Real Estate in the Cross Hairs of Potential Tax Law Changes

Source: Initial Draft – The Proposed Simplified New Federal Tax Code

Blog Author:  Robert W. Nelson, CCIM, CRE, MBA                                                                         

Pacwest Real Estate Investments, LLC

Date: 4/15/14

Benefit For Reader:  Gain insight on what Congress is considering as it attempts to simplify the federal Tax Code.

Background: Dave Camp (R Michigan) is the Chair of the House Ways and Means Committee. The House instructed him to go behind closed doors and come up with a simplified Federal Tax Code.

Simplification Goals: In simplifying the Tax Code, he was directed to accomplish three things.

• Lower the top income tax brackets for individuals and businesses.

• Achieve revenue neutrality (raise the same amount of tax dollars)

• Retain the progressive nature of the Tax Code (the more that you make, the proportionately more tax you will pay).

His Resulting Proposal: After two years, he emerged on February 26, 2014 with the initial draft of his proposed Federal Tax Code.

HIGHLIGHTED CHANGES IMPACTING REAL ESTATE

• Simplified Income Tax Brackets:  The highest income tax bracket for individuals and businesses would be 25%.

• Rather than the current seven income tax brackets (10%, 15%, 25%, 28%, 33%, 35% and 39.6%) there will be just three income tax brackets (10%, 25% and 35%).

Nelsonian Commentary:  Don’t relax too quickly Big Bucks Earner.

• If you are an individual earning over $400,000 or married filing jointly over $450,000 then that 35% highest bracket is just for you.

• Good News or Bad News?

• Good News: The highest income tax bracket dropped from 39.6% to 35%

• Bad News: A number of the current tax deductible items and tax exemptions that you have used in the past to reduced your taxable income have been  stripped away.

Several Examples – Significant Proposed Tax Shelter Take-Aways:

• Employer Provided Health Insurance: If your employer is paying some portion of your health insurance, that will be classed as income paid to you.

• Tax Exempt Interest: Same is true for the former tax-exempt interest that you used to reduce your Adjusted Gross Income.

• Result: Your effective new tax obligation could be significantly above that generated in the new 35% tax bracket. No free lunch here.

• Capital Gains Taxation:  Proposal:  40% of the taxable gain would be excluded from capital gains taxation.

• The remaining 60% of the gain would be taxed at your ordinary income tax bracket for the year that the sale occurred.

What Does This Mean?

• If you were in the lowest income tax bracket of 15%, your capital gain would be taxed at 6% (60% of 15% TB).

• If you were in the 25% income tax bracket, your capital gain would be taxed at 15% (60% of 25%TB).

• if in the 35% income tax bracket, your capital gains tax rate would be 21% (60% of 35% income tax bracket).

But There is More:  Add the 3.8% tax on net investment income (the “Obamacare Tax”) the top capital gains tax bracket would be 24.8%

The current long term capital gains tax rate is 20% plus the net investment income tax rate of 3.8% or 23.8%. As you can see, there will be no substantial  tax savings under the proposed Federal Tax Code.

• Home Mortgage Interest Deductibility Reduced:

For new home mortgages (taken out after 12/31/14), interest expense will still be deductible, but the existing limit on loan size will be reduced from the current $1,000,000 to $500,000. This reduction would be phased in over a four year period.

Restated: Once fully in place, a new $600,000 personal residence loan, only the interest on the first $500,000 would be deductible

• Existing loans in place as of 12/31/14: interest deductibility is not affected.

• New home equity line of credit loans: no interest would be deductible.

• Reduced Exclusion of Capital Gains on Sale of Personal Residence.

• Current Rule: If you resided in the home for at least two of the prior five years, your sale would allow you to exclude the first $250,000 of otherwise taxable gain per tax payer, and is available for use once every two years.

• Proposed Rule: You would have to reside in the home for at least five of the prior eight years to qualify for the exclusion.

• The exclusion could be used only once every five years.

• If your taxable income exceeded $500,000 (joint filers) or $250,000 (single filing tax payer) the exclusion would be phased out.

• Exceptions: No provision was made if the tax payer was required to relocate for change of employment or for health reasons.

• Mortgage Debt Forgiveness. [a huge inequity in the current Tax Code]

• This nasty phantom income problem typically results from a foreclosure or “deed in lieu of foreclosure” as a lender forecloses on the mortgaged property or takes the mortgage property back to satisfy the outstanding debt.

Example: As a real estate investor, you purchased a $1,000,000 property as follows:

• $250,000 cash down (25% down); and,

• you borrowed the remaining $750,000 from a mortgage lender.

Then, the tenant defaulted on the lease, and you had no income to make the mortgage payment.

