The Taxpayer Relief Act.

This summer Congress passed a major tax bill with substantial provisions affecting real estate. One key provision cuts the capital gains tax for income-producing real estate. Another offers tax relief on the gains from selling primary residences. It may prompt some homeowners to cash in equity nest eggs and pocket their gains or plow them into new investments.

On August 5, 1997, President Clinton signed into law the most comprehensive and far-reaching tax legislation in more than a decade. Many members of Congress have all but trampled each other in a rush to take credit for what they claim are the first tax cuts in 16 years and the first balanced budget in more than 30 years.

Others have been just as eager to point out that the new law created 285 new sections in the Internal Revenue Code and amended another 824. This was despite earlier calls by Ways and Means Committee Chairman Bill Archer (R-Texas), House Majority Leader Dick Armey (R-Texas), one-time (and possibly future) presidential hopeful Steve Forbes and other leaders to streamline the code and replace the income tax with a simpler and more egalitarian system of taxation.

This irony has been made even more poignant by hearings held in September by both the House and Senate tax-writing committees examining abuses of power, mismanagement and other problems surrounding the Internal Revenue Service (IRS). These revelations have prompted a renewed outcry from inside the beltway to "tame" the IRS and reform what many call our byzantine system of taxation.

Regardless of your political or ideological views on the subject, the new law includes a number of provisions sought by the Mortgage Bankers Association of America (MBA) that favorably affect the mortgage lending and real estate industries.

Known as the "Taxpayer Relief Act of 1997" (P.L. #105220), the new law contains provisions that accomplish the following:

* Grant individuals broad capital gains tax relief.

* Exempt capital gains on the sale of primary residences.

* Cut the rate applicable to depreciation recapture on gains from the sale of income-producing real estate from 28 to 25 percent.

* Ensure the continued operation of the Low-Income Housing Tax Credit (LIHTC).

* Ensure the continued operation of the Section 1031 "like-kind" exchange program in its current form.

* Reform rules governing REIT operations.

* Expand individual retirement account (IRA) provisions.

* Create a new back-loaded IRA (i.e., one in which gains are taxed when funds are withdrawn from the taxpayer's IRA account).

* Permit the early-penalty-free withdrawal of funds from all types of IRAs for the purchase of a first home.

* Encourage the cleanup of environmental "brownfield" sites.

Following is a brief description of the key real estate-related provisions of the new law that directly affect the real estate and mortgage lending industries.

Provisions in the new law

Capital gains

The new statute provides a variety of cuts in the capital gains rates. For example, in addition to the basic rate reductions, special rates apply to certain assets held for extended time periods, and real estate depreciation recapture was treated differently than non-real estate assets. In all, a number of special rules were created that greatly complicate how one determines what capital gains rate applies to any given transaction. Care must be taken in applying the new rates and in undertaking tax planning for future transactions.

Overall framework of cuts. In general, the new capital gains tax rates will be determined as follows:

* Ten percent for investments held for more than 18 months by taxpayers in the 15 percent bracket.

* Eight percent for investments held for more than five years by taxpayers in the 15 percent bracket (applicable to sales occurring on or after January 1, 2001).

* Twenty percent for investments held more than 18 months (or 12 to 18 months if the investment is sold between May 7, 1997, and July 29, 1997) by taxpayers in brackets above 15 percent.

* Eighteen percent for investments held longer than five years by taxpayers in brackets above 15 percent if the investment was purchased on or after January 1, 2001. For assets held by a taxpayer for five years before that date, the 18 percent rate can be applied to any gain attributable to the period beginning on January 1, 2001, by marking the asset to market (see below).

If an asset has been held for five or more years as of January 1, 2001, the taxpayer may elect to "mark that asset to market." To do this, the taxpayer purports to sell the asset to him/herself at the fair market value on January 1, 2001, and repurchase the asset on the same date for the same amount. The taxpayer then pays the capital gains tax on any "profit" on such hypothetical "sale" at the rate of 20 percent. When such asset is subsequently sold to a third party after January 1, 2006, any gain attributable to the period beginning January 2, 2001, will be taxed at the 18 percent rate. If the taxpayer opts not to make that election, however, the gain on the asset, if sold to a third party after January 1, 2001, will be 20 percent.

