In a highly watched case of The Frank Aragona Trust v. Comm’r., the Tax Court held that it was possible for a trust to qualify for the coveted title of “real estate professional” under the Section 469 passive loss rules. This result greatly expands the ability of trusts to avoid the passive loss deduction limitations and the new Section 1411 3.8% net investment income tax.
In the case the IRS argued that a trust could not be a real estate professional because the statutory test for real estate professional status looked to “personal services,” and a trust was an entity that could not perform personal services. The IRS also argued that if a trust could qualify, the relevant participation must come from the fiduciaries in their capacity as fiduciaries and not as employees . The court clearly disagreed with the first argument and held that a trust could qualify as a real estate professional. The court did not need to decide the second issue since it found that the trustees who were also full-time employees were always acting as fiduciaries.
This week the IRS announced a realignment of its Exempt Organizations (EO) division. This realignment will affect primarily the legal and technical side of EO. This realignment will cause major disruption in the short term, and taxpayers should allow additional time for private letter ruling requests or for exemption applications assigned to EO Technical. In the long-term, however, there may be some benefit to the new streamlining. On the IRS ruling function, despite the massive existing backlog (over 80,000 applications, by recent accounts), there is already reason to hope. EO rulings have over the past year developed a more streamlined application process. A few weeks ago, the IRS released an internal memorandum describing that process, which would include a new Form 1023EZ for certain tax-exempt classification rulings. According to the IRS memo, this form “drastically reduces the informational burden for both the taxpayer and the Service through Taxpayer assurance of meeting the organizational and operational tests through representational attestations.”
Last week Rep. Camp (R-MI), Chair of the House Ways and Means Committee, announced a comprehensive tax reform discussion draft as part of his efforts to reduce top corporate tax rates to 25% and provide individual brackets at 10%, 25%, and for many, 35% (after adding a 10% surtax for non-domestic production income of high-income individuals). The lengthy discussion draft includes many new concepts not included in prior tax reform proposals, with the “short-form” section-by-section summary coming in at 194 pages and the JCT’s 11-part analysis being nothing short of daunting.
The Camp House proposal’s impact on real estate would be significant, with this top-ten list of particular interest to those in the industry. Compare also to the items in our prior blog discussing the real estate impact of Senate Finance Committee’s tax reform proposals. Inclusion of items in both the House and Senate discussion drafts, such as long 40-year real property depreciation lives and Section 1031 repeal, puts those ideas front and center in the greater tax reform efforts. Despite the low probability of passage during this election year, these proposals are expected to be with us for years to come in one form or another.
Top 10 List
- Corporate Rates 25%, Real Estate 35% (21% Capital Gains). Although Rep. Camp speaks in terms of a 25% top marginal rate for both corporations and individuals, there is a 10% surtax for families with incomes over $450,000 that will impact many in the real estate industry. This surtax excludes “qualified domestic manufacturing income”, including income from construction of domestic real property as part of the active conduct of a construction trade or business. However, this exclusion is expected to have only a limited impact for the real estate industry as a whole.
- Repeal Section 1031 Like-Kind Exchanges. Like the Senate Finance proposal, Camp’s proposal would simply repeal tax-deferral under the current longstanding like-kind exchange rules and generate a hefty $40.9 billion of government revenue over 10 years. The provision would be effective for transfers after 2014. However, a like-kind exchange would be permitted if a written binding contract is entered into on or before December 31, 2014, and the exchange under the contract is completed before January 1, 2017.
- REIT Changes – Some Good, Some Bad. Although the Camp proposal includes many provisions found in recent industry-supported REIT reform, there are also many provisions that restrict the use of REITs, especially curbing the current trend of non-traditional REIT assets being spun off into REIT solution. Some of the restrictive provisions include: (1) defining real estate to exclude timber and assets with less than a 27.5 year life (such as telecommunication towers and billboards), (2) denying Section 355 tax-free spin-off treatment to non-REIT C corporations spinning off a REIT (Sec. 3631), (3) lower TRS value limits to 20% of REIT assets, (4) requiring use of only cash to purge E&P before electing REIT status (not a mix of cash and REIT stock), (5) requiring immediate built-in gain recognition upon conversion from a C corporation to a REIT, and (6) tightening percentage rent limitations.
- Many Changes to Technical Partnership Rules. The Camp proposal includes a series of changes with some of the highlights as follows: (1) repeal the concept of a partner guaranteed payment, (2) make all “inside basis” adjustments mandatory and eliminate the concept of a Section 754 election, (3) make mixing bowl partnership distribution rules apply forever (no longer limited to 7 years from the contribution of the appreciated asset), (4) conform the Section 751 “hot asset” definition of inventory to eliminate the “substantial appreciation” requirement for partnership distributions, (5) repeal the Section 708(b)(1)(B) technical termination rules, (7) restrict the publicly traded partnership exception to mining and natural resources partnerships, and (8) introduce carried interest concepts to impose ordinary income on certain service partner income.
