A. Introduction I. TAX LAW CHANGES AFFECTING REAL ESTATE 1. RRA 93 REAL ESTATE TAX LAW CHANGES a. Passive Activity Income and Losses 1) Under the passive activity loss rules which were enacted as part of the Tax Reform Act of 1986, the real estate industry was treated more harshly than other businesses. 2) A passive activity was any activity in which the taxpayer did not materially participate. a) Material participation generally requires personal services of over 500 hours per year in an activity or personal services which constitute substantially all the participation in such activity for the year. 3) The passive activity loss rules required taxpayers to segment their income into the following classes (note: in general, losses from one class could only offset income from the same class): a) Non-passive activities, which are activities in which the taxpayer materially participates, such as the taxpayer s main occupation; b) Portfolio income, which is income from dividends and interest; and c) Passive activities, which are activities in which the taxpayer does not materially participate. 4) The problem for the real estate industry was that all real estate leasing activities were classified as passive activities, regardless of the taxpayer s participation; therefore, a real estate professional could not deduct his or her losses against non-passive activity or portfolio income. (1) Except to a limited extent, passive activity losses could not be used to offset non-passive or portfolio income. -1-
(2) Taxpayers who were actively engaged in real estate activities (such as building rentals) could utilize up to $25,000 in losses to offset non-passive activity income and portfolio income; however, this benefit was phased out beginning with adjusted gross incomes of $100,000 and ending with adjusted gross incomes over $150,000. 5) The Revenue Reconciliation Act of 1993 ( RRA ) corrects this problem by providing that certain real estate professionals will be permitted to deduct losses from their investment real estate against their non-passive income such as wages, commissions, dividends and interest. b. Real Estate Workouts 1) RRA now permits borrowers to reduce the amount of indebtedness on real estate, without having to treat the debt reduction as current income. 2) Under prior law, only if the borrower was in bankruptcy or insolvent could he or she reduce the debt on real estate without incurring income under the cancellation of indebtedness ( COD ) income doctrine. c. Miscellaneous Changes 1) Depreciation on commercial buildings and other non-residential real property is extended from 31.5 years to 39 years. 2) Passive activity losses are now considered a tax attribute under the insolvency rules of Section 108(b). B. Passive Activity Income and Losses 1. PRIOR LAW a. Under prior law, real estate activities were classified as passive activities, regardless of the actual participation in the activity. 1) Therefore, if, for example, a surgeon and a real estate developer both owned rental property, the real property would be considered a passive activity to both. 2) The passive activity loss rules were enacted to prevent the surgeon or other highly paid professional from using losses generated from investment activities to offset income earned as a surgeon. a) But the law, as enacted, also prevented the real estate professional from offsetting his real estate losses against his income from real estate a detrimental situation unique to the real estate industry. -2-
2. CHANGES MADE BY RRA a. RRA added Section 469(c)(7) to provide relief for certain real estate professionals. A taxpayer who qualifies under IRC Sec. 469(c)(7)(B) or (C) will be eligible to deduct losses from real estate from nonpassive income, such as wages, interest and dividends. 1) IRC Sec 469(c)(7) is effective for taxable years beginning after December 31, 1993. 2) Pre-1994 passive activity losses are considered losses from a former passive activity and cannot be used to offset nonpassive income from an activity other than real estate. b. Under RRA, real estate professionals those who spend more than 750 hours per year in services involving a real property trade or business, and who perform more than 50% of their total personal services engaged in real estate activities will be permitted to offset real estate losses against all their income, including portfolio income (dividends and interest). 1) A real property trade or business includes any real estate property development, construction, acquisition, conversion, rental, operation, management, leasing or brokering business. 2) In the case of a married couple, at least one of them must meet all the requirements, including the more than 750-hour per year requirement. 3) Personal services provided to a closely-held C corporation in which the taxpayer owns more than 5% of the corporation, will qualify as hours of service for the 750-hour per year test. c. Additionally, for a closely-held C corporation to meet the new passive activity loss deduction requirements 1) More than 50% of its gross receipts must be derived from real property trades or businesses; and 2) The corporation must materially participate (perform at least 500 hours of personal service) in such activities. a) A corporation materially participates in an activity if the shareholders owning more than 50% of the outstanding stock (measured by value) materially participate or the statutory test under IRC Sec. 469(c)(7)(D) is met. b) As stated above, personal services performed by a more than 5% shareholder will count towards the material participation requirement. -3-
