Taxes,Trading,and the Value of Real Estate

Abstract

Models of optimal trading strategy for real estate typically compare the benefits of stepping up the depreciable basis of property against the cost of depreciation recapture and capital gains taxes. These models routinely predict holding periods that are much longer than those that actually occur. Although this predictive failure can be explained in part by the omission from these models of nontax motivations for property turnover, we argue that an important taxfeature has also been ignored: namely, the special treatment accorded installment sales under Section 453 of the Internal Revenue Code.

We demonstrate that when installment sales of property are used, predicted property values and turnover rates increase significantly prior to the 1986 Tax Reform Act. In contrast, installment sales are shown to have only minor impact after the 1986 Act. To derive our results, we rely on a simple dynamic programming model that determines both optimal trading strategies and market values. We also cite empirical evidence that supports our model.

We further investigate the sensitivity of property market values and turnover rates to the magnitude of nontax transaction costs that are incurred when investors trade real estate. Here we show that when installment sales are ignored, transaction costs have very little effect on property values and turnover rates because recapture taxes and capital gains taxes are, by themselves, sufficient to deter frequent sales. But when installment sales are introduced, market values and turnover rates become quite sensitive to the size of the nontax transaction costs.