One of the great frustrations about US tax law for a lot of Americans is that everyday wage earners can often pay a higher tax rate than billionaire real estate investors.
The publishing of data about more than a decade of President Donald Trump’s tax returns in The New York Times confirms he often paid little or no federal income tax and suggests running for president and being elected did nothing to awaken a patriotic sense of tax-paying duty in Trump.
The report left me completely confused about how and why tax law allows this type of behavior and how, specifically, Trump’s tax lawyers might have gone about reducing his tax bill so dramatically below the more than $10,000 per capita that Americans pay in federal income tax. I reached out to Charlene Luke, a professor at the Levin College of Law at the University of Florida who is a tax law expert.
She answered my questions but wanted to make clear that she hasn’t reviewed the returns reported on by the Times — this is a good place to note that no one outside the Times has seen them — so she couldn’t weigh in on the specific avoidance measures he is reported to have used.
Our conversation, conducted by email and lightly edited for flow, is below. And I’ll be the first to admit that while Luke made this more accessible, I don’t completely understand all of it, particularly what led to the refund of years of taxes that Trump’s now fighting with the IRS over. The hard-to-follow nature of US tax law is one of its less attractive features.
Is not paying tax common for billionaires?
WHAT MATTERS: The New York Times reports President Trump paid no taxes in multiple years, including when he was running for president and only $750 in two subsequent years. Is it common for billionaire real estate investors to pay no federal income tax?
LUKE: Because return information is generally not publicly available, it is hard to know. There are tax rules, most of which have been in place for decades, that favor active real estate investors, and so it is possible that such real estate investors would have lower taxes than other types of investors or business owners.
Whether it is common to have that lower amount approach zero is hard to say. One of these special favorable tax rules is available only if the real estate investor spends “more than one half of the personal services” performed for a particular year in real property trades or businesses. In some situations, these rules do allow losses from earlier years to be used in later years, which could also further explain a tax reduction.
Is a billionaire paying no tax the way it’s supposed to happen?
WHAT MATTERS: Is this the way US tax law is supposed to work?
LUKE: Genuine losses and expenses that arise in connection with active real estate holdings, including when those holdings are funded by debt, are deductible and can be applied to reduce salary or income from other businesses.
I am personally of the view that the tax law needs to be revised to place real estate investing on the same footing as other types of businesses and investing. For example, if instead a person engaged in equipment leasing, the losses from that investment could only be used to reduce the taxes for the equipment leasing investment and not to reduce the taxes on salary or the income of other businesses.
Is Trump a person or a business?
WHAT MATTERS: One thing I’ve never completely understood — Would an investor with many associated corporations file taxes as a person or a company? Or both?
LUKE: Someone with extensive real estate holdings likely has interests in businesses where the owners are taxed on the operations of the business and where the business does not pay taxes on a separate return. For example, LLCs generally are not taxed directly; instead, the income, losses and deductions of the LLC are assigned to the owners by agreement with the tax consequences following from there and reported on the owners’ individual returns. As you may imagine, having tax consequences determined by agreement of the owners causes a great deal of room for tax maneuvering.
There are many tax rules intended to limit the use of LLCs and similar “pass-through” entities, such as various types of state law partnerships, for tax gamesmanship, but such entities are notoriously difficult to audit. For an individual to bring his or her tax reported on the personal income tax form down to zero or near zero using business losses and deductions, the losses and deductions would be flowing from businesses where the owners are taxed and not the businesses. Corporations, with the exception of a type known as S corporations, would not allow for the corporate losses and deductions to appear on an individual owner’s personal tax return.
Why could Trump deduct so much interest from his massive loans?
WHAT MATTERS: Trump has nearly half a billion dollars in outstanding debt, much of which is due in the next few years. Can a person like Trump deduct this type of debt in a different way than, say, I deduct my interest associated with my mortgage? There are caps associated with my mortgage deduction. Are there no caps for interest on business loans?
LUKE: Repayment of the outstanding loan principal would not be deductible, but interest on investment and business debt is generally more readily deductible. Interest on investment debt is limited to net investment income, but anything not used can be carried forward. The 2017 tax legislation imposes some new limits on deducting business interest but also allows taxpayers to carry forward any business interest that was limited to a later year. While loan principal is not directly deductible, taxpayers can still take depreciation deductions on investment and business assets purchased with debt. A special rule permits these deductions to be available in the case of real estate even when the individual does not have a personal obligation to repay the debt and the creditor’s only remedy is foreclosure.
