Real Estate Tax Alert A Comparative Analysis of the Real Estate

Real Estate Tax Alert
A Comparative Analysis of the Real Estate
Related Provisions in the Camp, Baucus, and
Obama Proposals
Both House Way s and Means Committee Chairman Dav e Camp and former Senate Finance Committee
Chairman Max Baucus have released discussion drafts of proposal packages aimed at comprehensive tax reform.
Mr. Camp proposes to reduce the corporate rate to 25% and the top individual rate to 35%. He further proposes
a repeal of the alternative minimum tax.
While Mr. Baucus did not focus on individual rates, he indicated that his package was intended to reduce the
corporate rate to less than 30%. Giv en the intention to provide for tax neutral reform, both documents
recommend a number of revenue raisers.
Last week President Obama released his fiscal 2015 budget which included a number of tax modifications. While
not a v ehicle for comprehensive tax reform, the proposed budg et does include a number of provisions that
ov erlap or contrast with the Camp and Baucus plans. Mr. Obama did not propose a change to corporate tax rate.
Similarly to last y ear, his budget proposals do include the “Buffett rule,” designed to ensure that high income
tax payers pay at least 30% tax on their adjusted gross income less charitable contributions.
It is not clear that the legislative will ex ists to pass significant tax changes prior to the fall mid -term elections.
Bey ond the political uncertainty, the prospects of the Baucus proposals are further clouded by his transition
from the Senate to a post as Ambassador to China. Mr. Wy den, new Chairman of the Senate Finance Committee,
has not y et provided his v iewpoint. The proposals will, though, help frame the discussion around tax reform
going forward. The discussion below compares and contrasts provisions in the three proposals that are
particularly focused on real estate businesses.
Areas of common ground in all three proposals
Like-kind exchanges
The Camp, Baucus, and Obama packages all contain provisions that would eliminate or significantly reduce the
ability of real estate businesses to defer gain through the use of like -kind exchanges. The Camp proposal includes
an outright repeal of Internal Revenue Code (IRC) Section 1031. The Baucus proposal would allow for like -kind
ex changes in limited circumstances, but not for exchanges of real property. The Obama budget provision would
limit the amount that a tax payer could defer in like-kind exchange transactions to $1 million per year.
Election to deduct certain business asset expenditures
Tax payers are currently allowed to deduct amounts paid for a limited amount of capital assets, including real
estate, placed in service each y ear. This deduction is often referred to as the “179 deduction” in reference to the
Internal Revenue Code section under which it is allowed. This statute has been regularly extended on an annual
basis, but remains temporary. All three tax drafts would make the deduction permanent. Limits and phase-outs
v ary as follows:
Lim it on deduction
Camp
Income beginning of phase-out
$500,000
$800,000
Baucus
$1 ,000,000
$2,000,000
Obama
$500,000
$2,000,000
Overlap between two proposals
Carried interest
Both the Camp and Obama proposals would require that income from a “carried interest” be treated as ordinary
income. A carried interest is an interest in the future profits of a partnership received in compensation for the
provision of services, rather than in return for an inv estment in capital. Of particular interest to the readers of
this article, though, Mr. Camp would exempt income from partnerships engaged in a real property trade or
business. The Obama proposal does not include this exemption, although it does include language intended to
prev ent REIT qualification from being adversely impacted by the re -characterization of income. The Baucus
proposal does not include a carried interest provision.
Depreciation and recapture
Both the Camp and Baucus proposals extend depreciable lives for real estate assets. The Camp provision would
require the use of the alternative depreciation system, which includes a 40 y ear life for real property. The Baucus
plan would ex tend the life of all real property to 43 ye ars. These provisions would particularly impact owners of
multifamily properties which are currently depreciated over 27 .5 y ears under the modified accelerated cost
recovery system.
Each of the proposals contains additional adverse changes to depreciation of real estate assets. The Camp
proposal would eliminate the special class lives for qualified leasehold improvements, restaurant, and retail
assets. Under the Baucus plan, taxpayers would be required a restart of depreciation based on basis at the
effective date over the remaining life. As an ex ample, a multifamily asset that has been depreciated for ten y ears
would be required to spread the remaining basis that it expected to deduct over 17.5 year and spread it over 33
y ears.
Both the Camp and Baucus pro posals would require all amounts deducted as depreciation, even when computed
on a straight-line basis, to be recaptured as ordinary income.
Preferential dividends for REIT
Both the Camp and Obama proposals would eliminate the disallowance of preferential dividends in calculating
the div idends paid deduction for publicly traded and publicly offered REITs, in line with the current rule for
regulated investment companies (RICs.) The Camp proposal would provide the Internal Revenue Service with
the authority to consider other deterrents to abuse.
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Interest expense deductions and withholding on US source interest income
Both the Camp and Baucus proposals address the effect of debt financing on the US tax base. The Camp proposal
would modify the existing “earnings stripping” provisions of the Internal Revenue Code. Under current law, the
deduction for interest paid or accrued on debt owed to related persons may be subject to limitations if certain
thresholds are met. Among those thresholds is the requirement that net interest expense exceed 50% of adjusted
tax able income (“ATI”). The Camp proposal would lower that threshold to 40% of ATI thus increasing the
possibility that the threshold would be met and the limitation on deduction triggered.
The Baucus proposal would eliminate the “portfolio interest” exemption for US corporate debt. Under current
law, no US withholding tax is imposed on interest paid by US corporations on debt issued to foreign persons
provided that certain conditions are met. The elimination of this provision could affect, among others, foreign
persons that hold debt issued by US real property holding corporations.
Exemption from FIRPTA for foreign pension funds
Both the Baucus plan and the Obama budget propose to exempt qua lified foreign pension funds as defined from
tax on gains on the sale of an interest in US real estate as provided by the Foreign Investment in Real Property
Tax Act (FIRPTA). This could increase the attractiveness of US real estate for this group of inv es tors. The
application of the terms in any final legislation, including the definition of a qualified foreign pension fund, will
need to be ev aluated on a case by case basis.
Percentage of completion
Current law regarding the tax accounting for long-term contracts currently requires income recognition based on
percentage of completion, but contains an ex ception for home construction contracts. Both the Camp and
Baucus discussion drafts include provisions that would eliminate the housing exception. This would accelerate
income recognition for builders of individual homes and condominium projects ratably over the construction
process, rather than allowing a deferral to completion. Small construction companies retain the exception under
both provisions. The Obama budget includes no modification to the accounting for long-term contracts.
Low income housing credit
In contrast to other tax credits and deductions that the Camp proposals would to eliminate, the Camp discussion
draft recommends retaining and enhancing the low income housing credit (LIHC.) The Obama budget proposes
to allow REIT shareholders to benefit from the LIHC by allowing the REIT to designate a portion of its dividend
as tax ex empt based on a formula related to its LIHC.
Areas of divergence
REITs
Mr. Camp proposed a number of changes to the REIT rules, many of which are aimed at the conversion of C
corporations to REITs. High profile REIT conversions, especially those involving property types not previously
included in REITs, hav e left Mr. Camp co ncerned that REITs are now being used for purposes other than those
intended. Related provisions include:

