IT'S BETTER TO LOSE by C. David Anderson

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Shortly after Reagan’s 1981 ERTA tax cuts, a major client asked if I could help with a troubled tax project. 

The client was working with a real estate tax specialist firm to see if a three-cornered like-kind exchange could be arranged for him.  The problem was that this was then a technically unsettled issue, and the legal bill had ballooned to well over $100k in today’s dollars – still with no certain answer.

I had recently joined the planning committee for the USC Tax Institute, which gave me an opportunity to ask the committee – all distinguished senior practitioners – a question which bothered me:  Just how good were the tax planning moves which were our bread and butter?  Were tax free reorganizations and like-kind exchanges really that good financially for taxpayers?

Surprisingly, everyone, including the accountants, said they hadn’t really done the analysis.  They just relied on the taxpayer-attractive idea that paying tax later is better.  The committee talked me into writing an article for the Institute on the “quantitative dimension” of tax planning.

Writing the presentation caused me to realize that ERTA’s combination of faster depreciation and lower capital gain rates had stood real estate tax deferral on its head.  The new faster depreciation meant that the tax benefit of the depreciation after a taxable sale was greater than the new lower capital gain paid up front to get the additional depreciable basis.  So, after ERTA, real estate tax deferral was bad!

Armed with this insight, I gave the client a simple spreadsheet present value calculation which showed that the client would be better off if the three-cornered exchange failed.  If it did fail, he would pay a capital gain tax up front which was smaller than the value of the resulting increased depreciation deductions against future ordinary income.

The client agreed to shut down the expensive tax analysis and just finish the exchange, which was well along.  My strategy, if the transaction was audited, was to ask IRS to please disqualify the exchange, let us pay tax on the gain, but then to give us a refund for the increased depreciation deductions in the later years under audit.  

The specialty tax firm’s partner was incredulous – this turned-on-its-head result was a shock – but the client was delighted.