By George Livanos
Senate Finance Committee Chairman Max
Baucus recently released several “Staff Discussion
Drafts” containing proposals to reform the
tax code. The proposals include reforms to cost
recovery and tax accounting rules.
Included within the proposals are a number
of provisions that could impact the real estate
industry, including:
• Complete repeal of the deferral of gain for
like-kind exchanges.
• Lengthening of depreciable life of real
property, including residential rental and nonresidential
property, to 43 years for both new
and prior real estate investment.
• Recapture of previously claimed depreciation
deductions taxed at ordinary income rates
upon sale or other disposition of real property.
Proposed Repeal of Section 1031 The proposed reforms to cost recovery and tax accounting rules include a proposal to repeal Section 1031 of the Internal Revenue Code. The proposed repeal would apply to exchanges made in taxable years after Dec. 31, 2014.
Section 1031 allows taxpayers to defer realized gain upon disposition of real estate or other qualifying property held for productive use in a trade, business or investment if such property is exchanged for other property of a “like-kind” that is to be held for productive use in a trade or business or for investment. The realized gain in this case is deferred, generally until the taxpayer disposes of the replacement property in a taxable transaction.
Recent attention to Section 1031 from both Congress and the Obama Administration focused on outright repeal.
The president’s Economic Recovery Advisory Board issued a report in 2010 outlining pros and cons to limiting, or repealing, Section 1031. In 2011, the Congressional Budget Office issued a report on spending and revenue options that included an option as part of a larger plan to raise tax rates on capital gains under which taxpayers could no longer defer gains under Section 1031.
The recent proposals re-introduce the concept of outright repeal of Section 1031, and provide detailed statutory provisions to modify the Code in order to accomplish the same. This provision merits careful monitoring in that it is now “on the shelf” and potentially available as a revenue-generating measure that could be considered part of any future tax legislation.
Lengthening of the Real Property Cost Recovery Period Another proposal extends the depreciable life of all residential rental property and non-residential real property to 43 years.
This represents a four-year increase from the present 39-year cost recovery period for nonresidential property. In the case of residential rental property, the increase would be 15.5 years from the 27.5-year cost recovery period under present law.
In addition, the recovery period for qualified leasehold improvements would be extended to 43 years from 15 years. Land improvements (sidewalks, driveways, parking lots, lighting, fences etc.) would be re-classified from 15- year property under current law to 20-year property under a newly proposed pooled asset recovery system.
Cost recovery of depreciable real property basis would be under the straight-line method. Real property placed in service in a taxable year prior to Jan. 1, 2015, still would be subject to the new longer recovery period, but would be eligible for a transition rule. Thus, residential rental or non-residential real property would be affected regardless of when it was placed in service, with the remaining adjusted basis of such property depreciated over a term of 43 years, reduced by the number of taxable years that the property has already been depreciated.
The result: new and existing real estate investments would have lengthened depreciation lives, and reduced annual depreciation deductions going forward if the proposal is enacted into law.
Recapture of Prior Depreciation Deductions Taxable at Ordinary Income Rates Another proposal states that upon sale or other disposition of “real property,” taxpayers must recapture and treat as ordinary income any gain to the extent of previously claimed depreciation or amortization deductions with respect to the property.
For individuals, this means a substantial potential increase in the rate of tax on such gain. Under current law, gain to the extent of previously claimed depreciation deductions is subject to a special 25 percent federal tax rate for individuals.
Under the proposal, the tax rate on such gain for individuals would be increased to a person’s marginal rate on ordinary income which, under current law, could be as high as 39.6 percent. This represents a tax increase of approximately 60 percent on such gain.
These proposals potentially could affect real estate owners, developers and investors. Always consult with your tax advisor regarding the importance of tracking state and federal tax law changes.
Livanos is a tax partner in SaxBST’s Real Estate Industry Service Group.