- Technical Changes to SECA Taxes and COD Debt Modification Rules. Under section 1502 of the proposal, the Self-Employment tax would be clarified to apply to general and limited partners of a partnership (including limited liability companies) as well as to shareholders of an S corporation to the extent of their distributive share of the entity’s income or loss (subject to the exclusions for certain types of income described above under current law). Under Section 3412 of the proposal, there would also be a helpful change to the debt modification rules for debt restructurings that do not involve a forgiveness of principal to reduce the prevalence of “phantom” cancellation-of-indebtedness income when debt is restructured.
- 40-Year Depreciation. Like the Senate Finance proposal, the Camp proposal would also extend the tax depreciation for all real estate to 40-years (as opposed to current 15 years for leasehold improvements, 27.5 for residential, and 39 years for non-residential).
- Eliminate Favorable 25% Real Estate Depreciation Recapture. Like the Senate Finance proposal, the Camp proposal would eliminate the current 25% rate applicable to straight-line real property depreciation recapture and treat the item as ordinary income (although technically still a 25% marginal rate, this would be at a 35% marginal rate for high-income taxpayers.
- Replace TEFRA Audit Rules With Simpler Regime. The proposal to replace the complex TEFRA partnership audit rules with a simpler comprehensive audit regime is a welcome administrative benefit. The idea is that a single partnership-level audit will cover all the related tax issues and the audit tax adjustments would be paid (or received) at the partnership level, similar to a corporation. While this is an overall positive administrative development, it is likely to increase IRS audits, which are currently at only about half the audit rate of corporations. Likely for this reason, the TEFRA proposal is expected to generate a sizable $13.4 billion of revenue over 10 years.
- Carried Interest. Section 3621 is a complete rewrite of the historical Democrat Carried Interest proposal, with the old bill complexity replaced with new complexity. Under the proposal, the service partner is deemed to have an ordinary income recast of gain capped at a complex assumed interest-like cost of capital. Although the statutory text could use clarification, the section-by-section description clearly states that the provision would not apply to a partnership engaged in a real property trade or business. The provision would be effective for tax years beginning after 2014.
- Low Income Housing Tax Credit (LIHTC). Section 3204 of the Camp proposal includes a number of material modifications to the LIHTC rules including (1) state and local housing authorities would allocate qualified basis, rather than credit amounts, (2) the credit period would be extended from 10 years to 15 years to match the current 15-year compliance period, (3) although the 9% credit would be retained, the 4% credit would be repealed, (4) the increased basis rule for high-cost and difficult development areas would be repealed, (5) the general-public-use requirement would be revised, and (6) the requirement that states include in their low-income-housing selection criteria the energy efficiency of the project and the historic nature of the project would be repealed. The provision would be effective for state basis amounts and allocations of such amounts determined for calendar years after 2014. A transition rule would translate credit allocations prior to 2015 into equivalent amounts of eligible basis for purposes of determining new allocations of basis after 2014.
New IRS final regulations address when a service provider (employee) can defer income for compensatory equity that is subject to a “substantial risk of forfeiture”. Section 83 allows service providers to defer taxation on the transfer of property in connection with the performance of services until the earlier of when the property (a) is no longer subject to a substantial risk of forfeiture or (b) becomes transferrable. The final regulations generally followed the proposed regulations to make clear that a substantial risk of forfeiture is created only when the property is conditioned on the employee performing services or refraining from performing services (for example, continued employment for a given number of years), or when the property is subject to a condition related to the purpose of the transfer (for example, the company retaining a certain level of performance). In determining whether a performance condition is substantial, the analysis must include the likelihood that (i) the forfeiture event will occur and (ii) forfeiture actually will be enforced. The regulations also make it clear that transfer restrictions on the property do not create a substantial risk of forfeiture, except during the 6-month restriction period imposed by the “short-swing profits” rule under Section 16(b). The regulations are effective February 26, 2014 but apply retroactively to property transferred on or after January 1, 2013.
Today the IRS announced two new sets of regulations on the FATCA rules. In general, FATCA creates 30% withholding on certain distributions to certain Foreign Financial Institutions (FFIs) unless those FFIs comply with onerous rules to disclose certain investor information to the U.S. government. The new regulations are T.D. 9657 and T.D. 9658.
The new regulations address the following:
- Make over 50 discrete amendments and clarifications of prior guidance to address comments aimed at reducing compliance burdens.
- Coordinate FATCA with pre-existing reporting and withholding rules.
- Incorporate various conforming amendments such as unifying definitions and adding appropriate cross references.
Click here for information on prior FATCA guidance.
Under the Completed Contract method of accounting, homebuilders are allowed to defer taxable income until 95% of the costs of the home development are incurred. Taxpayers have traditionally treated the “development” for this purpose as including the common areas and amenities, effectively deferring income recognition because it takes longer to reach the 95% threshold. The IRS disagrees. The Tax Court has now held against the IRS in Shea Homes, Inc. In this case, IRS argued that the development included only houses and the lots upon which the houses are built, causing the 95% threshold to be reached more quickly. In a huge win for home developers, the Tax Court concluded that the subject matter of the contracts consists of the homes and the larger development, including amenities and other common improvements. This significantly defers the 95% threshold date, and the associated taxable income.
