Tax issues in real estate investing.

Recently, significant new developments have occurred that have an impact on the tax consequences of real estate transactions. Following is a brief summary of some of the more relevant new developments that could impact those in the real estate industry.

Economic Performance Regulations Issued

On April 9, 1992, the Internal Revenue Service issued regulations under IRC Section 461(h). Section 461(h) relates to the use of the so-called "events test" to determine when economic performance occurs.

Generally, the regulations provide that economic performance occurs with respect to "payment liabilities," when payment is made. Identified are six types of payment liabilities, including real estate taxes, which must be paid in order to be deducted. The regulations apply for taxable years beginning after December 31, 1991, for payment liabilities.

Section 461(h) allows an exception to the economic performance requirement for certain recurring items. However, this exception does not apply to tax shelters. Therefore, in most cases, tax shelters must, in effect, deduct real estate taxes on the cash basis method.

The final regulations also address when economic performance occurs with respect to employee benefit plans, expenses attributable to a long term contract reported on the percentage of completion method and liabilities arising in connection with providing property or services.

Also incorporated within the regulations is a provision that any taxpayer is granted consent to change to or to modify a previous election to use the recurring item exception, for the first taxable year beginning after December 31, 1991. The taxpayer avoids using an election statement or a Form 3115 by accounting for the item under the recurring item exception method on the timely-filed original return for that year. Any change in method, in subsequent years will require the advance consent of the Commissioner.

The regulations are effective April 10, 1992, and apply to liabilities that would have been allowable under the previous regulation or were otherwise incurred after July 18, 1984.

IRS Issues Guidance on Allocation of Future Development Costs for Real Estate Subdividers

On April 9, 1992, the IRS issued an advance copy of Rev. Proc. 92-29, which allows real estate subdividers to include future improvement costs in the basis of subdivided property to determine gain or loss upon sale.

This new ruling permits developers to include in the basis of properties sold, their allocable share of the estimated cost of future common improvements. The total amount of common improvement costs included in the basis of properties sold may not exceed the amount of common improvement costs for which economic performance has occurred under Section 461(h) of the Internal Revenue Code.

For example, a developer builds 10 houses of equal value on a tract of land. The developer estimated that common improvements will cost $500,000; therefore, when all have been completed, each house will have an allocable share of these improvements equal to $50,000. In year one, the developer sells four houses and incurs $250,000 of common improvement costs. Under Rev. Proc. 92-29, the developer may include a total of $200,000 of common improvement costs, or $50,000 in the basis of each lot sold. The excess costs not included in basis in year one, may be included in year two. If the developer had incurred only $160,000 in improvements at the end of year one, they would be limited by the economic performance rules to costs actually incurred, allowing an increase in basis of only $40,000 for each house sold ($160,000/4).

Taxpayers wishing to use this method of cost allocation must request and receive the consent of the Commissioner for each project. To determine what constitutes a project, any reasonable method may be used, in light of the common improvements to be provided. The taxpayer also must agree to extend the period of limitations for assessment of deficiencies attributable to the use of this method.

IRS Rejects Fulton Gold Doctrine

In Fulton Gold, a taxpayer purchased property subject to a mortgage for which the purchaser had no personal liability. The purchaser subsequently satisfied the mortgage for less than its face amount. The court held that the discharge of a portion of a nonrecourse debt encumbering the retained property did not give rise to current income, but instead resulted in a corresponding reduction to the taxpayer's basis in the property. The rationale was that since none of the taxpayer's other assets were subject to the nonrecourse debt, there was no "freeing of assets" upon discharge of a portion of that debt. The fact the discharge may have resulted in the taxpayer having equity (or increased equity) in the collateral (because the value of the collateral exceeded the reduced debt) was not considered a "freeing of assets" within the rule of Kirby Lumber Company.

In a recent revenue ruling, however, the IRS held that the reduction of the principal amount of an undersecured non-recourse, non-purchase money debt by the lender results in the realization of discharge of indebtedness income under Section 61 of the IR Code. The IRS stated that Fulton Gold, as interpreted, is inconsistent with Tufts and Gershkowitz and will not be followed (Revenue Ruling 91-31).

Final Regulations Provide Guidance as to Deferred Like-Kind Exchanges and Exchanges of Partnership Interests

In the like-kind exchange provision of Section 1031, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for that of a like-kind which is to be held for productive use in a trade or business or for investment.

For deferred exchanges (i.e., where transfer of one's own property and receipt of replacement property is not simultaneous), special requirements as to the identification and time that replacement property is received, must be met.

The IRS has issued final regulations in connection with these limitations. The regulations explain how to meet the identification requirement and provide four safe harbors for the use of guarantees, security agreements, intermediaries and other special arrangements often found in deferred exchanges.

The regulations do not apply to exchanges where the taxpayer transfers his own property after having received the replacement property (so-called "reverse Starker transactions"). However, the Services says it will continue to study how Section 1031 applies to those situations.

The provision on deferred exchanges apply to transfers of property after June 9, 1991. The provisions on exchanges of partnership interests apply to transfers after April 24, 1991.

Proposed Regulations Clarify Section 179 Expense Deduction 

Section 179 allows a qualified taxpayer to expense up to $10,000 of depreciable business assets each year rather than depreciate the asset over his life. This election has three major limitations: (1) it is reduced for each dollar of investment in excess of $200,000; (2) the property must be purchased in the taxpayer's active conduct of trade or business; and (3) the deduction is limited to the taxpayer's taxable income from active trade of businesses.

The IRS has issued proposed amendments to the final Section 179, bringing them into line with the provisions of the Tax Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of 1988.

Under the proposed regulations, the $200,000 limitation is imposed at both the partnership and partner level. In determining the partner limitation, however, the cost of the property placed in service by the partnership would not be attributed to the partner. Similarly, the taxable income limitation applies at both the partnership and partner level. Similar rules apply to subchapter S corporations with respect to the corporation and its shareholders.

The proposed regulations explain what constitutes "actively conducted trade or business" and how taxable income is calculated. An actively conducted trade or business is one in which the taxpayer "meaningfully participates in its management or operations." Taxable income from all actively conducted trade of businesses is aggregated in determining the limitation. Although rental activities are considered "passive," any income or loss from these activities is aggregated with the other actively conducted trade or business, even if all or a portion of the gross rental loss is disallowed under the passive activity provisions.

The proposed regulations also state that there is no requirement that the Section 179 expense be capitalized under the uniform capitalization rules.

The proposed regulations are effective for property placed in service in tax years ending after April 29, 1991. For property placed in service prior to this date, taxpayers may rely on the old regulation using any reasonable method to apply the 1986 and 1988 changes.