I heard a legal podcaster comment recently that, while she understood Bob Mueller’s investigations into obstruction of justice, she was having a hard time getting her head around the financial crime allegations floating around the Trump election and presidency. In general, the media, with some exceptions, has not asked good questions about where the Trump and Kushner wealth came from, especially with their past record of bankruptcies and other legal difficulties.

Professor Aswath Damodaran’s research at New York University asserts that U.S. real estate development firms pay on average only one percent of revenues in federal taxes. [1] This post will look how money is really made in real estate development, where its peculiarities find it often skirting the U.S. Tax Code, and where Donald Trump and Jared Kushner may be skating on thin ice, either legally or financially. [1]

You want to lose money in real estate

This first principle seems counter-intuitive, but the essence is that you want to show an accounting loss to the IRS, or at least minimal accounting profits, on your real estate development, while at the same time you generate a large positive cash flow. In this way, you get the maximum tax benefits, which often go to companies appearing to lose money, but you keep cash coming in the door so you can first, pay the bills and second, extract enough cash for your own personal use. And at the same time, you don’t want most of that “personal use” cash to show as taxable income to you in your individual tax returns.

How do you pull this trick off? For starters, it helps to be a privately-held company, which most big real estate consortiums (including the Trump and Kushner companies) are. Outside of public scrutiny, a “tax loss” is just a paper transaction. “Book” profits and losses have often become accounting fictions, especially if you have intentionally set them up this way.

There is some of chicken-and-egg going on here. Real estate taxes are incredibly complex and rife with special-interest provisions that best work under cover of private financial holdings. And so the companies are privately-held. Or the other way around. Powerful private financial interests have peppered the tax code with favorable tax treatment for real estate development because of its unique abilities to “obscure” cash. The Trump and Kushner organizations may well be in technical compliance with tax law here, because it was set up to benefit companies like theirs. However skirting the line between tax minimization and tax fraud is often part of the game.

Depreciating an appreciating property

The bulk of the “tax loss” is achieved through accounting for “depreciation” of the property. Depreciation is shown on the accounting books as an expense, but importantly, no cash changes hands when the expense is declared. Accounting depreciation is intended to “match” the cost of deteriorating assets, such as manufacturing equipment, to the pace of generated revenue from those assets. But it applies to buildings as well, even though the total value of the property, especially in New York City and south Florida, may be steadily increasing.

In other words, ideally the “book value” of your real estate development keeps going down year after year, and you get a huge tax deduction from that loss, but the “market value” of the property keeps going up. The increased market value itself never shows on your balance sheet unless, and until, you sell the property. If your company were publicly-held, this might bother you because you would be grossly understating the value of your assets, but not if you are private and have a “back pocket” understanding of the true market value of your properties.

This strategy can go sour in two ways. First, there can be a crash in the overall market, as happened in 2008, bankrupting scores of Florida developers. Second, you can overpay for a property, which Jared Kushner apparently did with his 666 Broadway property in New York City. He was betting that he could boost the market value of the property before it came time to refinance his debt. This will likely not happen, so he desperately needs an outside investor to rescue this property. And here Kushner has been playing footsie with ethical rules, and perhaps legal prohibitions, in meeting with prospective foreign sources of investment both right after the election, and while working in the White House as an adviser.

Borrow to the hilt

Characteristic of real estate development is the use of high debt leverage to put as little of your own money into a development as possible. This gives you very favorable tax treatment via the tax-deductibility of interest. Business debt is much different from consumer debt.  It is really just a different form of equity with different risks and investor powers over the project. I have written about the abuses of business debt by private equity at length in an earlier post.

This way to view debt is especially true in real estate development. The nature of real estate favors the use of mortgage-based debt, because you have a very tangible asset on which to literally “death pledge” (the source of the word “mortgage”). Risky real estate ventures especially have very strong mortgage covenants that really come closer to a “preferred stock” position, and especially when you use funding sources other than major U.S. banks, where transparency of the transaction to regulators is lessened.

The Trump Organization burned most of its bridges with U.S. banks in their failed Atlantic City casino venture. [2] In the few financial disclosures we have, some Trump properties are not visibly mortgaged at high levels. The high-leverage strategy of real estate development is so near-universal that this alone would be suspicious. The likely and rumored use of foreign non-bank sources of debt for many of his properties raises the inevitable suspicions that there are undisclosed security agreements in place.

