Over the weekend, the New York Times dropped a bombshell: three pages taken from Republican presidential nominee Donald Trump’s state tax returns in 1995 that show he reported a big enough loss that he could potentially have avoided paying any federal income tax for almost two decades.
Middle- and lower-income Americans may have wondered: why don’t we get to avoid paying taxes if we sell our houses at a loss or lose a bunch of money in the stock market?
The reason is that Trump, and anyone in the real estate business, can take advantage of a part of the tax code carved out just for them.
All businesses are able to do what experts call smoothing: if they experience a loss in money in one year, they can deduct it against a profit in other years and reduce how much they pay taxes on, thus averaging everything out.
But for a traditional corporation — known as a C corporation — things are pretty straightforward. The loss and income come from the same source: the money the company itself either makes or loses.
In the case of Trump and anyone else in real estate, they’re dealing instead with what are called pass through businesses, or LLCs, S corporations, partnerships, and others. Rather than the business entity itself paying a corporate tax, the money made from a pass through shows up immediately on its owner’s own personal tax return and gets taxed as if it’s an individual’s income.
If someone owns many different pass through businesses, as Trump does, then the income and the losses from all of them end up in one place, on his tax return. That allows Trump to count losses from some businesses against any other money he may have made elsewhere.
Trump owns quite a lot of these entities, reporting more than 200 LLCs on his presidential disclosure report. “He has income from all kinds of things, from his personal brand to his steaks,” said Alexandra Thornton, senior director of tax policy at the Center for American Progress (CAP). (ThinkProgress is an editorially independent project of the Center for American Progress Action Fund.) “So any income he has from those other things he can offset with losses that he may have from his other pass through businesses.”
Those in the real estate business can go even further, tallying up losses that aren’t actually money lost but what are called paper losses. Developers are allowed to assume that the buildings they own lose value over time, or depreciate, and deduct that potential reduction against their income, no matter whether their buildings may be rising in value or not. They can also borrow money to buy more real estate properties and then deduct the interest they have to pay on that debt.
These are all common tactics, although the sheer size of what Trump may have done on his taxes in the 1990s is staggering. According to the documents obtained by the New York Times, he declared a $916 million loss in 1995, which could include both real and paper losses. IRS rules at the time would have allowed him to use that loss to count against any tax obligations for three years prior and 15 years after, although he may have already been counting losses against income before 1995. But that would have been enough to negate more than $50 million in taxable income per year for 18 years, enough to cancel out what he made as CEO of his Atlantic City casinos or what he was paid for “The Apprentice.”
It is also a huge outlier for these kind of maneuvers. The net operating loss Trump claimed in 1995 amounted to a full 2 percent of all net operating losses claimed by all Americans in the same year. The average loss claimed by those using this tactic was just $97,600, far less than Trump’s $916 million.
And most Americans don’t get to do these things on their own tax returns. If someone has to sell her house for less than she bought it, she can’t apply the amount she lost out on against her personal income to reduce her federal tax burden. Similarly, if she invested in a company and then the company lost money, she can’t deduct it against her ordinary income.
And while many small businesses are set up as pass throughs, it takes owning a vast array of them to be able to pull off what Trump seems to have done.
All of this is thanks to a hard-won loophole that the real estate industry carved out in the tax code for itself. Before 1986, wealthier Americans of all stripes could invest money in real estate partnerships and then write off losses on their tax returns and lower their obligations. But then Congress decided to crack down on the practice and strictly limited the deductions that these passive investors could use.
This could have cut real estate off from an enormously beneficial tax break. So it fought back hard — and won. In the early 1990s, Congress passed a carve out that lifted any limits on deductions for those who qualify as “real estate professionals,” or spend 750 hours a year on such businesses.
“Real estate people are allowed to deduct losses against passive income because they have a special rule in the tax code,” Thornton pointed out.
While small business owners certainly benefit from these carveouts, the vast majority of beneficiaries are quite well off. Seventy percent of the income generated by partnerships and S corporations is captured by the richest 1 percent of Americans. Seventy percent also flows to big businesses.
“It’s dominated by hedge funds, real estate, private equity,” Brendan V. Duke, associate director of economic policy at CAP, pointed out, “financial vehicles that middle-class Americans have no access to.”
Getting rid of this carveout entirely could end up hurting businesses, including many small ones. And it can make sense to allow them to average out income and losses. But one fix that Thornton and Duke have argued for would be to ensure that pass through businesses pay corporate tax like other companies. “If you drafted that correctly, it would mean that these losses that [Trump] had in any given business could only be deducted against income from that particular business,” the way it works for C corporations, Thornton explained.
Most Americans also aren’t able to smooth out their income over many years the way that corporations and those with pass through businesses can. “We’ve done a pretty good job of that for real estate investors and wealthy people like Donald Trump,” Duke noted. “We haven’t done it well for middle-income and low-income Americans.” As just one example, a family that has low enough income to qualify for the Earned Income Tax Credit in one year could miss out on it the next if its income rises, with no ability to average things out.
So some have argued that lower-income Americans should also be allowed to smooth out their income and tax burdens. Lily Batchelder, a law professor at New York University, has found that poorer families’ incomes fluctuate much more than higher-income ones, which leads to a higher average tax rate than those with more stable incomes, and would therefore disproportionately benefit from averaging things out. She proposes allowing families to average their income for two years to calculate the Earned Income Tax Credit and to let them apply unused deductions and exemptions in a given year to the previous one.