Commentary

Suspend Cap Gains Tax On Toxic Assets

A simple change in tax laws could do more to resolve the current credit crisis than the massive bailout legislation that was just enacted or Sen. McCain’s recent proposal that the federal government buy up all bad mortgages.

We were cautioned that if Treasury’s plans were not adopted, all hell would break loose. After all, the Dow Jones industrial average was telling us so. So the bailout legislation passed. The stock market did not respond favorably to the fix. In fact it went into free fall. The fall in housing prices didn’t just stop, and the securities that are in part collateralized by the housing stock did not all of a sudden trade.

And the U.S. is on a path that will accelerate its already well-established departure from free-market principles, individual liberty and personal responsibility.

What do we do, then, to reverse this trajectory, to support housing prices and facilitate the market for toxic securities that ultimately are tied to housing? Here’s a simple, promising idea:

No tax on short- or long-term capital gains or other income realized upon sale of the asset through 2013 for any individual or institution that purchases either the distressed real estate or securities collateralized by the real estate. This idea will produce winners and no - or few - losers.

When the seller would keep all of the proceeds from the sale of a house, because none are taxed, the future value of the house is greater than if it were taxed. The present value, therefore, is also greater.

Stated differently, housing prices rise when taxes are reduced. An individual who has been thinking of investing in distressed real estate may now find the timing right. If he assumes that housing in his market would rebound within five years, he now has an incentive, at the margin, to buy.

Institutions may provide a limited-purpose collective pool, such as a mutual fund, to buy distressed real estate, and then distribute the sales proceeds tax-free within five years. This structure would allow individuals who are not real estate professionals, but who nonetheless find the present housing market now more attractive because of the tax treatment, to easily participate and profit in its rebound. Private capital would enter the market, buy distressed property, and aid in re-establishing the market for housing.

Homeowners who are able to service their mortgage, but who are considering dropping the keys off at the bank, will rethink because their negative equity will shrink. Homeowners who are unable to meet their mortgage responsibilities would also benefit in those cases where the equity flips from negative to positive.

[T]he U.S. is on a path that will accelerate its already well-established departure from free-market principles, individual liberty and personal responsibility.”

The securities collateralized by the real estate will increase in value as well, for two reasons. The first is that the collateral is now greater, therefore the risk is less. The second is that the gain on the sale of the securities is not subject to tax, therefore increasing the after-tax return to capital. Purchasing these securities from banks, an objective of the legislation just passed, would improve their balance sheets.

I have presented this idea to some members of Congress and others in our government. It has found a warm reception, and it has gained adherents.

We have heard two objections. The first is that investors would reap a windfall due to the tax treatment. This objection is a confirmation that the idea has merit because no windfall can accrue unless private capital invests.

The second objection is that it would cost the government money in the form of the lost income and capital gains tax. This is a red herring because the private sector isn’t investing, and without investing there can be no gain to tax. From the government’s point of view, not investing, or investing with no tax, yields the same zero revenue.

This private initiative now must be ready, in the form of legislation, for the almost certain challenges ahead. It needs to be shared with the American people, most of whom are against the just-passed legislation.

If the voters enthusiastically support this, then perhaps enough politicians will as well. If so, it will increase the return to private capital by reducing taxes, encourage the participation of individuals through the opportunity of profit, provide a solution that requires less government, not more, and help confront the very real challenges we face.

William G. Shipman is chairman of CarriageOaks Partners LLC and co-chairman of the Cato Institute Project on Social Security Choice.