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Wednesday, June 11, 2014

Changes to Real Estate Taxation—On the Horizon


Release of Congressman Dave Camp’s tax reform discussion draft and President Obama’s 2015 budget proposals give proponents and opponents of tax reform much to discuss. More so, the proposed changes for real estate taxation could, if passed, significantly alter the real estate landscape.

Both Chairman Camp and President Obama’s proposed changes seek to cut tax rates on individuals and corporations by reducing the number of available deductions, credits and other significant changes affecting taxpayers across industries. The likelihood that tax reform will happen in 2014 does not hold much promise. However, it is important for taxpayers to be aware of some of the considered provisions, which may influence their decision-making going forward.

Three areas to be reviewed in this tax alert are the proposals affecting carried interest, proposed cap on deferring gains in 1031 Exchange transaction, and the proposal to eliminate MACRS depreciation.

Carried Interest – Debate Continues
Carried interest — loophole or a necessary incentive to keep long-term investments in the pipeline? That is the ongoing debate. Carried interest allows managers of some investment funds (such as hedge, private equity, venture capital, and yes — real estate) to enjoy the benefits of capital gain tax rates. Under current tax laws, when a promoter (who happens to be a partner; in a partnership or a member on a LLC) receives his or her allocable share of profits from any investment type gain (i.e. stocks, bonds, securities, and real estate), the tax code treats that income as long-term capital gain regardless of whether such allocation was proportionate or disproportionate to the capital contributions made to a partnership. While there is no such term as “carried interest” in the Internal Revenue Code, colloquially, the term “carried interest” refers to the portion of the gain received by a promoter that is disproportionate to his capital contribution to the partnership. For example, a promoter could contribute 10% of the capital, but receive 50% of the profits of a partnership after all investors recover their capital contributions and some negotiated preferred return.

Obama Proposal
Conversations have ensued for many years on changing the current law but to no avail. In fact, during the 2008 presidential campaign, President Obama first proposed his plan to tax Carried interest at the same rate as regular income, rather than at the lower capital-gain rate and with no exceptions. The President and supporters of this proposal say that carried interest is essentially a management fee or a service fee income rather than investment profits and should be taxed just like any other service type income (i.e., as income generated from self-employment).

The impact of this proposal would apply to all disproportionate capital gain income allocation regardless of the character of the income at the partnership level. The President does not differentiate between hedge fund managers, venture capitalists, and real estate.

Camp Proposal
Chairman Camp’s proposal would exclude real estate trade or businesses from the application of carried interest rules.

Is This the End of 1031 Like-kind Exchanges in Real Estate?
Real estate investors have long depended on the 1031 like-kind exchange rules. Critics say that a change in the like-kind exchange rules may have a deep impact upon economic growth. In a nutshell, a real estate investor can defer capital gain generated on the sale of a property held for trade or business or investment as long as they use the proceeds from that sale to buy another property for trade or business or investment (subject to some certain very specific limitations contained in the Internal Revenue Code and the Treasury Regulations thereunder).

Obama Proposal
In the 2015 budget proposal, President Obama would limit the amount of capital gain deferred under Code Sec. 1031 on a like-kind exchange of real property to $1 million per taxpayer per tax year.

Camp Proposal
Chairman Camp proposes to totally eliminate the like-kind exchange rules for real property and for other property. The proposal has not been presented as a bill but as a part of tax reform discussions in 2015.

Real Estate Depreciation Plan
Conceptually, real estate investors “appreciate” depreciation. And what’s not to appreciate? The cost of income-producing property can be recovered through depreciation. The depreciation system or MACRS allows taxpayers to depreciate capital assets faster and over shorter periods of time and may produce yearly tax deductions.
The length of time over which an asset is depreciated is called its depreciable life.

Under current tax law, the MACR classes for commercial real estate is depreciated over 39 years and residential real estate is depreciated over 27.5 years.

Camp Proposal
Chairman Camp’s proposal would extend the tax depreciation for all real estate to 40 years and eliminate MACRS.

In conclusion, a change in depreciation rules, capital gain taxes and 1031 exchanges can deeply alter the real estate business for both investors and developers. As a taxpayer understanding the dynamics in these changes will equip you to stay abreast and make wise investment decisions and if inclined, let your elected officials know what you’re thinking.

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