White House Tax Law Changes for Real Estate
On March 28, 2022, the Biden administration proposed changes to real estate taxation.
Restrict deferral of gain for like-kind exchanges under Section 1031
The Biden administration has proposed limiting the gain that can be deferred on an exchange of like-kind real estate under Section 1031 to $500,000/year for individual taxpayers (or $1 million/ year for married persons declaring jointly).1 Taxpayers will be required to recognize the gain above the $500,000/$1 million threshold in the year the property is traded. The proposal does not apply to real estate investment trusts (“REITs”) or C corporations, and so it appears that individuals are not limited in their ability to benefit from similar exchanges through these entities.
If the proposal is enacted, one would expect to see increased use of Up-REITs, “mixing bowls” and long-term net leases. These arrangements all allow tax deferral while reducing a taxpayer’s economic risk in the underlying property. An Up-REIT is a structure under which a REIT owns a partnership that owns real estate. Investors bring appreciated property to the partnership on a tax-free exchange for an interest in the partnership and the option to exchange the interest in the partnership for an interest in the REIT . Up-REITs allow for deferral, diversification and (for publicly traded REITs) liquidity. In a mixing bowl transaction, a taxpayer contributes value-added real estate to a partnership, and after a specified period (usually seven years), the real estate is distributed to another partner and the contributing partner retains a economic interest in the other assets of the partnership. In a long-term lease, the taxpayer secures a fixed economic return over a long period. These transactions would not be affected by the Biden administration’s proposal.
Treat 100% of recapture of depreciation on sale of Section 1250 property as ordinary income
The Biden administration has proposed treating all gains on Section 1250 property held for more than one year as ordinary income to the extent of accumulated depreciation deductions taken after December 31, 2022. Depreciation deductions taken on Section 1250 property before December 31, 2022 continues to be subject to the current rules (and can only be recaptured to the extent the depreciation exceeds the amount that would be allowable on a straight-line basis). Any gain on the sale of Section 1250 property greater than the recapture of depreciation would continue to be treated as a Section 1231 gain. Any unrecovered gain on Section 1250 property would continue to be treated as a Section 1231 gain. be taxable for unincorporated taxpayers at a maximum rate of 25%.
Under current law, Section 1250 requires that a certain amount of the gain from the sale or disposition of certain depreciable real property used in a trade or business be “recaptured” or recharacterized as ordinary income, in the extent of prior capital cost allowances taken on that property.2 For assets held for one year or less, the amount of gain recaptured is all previous capital cost allowances. For assets held for more than one year, the amount of gain recaptured is the amount of depreciation that exceeds the amount that would have been allowable on a straight-line basis. Thus, only the gain attributed to deductions equal to the difference between those taken according to an accelerated depreciation or depreciation premium method and those allowed according to a straight-line method is recovered and taxed at ordinary rates. That would be changed under the Biden administration’s proposal. For unincorporated taxpayers, the gain attributable to straight-line depreciation, or “unrecovered 1250 gain,” is taxed at a maximum rate of 25%. That rule would remain under the Biden administration’s proposal.
Further, under section 1231, unincorporated taxpayers treat section 1231 losses as ordinary losses and section 1231 gains as long-term capital gains. That rule would remain under the Biden administration’s proposal.
The Biden administration’s proposal would not apply to unincorporated taxpayers with adjusted taxable income below $400,000 (or $200,000 for married people filing separately). These income amounts would be calculated before applying the proposed 100% capital cost allowance recapture on property in section 1250.
Under the Biden administration’s proposal, flow-through entities would be required to calculate the character of gains and losses on the sale or disposition of section 1250 assets and report to the owners of the entity the amounts of income or ordinary loss, capital gain or loss, and unrecovered gain under section 1250 under existing and proposed rules. Owners with an income of at least the $400,000/$200,000 threshold would report the tax items calculated under the proposed rules.
The proposal would apply to capital cost allowances taken from Section 1250 property in tax years beginning after December 31, 2022, and to sales or dispositions of Section 1250 property made in tax years beginning after December 31, 2022.
Rita N. Halabi also contributed to this article.
All section references are to the Internal Revenue Code or Treasury regulations.
For this purpose, “sale or disposition” includes sale, exchange, involuntary conversion, transfer by a corporation to a shareholder, transfer under a sale-leaseback transaction, and transfer upon foreclosure. of a surety. Treasury Regulations section 1.1250-1(a)(4).
© 2022 Proskauer Rose LLP. National Law Review, Volume XII, Number 131