Next, the lender forecloses on the mortgaged property.

Result:  You not only lost your $250,000 equity investment, but

•   you are viewed as being relieved of $750,000 in debt.

Debt Relief: A Huge Tax Problem.  The $750,000 in mortgage debt relief is viewed by IRS as having received $750,000 in cash which you used to pay off the $750,000 mortgage loan.

• If you received $750,000 in cash, then you will be taxed on that as income received.

OUCH:  You lost your $250,000 initial investment, went “broke” on that investment, and now owe IRS the tax on $750,000 of taxable income.

• The phantom income generated by debt relief is a huge tax problem that can haunt unsuspecting real estate investors – those who borrowed large amounts of money to substantially increase the amount of real estate that they can control with a limited amount of investment capital.

You see, there really is something worse than being “broke”.  It is possible to be broke and still owe a huge tax bill to IRS, and that bill can stick around to haunt you for a long time.

PROPOSED ADVERSE CHANGES

IMPACTING COMMERCIAL – INVESTMENT REAL ESTATE

• Elimination of the 1031 Tax Deferred Exchange.

As initially proposed in the Dave Camp’s Draft, after 2014, the tax deferred exchange would be completely eliminated

Nelsonian Commentary:

• This will directly result in a slowdown in the number of real estate business and investment transactions.

• Owners will refuse to face equity depleting huge capital gains tax bills, and will simply adopt much longer term holding periods.

• Reduced Depreciation Allowance:  Properties Acquired After 2016.

• For Business or Rental Properties Acquired after 2016

• Current Rule:  Cost Recovery or “Depreciation”

• If a residential investment property:

• the owner is allowed to recapture the portion of the cost basis attributed to improvements over a 27.5 year term (1/27.5th of the improvement value of the property is deducted each year during the ownership period).

• If other than residential property:

• The recapture period is 39 years.

• Proposed Change:

1.  Regardless of the nature of the real estate,

• all depreciable properties would be depreciated over a 40 year term.

This will result In a smaller amount of income tax savings each year. This will not be the end of the world, but it will diminish the after tax benefits of owning certain types of real estate. Less tax shelter means that you will pay more income tax on the same amount of annual earnings.

• Depreciation Recapture Upon Sale For Depreciation Taken After 2014

• What is It?: Upon sale of a depreciated property, the total amount of depreciation taken during the term of ownership is “recaptured” or taxed at a separate and higher tax rate from the long term capital gains experienced during the term of ownership.

• Current Federal Tax Rate:  Accrued deprecation is federally taxed in the year of sale at a 25% tax bracket.

1.  Of the total amount of calculated gain resulting from a sale, the first portion taxed of that gain is treated as “depreciation recapture”, not long term capital gain.

2.  The remaining gain is taxed at long term capital gain rates, assuming that the property had been owned longer than one year.

• Proposed Change: For sales occurring after 2014:

• recaptured depreciation would be taxed as ordinary income (potentially as high as 35% for higher income tax payers).

Restated, the annual depreciation allowance was used by the owner to offset other ordinary income, so when you sell and face the depreciation recapture problem, it will now be repaid at ordinary income tax rates.

The remainder of the defined gain on resale would be taxed at long term capital gains rates.

HUGE CAVEAT TO THIS ARTICLE

While this presentation has been assembled with care from sparse preliminary information recently reported in several real estate trade journals, it is not intended to be a complete and comprehensive coverage of the Camp Proposed Tax Code. Further, this presentation is intended to be educational in nature.

TAKE NO ACTION BASED UPON INFORMATION CONTAINED HEREIN.

 

• Consult with your CPA, tax attorney or other tax expert to understand your vulnerability if the proposed tax law changes were enacted into law.

• Then consult with an extremely knowledgeable Real Estate Investment Broker to form a viable real estate investment strategy that would minimize the tax impact on your real estate investment portfolio.

THE SPECIFIED CHANGES ARE NOT TAX LAW YET.

Some or all of the reported changes may never become new tax law. The politically divided current House and Senate can’t seem to agree on much of anything at this time.

A new federal Tax Code must be passed by a majority in the House, then the Senate. Differences in versions passed by each legislative body must be ironed out into an acceptable bill that each would approve, and then be signed into law by the President of the United States. The lobbying efforts will be intense to “not to gore my ox!” as occurs with any proposed Tax Code change.

There is a high likelihood that the tax law changes proposed by the House Ways and Means Committee will become diluted and amended substantially by the various special interest groups that substantially impact our government.

THEN, WHY PAY ATTENTION TODAY?

By understanding the biased thinking of our law makers, you may be able to gird your financial loins for changes that will come in the future. You have now been given a brief hint of things to come.