That was the total loss Donald Trump and his then-wife Marla Maples reported on their 1995 tax return, a staggering amount even for a man who had taken four companies through the muck of Chapter 11 bankruptcy.
In the early 1990s, a vortex of business collapses nearly swallowed the Trump Organization whole. Trump racked up $3.4 billion in debt on his Atlantic City holdings alone. In Manhattan, a Citibank-led consortium of lenders seized control of Trump’s Plaza Hotel. Trump’s airline, the Trump Shuttle, as well as his personal yacht, were other casualties.
Trump managed to walk away from the wreckage and resurrect his empire. Not only that, he parlayed the massive loss into opportunity. As the New York Times reported Saturday, the $916 million loss could have allowed him to legally avoid paying any federal income taxes for up to 18 years.
One of the perks of the real estate business is that it lends itself to many tax-avoidance strategies. Here are some of the accounting tools that Trump and other property owners can employ to turn losses into big tax savings.
Net Operating Losses
For many investors, buying income-generating real estate isn’t too different from buying corporate bonds or stocks. But there is one major advantage: losses on rental properties can be deducted from taxable income.
Getting that provision into the tax code was a rocky road. In 1986, Congress passed a law that treated virtually all investments in rental real estate properties as passive investments (much like stocks or bonds). This meant property owners could no longer deduct any operating losses on their properties from their taxable income. In the following years, property prices went into a tailspin. Legislators blamed the 1986 law in part for causing the savings & loan crisis by discouraging investment in real estate, according to a 1994 Chicago Tribune report. So they changed the rules again.
Since 1993, rental property owners can deduct operating losses on their properties from their taxable income, provided they spend at least half their working hours and at least 750 hours a year as a real estate professional.
But such operating losses rarely persist in New York’s real estate market, said Kenneth Weissenberg, a partner at accountancy and consulting firm Eisner Amper. Most of his real estate clients use deductions but still end up paying income tax, he said. “Even Leona Helmsley, who went to prison for tax evasion, she still paid income tax,” he added. “Just not enough.”
Depreciation is the most famous – and counterintuitive – way real estate investors can shrink their tax bill. The IRS treats properties as assets that lose value over time, along with cars, desks and refrigerators. Unlike cars and desks which actually do become less valuable over time due to wear and tear, buildings in New York City and other major metropolitan markets tend to steadily gain value over the years.
Property owners can deduct a certain portion of a property’s value every year until that value reaches zero. For residential rental properties, the typical depreciation period is 27.5 years, according to the IRS’ website.
As useful as depreciation is to property owners, it is a gradual process and rarely generates the kind of loss Trump recorded in 1995. Weissenberg said that, hypothetically, to deduct $916 million due to depreciation, you would need to have a real estate portfolio worth $30B or more.
Cancellation of Debt
Another way developers can drastically lower their annual income tax bill is through a cancellation of debt, or outstanding debt that has been forgiven after negotiations. Typically, this kind of debt forgiveness is treated as income on a tax bill, but current laws allow taxpayers to deduct this debt if it is tied to Chapter 11 bankruptcy (which Trump entities had undergone four times by 1995), or if the taxpayer is insolvent, meaning all of his or debt debt is greater than the total market value of his assets
However, after Congress passed the Omnibus Budget Reconciliation act of 1993, underwater real estate moguls with forgiven debt who didn’t meet either of those criteria had a new way to get out of paying income taxes. A line added to the tax code that year allowed canceled debt tied to “real property business indebtedness” to qualify for gross income exclusion, significantly broadening the pool of real estate owners eligible for major tax markdowns.
“It was in response to a crash in real estate and Congress perceived a need to bail out real estate operators whose properties suddenly lost value and whose debts had to be cancelled by banks,” said Richard Beck, a tax law professor at the New York Law School. The cancelled debt, Beck said, “created a lot of phantom income” which would otherwise be taxable.
Writing off phantom income does come at some cost, though.
“If you are able to exclude cancellation of debt income from your tax returns you then have to look down a waterfall of tax attributes that you have to reduce,” said Patrick O’Bryan, a tax attorney at law firm Polsinelli.
That waterfall includes things like the amount of net operating losses an owner can deduct from their taxes. It can also include lowering the tax basis of investments across one’s portfolio. “Usually what happens is if you reduce your basis in property it causes additional income down the road, both annually and when you sell the property, to be taxed more significantly” said Bill Sanders, chair of the tax department at Polsinelli.
(Here’s a drastically simplified example: Let’s say you have a property in which your basis is $1 million. If you sell the property for $6 million, your taxable gain is $5 million. But if your basis has been lowered, to say $500,000 due to debt forgiveness, the amount of taxable gain is $5.5 million.) Having a lower basis in the property also lessens the amount you can claim in depreciation annually, tax experts said.
But for many, holding on to whatever money you can keep at a time when times are tough makes sense, O’Bryan said, so developers often choose to kick the tax can toward a hopefully much more prosperous future.
Though former New York City mayor Rudolph Giuliani described Trump’s tax machinations as an example of his “absolute genius,” New York developers have long used these strategies, experts said. After the Times’ story, tax services firms sought to seize the moment by sending out email blasts advertising their tax reduction services.
One email from South Florida-based Property Tax Appeal Group, titled “Donald Trump Knows How to Avoid Taxes in Real Estate,” urged investors to file property tax appeals and “take advantage of what the law allows.”
“This is truly a win-win situation,” the email read.