A C corporation converting to REIT status or making a contribution of property to a REIT would recognize
inherent appreciation immediately prior to the transaction. This is in contrast to the current regime which
allows for the avoidance of this corporate level of tax as long as the property is retained ten years.

A REIT would not be considered to be engaged in an active trade or business for purposes o f satisfying one
of the requirements necessary for a tax-free spin-off.
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
Non-REIT earning and profits would have to be distributed in cash.

Property with a class life of less than 27 .5 y ears would not be considered a qualifying real e state asset. While
this change would no doubt affect REITs that hold assets such as transmission towers and pipelines, it
would also raise concerns regarding land improvements for REITs inv esting in the more traditional property
ty pes of apartments, hotels, office, and retail.

The limitation on the v alue of tax able REIT subsidiaries that may be held by a REIT under the REIT asset
tests would be reduced from 25% to 20% of the v alue of all REIT assets.

Special rules for timber REITs would be eliminated.
Some additional unfavorable provisions for REITs in the Camp proposal include:

The prohibition on re-electing REIT status after termination or revocation of REIT status would be
increased from fiv e y ears to ten y ears.

Limitations on percentage rents and interest as qualifying income for REIT purposes would apply under
certain circumstances, even if calculated based on gross income.

Distribution characterization rules would be clarified to indicate that the dividend attributable to capital
gains and qualified dividends could not exceed the amount actually paid.
There are also Camp proposals that are positive for REITs, including:

Debt instruments of REITs would be considered qualified REIT assets.

