loss limitations have not been adjusted for inflation.
Second, I can't think of a better time to repeal this piece of legislation (namely points #1 and #2) than a housing depression that is causing a global economic and banking crisis. By giving all Americans a real tax incentive to invest in real estate we would stimulate new demand for housing that would absorb the excess supply - something that falling home prices and lower mortgage rates have been unsuccessful at doing so far.
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The sustainable option is to let prices continue to decline until they are inline with real rental income and real people's ability to pay (income) rather than another subsidy that encourages higher prices. Let's let prices find their natural level, then have the government focus on policies that reduce volatility in housing pricing rather than trying to push prices in one direction or another. Both rapid increases and rapid decreases should be avoided. Both lead to inefficiencies.
Rapid decreases cause foreclosures, which are clearly wasteful (legal fees, property degredation, pain for those affected and their neighbors etc) while rapid increases cause poor quality development without proper planning in unsustainable neighborhoods (rush to get in before too late - e.g. Las Vegas) as well as cause unaffordability of housing for those unlucky enough to be in their 30's (house buying age) after the bubble inflates.
Why can't we realize that property values should be seen in a similar was we view inflation/deflation -- stability is good. Oh wait I just remembered real estate agents make more money if housing is inneficient because people move around more and eithe overpay (during bubble) or are forced to sell move into a temporary home due to financial limitations. There would be less demand for agents if we all only bought 1-2 houses during our lifetime, so they want us to have a cyclical market so we move every 5-7 years.