The Financial Accounting Standards Board (FASB) has announced new simplified financial accounting rules for qualified investors in Low-Income Housing Tax Credit (LIHTC) projects. The rule change will make it easier for investors to opt out of the Equity Method of accounting for LIHTC investments and instead use the new Proportional Amortization Method. The main benefit is improved clarity and simplicity in financial reporting: passed through losses from a LIHTC investment will appear on the investor’s income statement “below the line” along with the LIHTC and other tax items. In addition, the new method also provides for a relatively simple amortization calculation. Previously, those few investors who were able to opt for below-the-line loss reporting had relatively complicated calculations to do under the Effective Yield Method. For details see the G&S summary.
New Rev. Proc. 2014-20 allows “mezzanine” real estate loans to qualify for the Section 108(c) cancellation of debt (COD) income exception. When a lender forgives debt associated with a qualifying real estate loan, the borrower can avoid tax on the COD income by instead electing to reduce tax basis if the loan is “secured by” qualifying real property. The new guidance addresses the technical question of whether the modern version of a second mortgage qualifies for this exception when the security interest is indirect through a pledge of 100% of the interest in an LLC that owns the real property. In a 2009 private letter ruling, the IRS ruled favorably on similar facts, but commentators asked for more specific and authoritative guidance.
The new guidance sets forth a safe harbor for transactions that meet certain technical requirements. In general these technical requirements are typical of a mezzanine real estate loan. However, the final requirement may be too restrictive because it requires that, upon default and foreclosure the lender will replace the borrower as sole owner of the LLC. Although it is common for a lender to have the right to become the owner, the lender may choose not to exercise that right in favor of a different remedy. Luckily the procedure allows taxpayers with foot-faults to still argue that they qualify for coverage under a “facts and circumstances” test.
This revenue procedure is effective for taxpayers who make the section 108(c) election on or after February 5, 2014.
New proposed IRS partnership regulations, when finalized, promise to shut down taxpayer flexibility under debt allocation and “disguised sale” rules. The substantive restrictions and related “clean up” rules are numerous and detailed. Two of the most significant changes are (1) restrictions that effectively deny tax-motivated debt guarantees (e.g., no “bottom guarantees”) and (2) a new requirement to allocate residual nonrecourse debt based on relative capital percentages (replacing the current taxpayer flexibility of following a “significant item” or partnership deductions). These two rules alone will prove severely limiting to situations such as (i) partners in “UPREIT” partnerships who rely on bottom guarantees to support low tax basis, (ii) partnerships that refinance property and distribute proceeds disproportionately among the partners, and (iii) partners that contribute appreciated leveraged property to a partnership.
The many details of the regulations are beyond the scope of this blog, but given the severity of the rules, a careful review of the proposed effective dates is essential. The effective date rules are summarized below.
- The disguised sale rule changes apply to all transfers on or after the date the regulations are finalized.
- The recourse debt allocation changes (i.e., no bottom guarantees) are to apply to liabilities incurred or assumed by a partnership and to payment obligations imposed or undertaken with respect to a partnership liability on or after the date the regulations are finalized. These include an additional 7-year transition period to apply the prior rules to recourse liabilities to the extent existing recourse liabilities are covering a negative tax capital account measured on the regulation finalization date.
- The nonrecourse debt allocation changes are to apply to liabilities incurred or assumed by a partnership on or after the date the regulations are finalized (permitting the partnership to apply the provisions as of the beginning of the first taxable year of the partnership ending on or after the date the regulations are finalized).
New Rev. Proc. 2014-18 allows taxpayers a one-time catch up election for a surviving spouse to benefit from any unused estate tax exemption from the first spouse to die. Taxpayers have until December 31, 2014 to file the election for estates of decedents who died in 2011, 2012 or 2013.
What is portability and how is it elected?
Since 2010, the per-person estate tax exemption is $5M, adjusted for inflation (currently $5.34M). For a married couple, the estate of the first spouse to die can make a “portability election” to allow the surviving spouse to use any remaining unused exemption. For example, if the first spouse only had a $1M estate, but the second spouse had a $9M estate, a portability election by the estate of the first spouse would mean no estate tax for the second spouse’s estate.
In the example above, the estate of the first spouse would not have otherwise been required to file an estate tax return. However, since the portability election is only made on an estate tax return, a taxpayer would have missed the election if they didn’t file an estate return. Further, same-sex couples that are now treated as spouses for federal tax purposes under the Windsor decision may have also missed the opportunity.
Specifics of IRS Relief
Under Revenue Procedure 2014-18, the IRS will now allow certain estates of decedents who died in 2011, 2012 or 2013, including estates of decedents with surviving same-sex partners, a “catch-up” opportunity to elect portability without having to request an extension by letter ruling. To take advantage of this relief, an estate must file a complete estate tax return by December 31, 2014. This relief does not apply to estates that filed a timely return but failed to make the election, or to estates of those who died before 2011 or after 2013.