1977, February, Pg. 248. The 1976 Tax Reform Act As It Relates to the Real Estate Industry.

• Author: by Barry J. Goldstein

6 Colo.Law. 248

Colorado Lawyer

1977.

1977, February, Pg. 248.

The 1976 Tax Reform Act As It Relates to the Real Estate Industry

248Vol. 6, No. 2, Pg. 248The 1976 Tax Reform Act As It Relates to the Real Estate Industryby Barry J. GoldsteinBarry J. Goldstein, Denver, is Director with the firm of Isaacson, Rosenbaum, Spiegleman & Friedman, P.C.249The real estate industry, as a result of effective lobbying, was not affected as greatly as some of the other "shelter" areas. Real estate investments still remain one of the best "shelter" investments available to taxpayers since there is still substantial deferral allowable through the use of depreciation. In most cases, depreciation of real property is unrealistic and in many situations the improvements actually appreciate in value. This not only produces a deferral of tax due, but also produces a conversion by allowing straight line depreciation to reduce ordinary income, and upon a taxable disposition the effective recapture of that depreciation can be taxed as a capital gain. Also, investment real estate can be a relatively non-risk-oriented investment which can pass the test of being economically viable with the tax benefits adding "icing on the cake."

Selected changes brought about by the Tax Reform Act of 1976 ("Act") are presented in outline form for easy reference. The areas covered are as follows:

---I. Capitalization and amortization of real property construction period interest and taxes.---II. Recapture of depreciation on real property and amendment to Section 167(k) of the 1954 Internal Revenue Code as amended ("Code") relating to rehabilitation expenditures on low income rental housing.---III. Treatment of prepaid interest and limitation on interest deduction.---IV. Exclusion from the "at risk" provisions of the Act.---V. Effect of changes to the partnership provisions affecting real estate partnerships.---VI. Effect of minimum tax and maximum tax changes.---VII. Limitation of deductions for expenses attributable to business use of homes and rental of vacation homes; and sale of residence by the elderly.---VIII. Tax-exempt status of homeowner associations.---IX. Miscellaneous changes concerning real property.Changes affecting Real Estate Investment Trusts are not covered by this outline; however, there are numerous technical changes in the present law which should be reviewed by anyone representing such trusts.

250I. CAPITALIZATION AND AMORTIZATION OF REAL PROPERTY

CONSTRUCTION PERIOD INTEREST AND TAXES (NEW CODE SECTION 189)

1. For individuals, Subchapter S corporations and personal holding companies, interest and taxes paid or accrued during the construction period must be capitalized and amortized in accordance with the following table:

   If the amount is paid or accrued in a taxable year beginning in---

   Non-residential real property Residential real property (other than low-income housing) Low-income housing The percentage of such amount allowable for each amortization year shall be the following percentage of such amount

   1976 ... ... see below

   ... 1978 1982 25

   1977 1979 1983 20

   1978 1980 1984 162/3

   1979 1981 1985 142/7

   1980 1982 1986 12 1/2

   1981 1983 1987 11-1/9

   after 1981 1983 (after) 1987 (after) 10

   For interest and taxes paid or accrued on non-residential real property during 1976, the percentage allowable to be amortized in 1976 is 50%, and 16-2/3% for each of the following three years.

2. Construction period interest and taxes means all:1. interest paid or accrued on indebtedness incurred or continued to acquire, construct or carry real property; and

   2. real property taxes;

   to the extent such interest and taxes are attributable to the construction period for such property. Construction period begins on the date on which construction of the building or other improvements commences and ends on the date on which the item of property is ready to be placed in service or is ready to be held for sale. The end of the construction period sets the time for the commencement of the second year of amortization, which might create an intervening taxable year(s) in which no write-off is permissible. This would depend upon the length of time of construction in relation to the payment of accrual of the interest and taxes.

3. Upon sale of the property, that year's annual amortization is allowable and any unamortized balance shall be added to the basis of property. For a tax-free exchange, interest and taxes will not be treated as part of the exchange and the transferor will be able to amortize interest and taxes.

4. Personal residences are excluded from the provisions of Section 189 of the code.

5. Comments1. It has been suggested that partnerships involved in the construction industry can avoid the provisions of Section 189 by the partners borrowing funds individually and making capital contributions to the partnership, and then251252individually deducting the interest. It is my belief that this would fall under the substance versus form test and would fall on very shaky ground.

   2. Another possibility would be to negotiate with the construction lender to reduce the interest rate, but increase the points on the construction loan. Also, if the construction lender rolls over the construction loan to a permanent loan, it might be possible to increase the points on the construction loan and reduce the interest rate on the permanent loan. Points (as discussed later) will be amortized over the length of the loan and for a construction loan this would be substantially less than the ten-year period set forth in Section 189. However, the Service will take the position that "points" fall within the definition of interest under Section 189 and therefore must be amortized under Section 189.

   II. RECAPTURE OF DEPRECIATION ON REAL PROPERTY AND AMENDMENT TO REHABILITATION EXPENDITURES ON LOW INCOME RENTAL HOUSING

1. In general---The 1976 Tax Reform Act modified the recapture rules on depreciable real property by tightening the recapture rules on accelerated depreciation relating to residential property. This can, in effect, defeat the conversion of ordinary income deductions into capital gain taxation, but it does not defeat the deferral of taxation and the interest free loan effect received through accelerated depreciation. However, as discussed later, accelerated depreciation is a tax preference item and with the increase of the rate of taxation on tax preference items under the minimum tax provisions of the Code, as well as a reduction of the exemptions of tax preference income, it may no longer be advantageous to claim accelerated depreciation. However, as stated earlier, there are still substantial advantages to real estate investments, even when limited to straight line depreciation.

2. Basically, except for certain subsidized housing projects, any accelerated depreciation in excess of straight line depreciation after December 31, 1975, will be subject to recapture and taxed as ordinary income to the extent of gain. Government subsidized housing will be subject to the rules in effect from 1970 through 1975 on residential real estate with full recapture of post 1975 depreciation for the first 100 months and a reduction of 1% for each full month the property is held over 100 months.

3. The following chart sets forth the breakdown of the recapture rules under Section 1250, as modified by the 1976 Tax Reform Act.

   Holding Period Type of Depreciation Recaptured Recapture Percentage

   Over Not Over Res. Property Com. Prop. Federal Assisted Property

   12 mos. All depreciation 100% 100% 100%

   12 mos. -20 mos. Excess depreciation over straight line 100% 100% 100%

   20 mos. -100 mos. (a) Pre 1970 excess 100% minus 1% for each full month held over 20 mos. 100% minus 1% for each full mo. held over 20 mos. 100% minus 1% for each full month held over 20 months

   (b) (1/1/70---12/31/75) 100% 100% 100% minus 1% for each month the

   253 property was held over 20 months 100%

   (c) Post 1975 excess 100% 100%

   100 mos. -120 mos. (a) Pre 1970 excess 20% minus 1% for each full month held over 100 mos. 20% minus 1% for each full mo. held over 100 moths 20% minus 1% for each full mouth held over 100 months

   (b) 1/1/70---12/31/75 100% minus 1% for each full mo. held over 100 mos. 100% 20% minus 1% for each fullmonth held over 20 months

   (c) Post 1975 excess 100% 100% 100% minus 1% for each full month held over 100 months

   120 mos. (a) Pre 1970 excess 0% 0% 0%

   (b) 1/1/70---12/31/75 80% minus 1% for each full mo. held over 120 mos. 100% 0%

   (c) Post 1975 excess 100% 100% 80% minus 1% for each full month held over 120 months

4. If gain is subject to recapture, to the extent of...