When the debt is owed by an LLC or similar pass-through entity, bona fide guarantees by the LLC owners can be used to increase the deductions allocated to the guarantor. Treasury finalized regulations in 2019 aimed at limiting the ability to use noneconomically substantive guarantees to shift deductions financed by LLC debt.
Are tax returns a snapshot of wealth?
WHAT MATTERS: There’s previous evidence that Trump deflates his wealth to evade property tax bills. Is it possible for investors declaring massive losses to do so not because they are financially distressed but simply to avoid paying taxes?
LUKE: Yes, tax evasion and tax fraud can take the form of inflating losses and deductions.
How could ‘consulting fees’ be paid to an employee and daughter?
WHAT MATTERS: One of the more incredible-seeming elements of the Times report is that Trump, presumably in addition to the salary he was paying her, paid his daughter Ivanka around $750,000 in consulting fees for deals that ultimately didn’t go through. He then wrote off that fee as a loss to deduct from his taxes. Is the law meant to allow consulting expenses to family members who are also on the payroll?
LUKE: Tax law generally allows deductions for ordinary business expenses and for business losses, including abandonment of projects. The key is that the payment must be for bona fide business purposes. Payments to close family and friends by those in control of businesses are subject to scrutiny on audit because of the potential to inflate deductions and to avoid transfer taxes. In closely held businesses it is not uncommon to have multiple family members on the payroll or receive consulting fees or bonuses, and as long as the costs are ordinary and necessary to the business, then they are deductible.
What should taxpaying Americans take away from this?
WHAT MATTERS: How should wage-earning Americans who pay a lot more than $750 per year in federal income tax view these developments? Is there any legitimate reason an investor like Trump should pay not just a lower rate but also a lower dollar figure than so many Americans?
LUKE: I personally would like to see a more robust alternative minimum tax and see more accountability in terms of showing job creation, at a living wage, if tax benefits are touted as promoting entrepreneurship and investment. In my tax scholarship, I have written about the need to close loopholes relating to real estate and also more generally about the need for a tax system that is progressive, promotes a strong safety net for lower income individuals and curtails the ability of higher income individuals to use tax avoidance and evasion to reduce taxes.
What other kinds of taxes are there for a billionaire investor to pay?
WHAT MATTERS: Trump argues that he does pay taxes. What sorts of taxes could an investor pay other than income tax, and should these offset income taxes?
LUKE: There are other taxes, such as Social Security or state sales and use taxes, that are generally paid by all workers and consumers. Some types of taxes are deductible and offset income taxes, such as real property taxes, but it seems like what the question is really getting at is whether paying these other taxes somehow makes up for not paying income taxes, and I suppose that comes down to one’s personal view of what counts as fair in the sharing of our collective tax burden.
How will Trump’s tax law affect investors like him?
WHAT MATTERS: Trump’s top legislative accomplishment is slashing tax rates. How is that law likely to affect investors like him going forward?
LUKE: Depending on how expensive the out-of-pocket costs are of arranging the transactions, certain techniques may no longer be cost effective when rates are lower — but the new legislation also brought new areas where tax avoidance techniques will thrive, such as the 20% deduction for certain types of business income.
What about the infamous audit and a Great Recession refund?
WHAT MATTERS: The Times also reports that Trump has been engaged in a years-long standoff with the IRS over a $72.9 million refund he claimed after the Great Recession for the income tax he’d paid between 2005 and 2007. Why did the government allow business losses to be claimed retroactively during the Great Recession? Was that provision meant for an investor like Trump?
LUKE: The ability to carry back business losses from lean years to strong years would have been part of the multiple efforts to stimulate the economy and prevent a second Great Depression. The Times reporting suggests the loss carried back may relate to the abandonment of a partnership interest.
While in theory it is possible to abandon a partnership interest and thereby claim a business loss deduction instead of a capital loss deduction, which is limited to the extent of capital gains plus $3,000 per year for individuals, such a result is rare in practice.
As the Times notes, if the partner receives anything at the time of abandoning the partnership interest, claiming an ordinary business loss on the abandonment is not possible. It is rare because if any of the partnership’s debt had been assigned to the partner, the reduction of that debt assignment triggered by abandonment would also be treated as receipt of something and cause the usual capital loss limitations to apply.
As noted above, assignment of partnership debt potentially allows partners to increase their share of partnership deductions, which may then be used to reduce personal taxes. Abandonment may, however, also free up the ability to deduct business losses previously limited by rules relating to passive investment and investment financed by nonrecourse debt — but these are the very rules where active real estate owners get special breaks, described in the answer to the first question. If the losses were bona fide business losses — not capital losses — they would have been eligible for the special carry back provision.