Section 1031 like-kind exchanges

The depreciation strategy noted above has a big drawback as the property gets older. In a rising real estate market like New York City, the “book value” and the “market value” of the property get further and further apart, with accumulated depreciation taking the book value down every year and real estate inflation simultaneously boosting the market value. If you were to sell the property outright, a huge capital gain would be realized with a big income tax assessment.

However, IRS Code Section 1031 has for many years allowed the sale of your depreciated property and the quick purchase of another property, calling it a “like kind exchange.” While the qualifying rules are complicated, the net result is that you can keep deferring the capital gain by essentially “rolling it over” into the new property. The most recent tax law revision of 2017 eliminated the use of Section 1031 exchanges except for one kind of asset. You guessed it: Commercial real estate. I have not been able to document whether the Trump Organization has ever used Section 1031 exchanges to defer taxes, but at the time of the change in rules, there were many rumors to that effect. It would be a simple question to ask.

Other tax subsidies

Other tax-favorable options exist in commercial real estate, too numerous to mention, and often well-buried in the federal and state tax codes. Most cities look very favorably on real estate development, and so free infrastructure improvements, property and sales tax abatements, and other development incentives commonly drive down the effective tax rate while driving up the cash flow for developers.

Often overlooked is the ability, especially in real estate development, to blur the line as to what is “business expense” versus “personal expense.” Small entrepreneurs know well the stringent rules that apply to them in trying to deduct the costs of a home office, but one can be certain that much of the Trump lavish lifestyle is paid for with funds that are never declared as personal income, rather are carefully expensed by the accountants of the Trump Organization.

Keeping the cash flow going

As noted above, the game here is to pretend that you are not making money in order to keep taxes low, but still keep cash coming in so that debt payments can be made and “lifestyle” cash extracted. Because of typical high leverage and less-visible financing restrictions, interruption of cash flow can be fatal to projects. The Guardian has reported on continued cash drains at two Scottish golf courses owned by Trump, [3] and his Los Angeles course is also rumored to be a drain.

Increased scrutiny of the sources of buyer and renter cash, much of it from overseas sources, seems also to have depressed occupancy at key Trump properties in New York City and elsewhere. A major retail property in New York’s Times Square belonging to the Kushner family has been bleeding tenants, such as celebrity chef Guy Fieri’s restaurant closure, and its anchor Guitar Center store is struggling with poor traffic and its debt-laden parent’s private equity ownership. [4]

Because it has had such a hard time getting financing for traditional real estate development, the Trump Organization has turned in recent years to licensing, branding and hotel management to bring in cash, letting other developers, some questionable, finance their hotels and other properties. [5] Their troubled Toronto hotel has since disassociated themselves from the Trump Organization, as has their Panama City hotel.

The big problem with licensing and management contracts is that they are not leverageable in the same way real estate is, with cash flow limited instead to fairly staid percentage of generated revenue. Plus, there is no tangible asset to value or mortgage. Accounts call these “intangible assets,” and their value is usually a crap shoot. Reputation is a fickle asset.

The short story, known to the New York business press and bankers for decades, is that Donald Trump is not nearly as rich as he says he is. He often quotes gross revenues of his ventures rather than net profits, or the total market value of properties in which he is only a minority owner (or just a brand on an outside sign) as public proclamations of his wealth.

Back in the days of the collapse of Trump’s Atlantic City casinos, his company was once described as a “Zero billion dollar business,” meaning it was worthless, but Trump publicly pretended it to be worth a billion dollars. My professional guess is that both the Trump and Kushner organizations either are, or soon will be, “Zero billion dollar businesses” again.

Part Two of this series, delving deeper into Trump collateral, is now posted.

An updated and summarized version of this series is posted here.

Notes:

1. Ehrenfreund, Max. “How Donald Trump and Other Real-Estate Developers Pay Almost Nothing in Taxes.” The Washington Post, 4 Oct. 2016.
2. Buettner, Russ, and Charles V. Bagli. “How Donald Trump Bankrupted His Atlantic City Casinos, but Still Earned Millions.” The New York Times, 11 June 2016.
3. Carrell, Severin. “Donald Trump Has Lost Tens of Millions on Scottish Golf Courses, Accounts Show.” The Guardian, 12 Oct. 2016.
4. “Kushner Cos.’ Deutsche Bank–Backed Property Stung by Tenant Troubles.” Crain’s New York Business, 19 Jan. 2018.
5. Bertrand, Natasha. “Report: Russian Bank Whose CEO Met Secretly with Jared Kushner Helped Finance Trump’s Toronto Hotel.” Business Insider, 17 May 2017.