3. EXAMPLES a. Assume that Joel and his spouse, Janet, own several rental properties that generate a tax loss of $250,000 per year. Joel is a neurosurgeon who has income from his profession of $500,000 a year. Janet owns 50% of a real estate company. She spends over 50% of her total time working there, and that amount is over 750 hours per year. Janet earns $25,000 in her business. 1) Under prior law, Joel and Janet would have had non-passive income of $525,000 and none of the $250,000 passive loss would have been available to offset the income. 2) If Janet elects to treat the rental properties and her business collectively as a single business, then under IRC Sec. 469(c)(7) she would qualify as a real estate professional since a) More than 1/2 of her personal services were performed in real property; b) She is considered as materially participating in the business since she participates over 500 hours; and c) She has satisfied the 750 hour requirement. Her work at the company will be counted because she owns more than 5% of her employer. 3) The losses from the real estate will offset the income earned by Joel and Janet and their taxable income will be $275,000 instead of $525,000. 4) If Janet earned $300,000 and had suspended losses of $1,000,000 from years prior to 1993, then she could use the current loss of $250,000, plus $50,000 of the suspended loss from prior years to offset her income, but none of the suspended loss could offset Joel s income. 4. OBSERVATIONS a. One must affirmatively elect to treat all real estate activities, including the rental activities, as one activity. In almost every situation, eligible taxpayers will benefit from making this election. b. An eligible taxpayer should be able to utilize losses from real estate owned through a limited partnership, although there is not clear authority on this point. c. There is nothing in the new statute that requires the spouse who owns the real estate to be the spouse who qualifies as the eligible taxpayer. For example, if wife owned 5 rental buildings in her name and husband qualified as an eligible taxpayer because of his real estate -4-
development activities, the couple should be able to utilize IRC Sec. 469(c)(7). 1) There is room for interpretation over what type of business will qualify as a real estate trade or business. Will a lender who receives an equity kicker in a real estate development qualify? 2) What about a carpentry shop that builds home furnishings? 3) What about an accountant or an attorney who works on real estate acquisitions and workouts? C. Real Estate Workouts 1. PRIOR LAW a. Under prior law, if a lender forgave all or a portion of a debt, the borrower would have COD income arising from such cancellation. For instance, if a lender forgave a debtor $10, the debtor would have gross income of $10. The forgiveness of debt was treated as a cash payment to the debtor who then used the income to reduce the debt. b. Under prior law, taxpayers could avoid COD income if they were insolvent or if they filed for bankruptcy. c. There was also a limited exception for the reduction of purchase money debt, where the lender was the seller of the property and both parties agreed to reduce the purchase price. 2. CHANGES MADE BY RRA a. RRA added IRC Sec. 108(a)(1)(D) which provides a limited exclusion for non-corporate taxpayers in many real estate workouts in which debt is reduced, but not eliminated. b. COD income is not currently recognized, but the taxpayer s adjusted basis in the real estate is reduced by the amount of the COD not recognized, so that on a later sale of the property, the taxpayer will recognize the income. c. To be eligible for the exclusion, the debt must satisfy 4 conditions necessary to constitute qualified real property business indebtedness ( QRPI ) under IRC Sec. 108(c)(3). The debt must 1) Have been incurred or assumed in connection with real property used in a trade or business; 2) Secure such real property; 3) Have been incurred or assumed before 1993, or else is qualified acquisition indebtedness; and 4) Be the subject of an election to have IRC Sec. 108(c)(3) apply. d. The exclusion under IRC Sec. 108(c)(3) has two limitations. -5-