Modifications to REIT earnings and profits would not subject shareholders to tax twice.

The de minimis rule that allows personal property limited to 15% of FMV of a property to be disregarded for
income test purposes to be similarly included in qualifying assets for purposes of the asset tests.

The role of the TRS would be ex panded to cover t he operation of foreclosure property.
Taxation of state pension funds
The Camp proposal would subject state pension funds to unrelated business income tax (UBIT). If enacted, this
proposal may affect the degree to which and manner in which such funds would invest in real property.
FIRPTA
Both the Camp and Baucus proposals would make changes to FIRPTA. Under the Camp proposal shares of a
REIT may continue to be considered US real property interest subject to the FIRPTA regime even if the REIT
sells all of its US real property interests.
The Baucus proposal would provide that shares of a publicly traded REIT would not be treated as US real
property interests in the hands of a foreign person if the person owns no more than 1 0% of the REIT, ov erride
the Internal Revenue Service position on liquidating distributions contained in Notice 2007 -55, and apply the
corporate attribution regime to the determination of whether a REIT would be treated as domestically
controlled. A prior NewsAlert on the Baucus proposals discussed these provisions in further detail.
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Deductions and credits for homeowners
While the Baucus discussion draft does not address most individual deductions and credits, both the Camp
proposals and Obama budget would modify certain rules.
The Camp proposals would repeal the first time homebuyer credit and the penalty exemption for early
withdrawals from 401(k)s and IRAs. The deduction for mortgage interest would be limited to the amount
accruing on a principal balance of $500,000, down from $1,000,000. The exclusion for gain on the sale of a
principal residence would also be phased out for high income taxpayers.
The Obama budget to extend the exclusion from debt forgiveness income for underwater home mortgages to
201 4.
Credits other than LIHC
Prov isions included in the Camp draft would repeal that rehabilitation credit, the energy efficient new home
credit, and the credit for energy efficient appliances.
The Obama budget would extend the new markets credit.
Involuntary conversion and casualty
The Camp provisions would clarify that a taxpayer can defer the gain from an inv oluntary conversion or deduct
the related expenses, but cannot do both. Further all replacement property supporting deferral would be limited
to property of the same class life as the damaged asset.
Environmental remediation
A Camp proposal would require environmental remediation costs to be deducted over 40 years. Neither of the
other packages include a provision on environmental remediation.
For additional information concerning this issue, please contact:
Jill Loftus
312-298-3294
[email protected]
James Guiry
646-471-3620
[email protected]
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PwC Real Estate Tax Practice – National and Regional Contacts:
National
Paul Ryan
US RE Tax Co-Leader
New York
646-471-8419
[email protected]
Christine Lattanzio
US RE Tax Co-Leader
New York
646-471-8463
[email protected]
Regional
Atlanta
New York
San Francisco
Dennis Goginsky
678-419-8528
[email protected]
Eugene Chan
646-471-0240
[email protected]
Warren Glettner
415-498-6070
[email protected]
Tim Trifilo
678-419-1740
[email protected]
Dan Crowley
646-471-5123
[email protected]
Kevin Nishioka
415-498-7086
[email protected]
Steve Tyler
678-419-1224
[email protected]
James Guiry
646-471-3620
[email protected]
Neil Rosenberg
415-498-6222
[email protected]
Boston
Sean Kanousis
646-471-4858
[email protected]
Washington DC
Timothy Egan
617-530-7120
[email protected]
Laura Hewitt
617-530-5331
[email protected]
Rachel Kelly
617-530-7208
[email protected]
Chicago
Jill Loftus
312-298-3294
[email protected]
Alan Naragon
312-298-3228
[email protected]
James Oswald
646-471-4671
[email protected]
Oliver Reichel
646-471-5673
[email protected]
John Sheehan
646-471-6206
[email protected]
David Voss
646-471-7462
[email protected]
Karen Bowles
703-918-1576
[email protected]
Adam Feuerstein
703-918-6802
[email protected]
Kelly Nobis
703-918-3104
[email protected]
Shannon Stafford
703-918-3031
[email protected]
Los Angeles
Adam Handler
213-356-6499
[email protected]
Phil Sutton
213-830-8245
[email protected]
Real Es tate Alert | March 2014
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