A Comeback for Tax Breaks?

Published on 2013/07/10

“However, I expect that the tax orientation, especially in the area of residential real estate… will come back in a few years’ time, possibly even on a greater scale… But if the legislature curbs the market economy’s play of supply and demand through overregulation, or indeed deactivates it in major areas, that is, if rents are kept artificially low and construction is made costlier, yields will drop below acceptable levels and will no longer be able to compete with alternative investment options.

So as long as the landlord-tenant law is not liberalised – and this is something no party in Germany seeks except the Liberals – tax breaks will remain necessary to attract a sufficient flow of capital into rental housing construction. Policy makers may lose sight of these contexts from time to time when rashly closing ‘tax loopholes for depreciation acrobats’ but experience shows that such a policy leads to a contraction of the housing supply in a matter of years, creating once again the need to counteract the trend by granting new tax breaks and thus investment incentives.”

I wrote these lines not just a few weeks or months ago, but in my book on how to get rich with real estate (“Reich werden mit Immobilien,” p. 64-65) in September 1999, just after the special depreciation allowance program for East Germany was rescinded.

Now, 14 years later, the following situation presents itself:
Arnold Vaatz, Member of the Federal Executive Board of the CDU and Deputy Chairman of the Christian Democrat parliamentary group at the Bundestag, suggested in an interview with the IMMOBILIEN ZEITUNG, published on 04 July, that there is a need for a “special depreciation allowance deduction” in housing construction. He argued that it would work, in a manner of speaking, like an antidote to the rent control demanded by the Christian Democrats. Said Vaatz: “On the one hand, we wish to contain the risk of skyrocketing rents. On the other hand, we do not want to see a wait-and-see attitude when it comes to investments. After all, no one stands to benefit from a situation where people actually willing to invest in the housing market keep their hands on their wallets out of fear. Anyone worried that such an effect is imminent needs to do something about it.” Asked by the IMMOBILIEN ZEITUNG what exactly he had in mind, he replied: “new incentives via a special depreciation allowance deduction.”

Naturally, this brings back memories of the old special depreciation allowance deduction for East Germany (“Sonder-AfA-Ost”). This was a tax break intended to promote construction in Berlin and the East German states in the 1990s, following the country’s reunification. Up to the end of 1996, it was possible to deduct 50% of the replacement or acquisition costs for new construction projects. The highlight of this special depreciation allowance deduction was that policymakers had created the option to distribute the allowance at will across the first five years, enabling taxpayers to adjust their actual amount deducted flexibly to match their taxable income.

So far, no one has demanded that tax breaks of quite this magnitude be revived. But the housing policy spokesman of the Liberals already stated that it would be a good idea to grant an increased annual depreciation between 8% and 10% over a three-year period, and 4% p.a. thereafter. While this would remain below 50% within five years, it still adds up to a whopping 38%.

The two Christian Democrat parties (CDU and CSU) also advocate a reintroduction of the accelerated depreciation allowance in their election manifesto. They fail to quantify it though. As a reminder: Until 1995, the accelerated depreciation allowance (“degressive AfA”) permitted deductions of 7% p.a. over a four-year period, of 5% p.a. over the next 6 years, adding up to 58% over ten years. Later on, the deduction rates were successively lowered.

The DMB German Tenant Union, for one, has also clamoured for an increase in depreciation rates, ideally from 2% to 4%. And even the housing policy spokesperson of the GREENS signalled willingness to talk about raising the deduction rate, if moderately so.

Underlying these ideas is a simple logic: It is well known that Social Democrats, Greens, The Left, and Christian Democrats demand the introduction of rent control. Rent rates are to be frozen long-term, and the way to do it is by capping the rent for re-let units. Since the players have meanwhile understood that this will produce the exact opposite by choking housing construction, they intend to pair the measure with tax breaks.

The whole affair is perfectly absurd. First you announce that you are going to hit the brake hard, only to announce next that you will also step on the gas out of concern the car might stall.

So what is likely to happen?

  1. If a coalition government was to emerge from the general elections that does not include the Liberals, such as a grand coalition of Christian Democrats and Social Democrats or a coalition of left-wing parties, rent control is likely to be introduced, meaning a rent cap on new leases.
  2. Simultaneously, the accelerated depreciation allowance will be reintroduced, or at least the current depreciation allowance for housing construction will be doubled.
  3. Once it becomes obvious that this will by no means suffice to offset the negative ramification of the rent control, the tax rebates will probably be jacked up further, that is, deduction rates will be substantially raised.
  4. While this will indeed crank up the housing construction volume, it will involve a massive misallocation of capital.
  5. Assuming the investors go ahead and do what they are expected to so, that is, taking advantage of the tax breaks to invest in housing construction, they will get flak from the political arena a few years down the road as sinister “deduction acrobats” while demands will be raised to close the “tax loopholes” that policymakers themselves put in place just a short while ago. Neither will policymakers be bashful about curtailing the loss compensation options retroactively, as was done with Article 2, Section 3, German Income Tax Act.
  6. In the meantime, the tax rebates have caused massive misallocations, though. The German states have been authorised to introduce tax breaks in certain cities, so as to avoid a nationwide increase in deductions (not least because doing so would violate EU regulations). However, as it is virtually impossible to balance the measure with pinpoint accuracy, contractors will favour those sites where plots are comparatively affordable still, which in Berlin would be districts like Spandau or Marzahn.
  7. The vacancy rate that the misallocation will have raised in some areas will be reduced by spending yet more tax money on the demolition of vacant buildings, and did happen within the framework of the so-called urban renewal program for East Germany. (Under this program, 2.7 billion euros in tax revenues were spend to demolish 300,000 apartments in East Germany that had been raised in the 1990s in excess of demand, encouraged by the Assisted Area Act (FördG).

Is this scenario a figment of the imagination? No, it is not. There are historic precedents for (virtually) all of it – except for the rent cap for re-let apartment. I believe it was Hegel who quipped that the only thing we learn from history is that we learn nothing from history.

About the Author

Dr. Rainer Zitelmann is one of the leading experts for the strategic positioning and communications of companies.