3. EXAMPLE 1) First, the reduction in the debt is limited by the fair market value ( FMV ) of the property. a) For instance, if the debt is $1,000,000 and the FMV of the property is $600,000, then the taxpayer is eligible to exclude a maximum of $400,000 of COD income. 2) Second, the reduction in the debt is limited by the aggregate adjusted basis of all the taxpayer s depreciable property held immediately before the discharge. a) For instance, if in the above example the adjusted basis in the property is $200,000 and the taxpayer has no other depreciable real estate, then the COD income exclusion is limited to $200,000. a. Assume Joel owns a parcel of real estate consisting of a building that is subject to a ground lease. The building constitutes real estate used in a trade or business and is fully depreciable. The building is subject to a non-recourse loan of $1,000,000 which is due and payable in full on June 1, 1994. The FMV of the building is $750,000 and the adjusted basis is $250,000. b. If the lender and borrower renegotiate the loan by reducing the outstanding principal to $800,000 and stretch the due date to June 1, 1997 1) Joel will have COD income of $200,000 which will be eligible for exclusion under IRC Sec. 108(c)(3); 2) Joel s adjusted basis in the property will be reduced from $250,000 to $50,000, thereby postponing the recognition of the COD income until the building is sold. a) If Joel s adjusted basis were only $100,000, then he could only exclude $100,000 under IRC Sec. 108(c)(3) and would have $100,000 in immediate COD income. b) If the lender reduced the principal amount of the debt below the FMV of the property, thereby giving Joel an equity stake in the building, Joel would have immediate COD income. (1) For instance, if the lender reduced the debt from $1,000,000 to $600,000, then Joel would have immediate COD income of $150,000 since the FMV of the property was $750,000. He still could elect to exclude $250,000, the amount of debt reduction equal to his adjusted basis. -6-
c. Under prior law, Joel would have had an immediate recognition of $250,000 in income as COD income, unless he was insolvent or filed for bankruptcy. d. If the lender foreclosed on the property, Joel would have a capital gain of $750,000 the principal amount of the nonrecourse debt, less his adjusted basis in the property. 4. OBSERVATIONS a. The debt must have been incurred or assumed in connection with real property used in a trade or business. 1) Whether real property subject to a triple net lease qualifies as a trade or business is an open issue. If the taxpayer owns more than one building subject to a triple net lease, then it would appear that he or she is engaged in a trade or business. 2) Investment property is excluded from the definition of QRPI; raw land, however, will qualify if it is used in a trade or business. b. For partnerships, the determination of whether the debt is QRPI and the application of the FMV limitation are applied at the partnership level. The election on whether to include COD income is made by each partner. c. An S corporation makes the election to apply the COD exclusion at the corporate level. The exclusion will reduce the COD income the shareholders would otherwise have to report, but the adjusted basis in the property will be reduced, thereby decreasing future depreciation deductions. d. Taxpayers may combine the COD income exclusion and corresponding adjusted basis reduction with an IRC Sec. 1031 tax-free exchange to postpone the gain recognition caused by the IRC Sec. 108(c)(3) election. e. Property held or exchanged, but not sold, until the taxpayer dies will escape taxation on the COD income altogether since the taxpayer s estate will receive an adjusted basis step-up to FMV at the time of the taxpayer s death. 1) For example, assume in the above example that Joel had $200,000 of COD income that was excluded under IRC Sec. 108(c)(3). His basis in the property has been reduced to $50,000. He exchanges the property for like-kind property under IRC Sec. 1031 and when the replacement property is worth $1,000,000, he dies. His estate s adjusted basis is stepped up to $1,000,000 and the excluded COD income disappears completely! -7-
f. Clearly, where the taxpayer has a low adjusted basis relative to the FMV or the debt on the property, a workout is far more preferable than a foreclosure, since a foreclosure will be considered a sale of the property for the higher of the FMV or the amount of indebtedness. D. Miscellaneous Changes 1. PASSIVE LOSSES AND INSOLVENT OR BANKRUPT TAXPAYERS a. Under prior law, when a taxpayer became insolvent or filed for bankruptcy, he or she was permitted to exclude COD income under IRC Sec. 108(a). The price for such exclusion, however, was the reduction of certain tax attributes, such as net operating losses and the adjusted basis in certain property. 1) Suspended passive losses were not considered part of the tax attributes which were subject to reduction under the prior law. 2) Thus, the insolvent or bankrupt taxpayer with suspended passive losses was in a better position than a taxpayer with active business losses, since he or she could utilize the COD income exclusion without a reduction in the suspended passive losses. 3) IRC Sec. 108(b) has now been amended to include suspended passive losses as part of the tax attributions that will be reduced if the COD exclusion is utilized. This rule applies for taxable years after December 31, 1993. 2. DEPRECIATION FOR NON-RESIDENTIAL REAL PROPERTY a. Congress extended the recovery period for non-residential real property from 31.5 years to 39 years. b. Congress also rejected a shorter recovery period, such as the life of the lease, for tenant improvements primarily as a revenue raiser. 1) In general, it will be advantageous for tenants to have the landlord pay for the tenant improvements and pay a higher monthly rental, rather than pay for the improvements and depreciate those improvements over 39 years. -8-