Definition of long-term gain. The definition of long-term capital gain has not been changed in the new law. So gain realized on the sale of investments held for less than 12 months will be treated as ordinary income and taxed at the taxpayer's applicable marginal rate (i.e., up to 39.6 percent). Gain realized on the sale of investments held between 12 and 18 months that were purchased before May 7, 1997, or after July 29, 1997, will be taxed at the current 28 or 15 percent rates.

Depreciation recapture. With respect to income-producing real estate, Congress had considered recharacterizing real estate depreciation recapture as ordinary income (taxed at a rate as high as 39.6 percent). Because of efforts by MBA and others, this effort was soundly defeated. Furthermore, the rate was cut from 28 percent to 25 percent.

This represents a significant victory for the real estate industry and is a substantial improvement over current law. MBA and others had made considerable efforts to convince Congress to set the rate at, or closer to, the rate applicable to other asset classes (18/20 percent). MBA will continue to seek a further reduction in the rate.

Corporate tax rate; indexing. Although earlier drafts of the legislation would have set a lower capital gains tax rate of 30 percent for assets held by corporations for more than five years, this provision was dropped from the final version. Likewise, language in the legislation approved by the House in June that would have indexed capital gains taxes to inflation (for assets purchased by individuals after 2000) was dropped from the final bill.

Many felt that the indexing feature was an extremely attractive part of the legislation as originally proposed and one that made a great deal of sense in terms of attempting to make federal capital gains rules reflect economic reality. It was, however, an expensive provision and thus became extremely controversial, raising tremendous ire among Democrats who saw the proposed capital gains cuts as heavily favoring wealthier Americans.

At one point during the debate, the Speaker of the House, Newt Gingrich (R-Georgia), said that indexing of capital gains was a critical issue, indicating that it had to be included in the final bill for it to be approved by Congress. The House's insistence on this provision, Gingrich claimed, was nonnegotiable. President Clinton, however, threatened to veto any tax cut proposal that included a provision to index capital gains to inflation. Ultimately, the cost, in terms of dollars and political capital, forced the provision to be dropped from the final version.

Sale of primary residence. Significantly for residential real estate, the new law exempts from taxation gains of up to $500,000 (for married couples) and $250,000 (for individuals) from the sale of one's principal residence. To qualify as a principal residence, the taxpayer must have occupied the home for at least two of the five years preceding the sale. The exemption can be exercised once every two years. A proposed provision that would have permitted taxpayers to deduct losses realized from the sale of primary residences was not included in the bill that became law.

The provision exempting taxation on gain was first recommended by President Clinton during his acceptance speech at the Democratic nominating convention in Chicago in 1996. The campaign issue was picked up later in the presidential campaign by candidate Bob Dole and later included in the Clinton administration's FY '98 budget package. Supported by Republicans and Democrats alike, it was easily included in the bill, especially after budget analysts determined that the loss of revenues to the U.S. Treasury would be relatively low. The minimal revenue implications trace to the fact the IRS collects tax on relatively few home sales because most individuals currently roll any gain into the purchase of a new home at a similar or higher price, or take their one-time exemption for individuals age 55 or older.

Effective date. Except as otherwise noted, all of the capital gains provisions described in this article will apply to sales made on or after May 7, 1997.

Low-income housing tax credit

For several years, Ways and Means Committee Chairman Bill Archer has suggested that he would allow the Low-Income Housing Tax Credit program to expire as of December 31, 1997. He put such a sunset provision in the package of tax measures included in the 1995 budget reconciliation bill President Clinton vetoed in late 1995. The LIHTC program provides the primary source of financing for low-income multifamily housing in the United States.

Chairman Archer made a similar attempt this year to eliminate the credit. Early in the 105th Congress, he again suggested he would attempt to sunset the tax credit program as of December 31, 1997. He made numerous statements throughout the year that any tax cut bill approved by his committee would include a provision to end the program. Fortunately, efforts by MBA and others to defeat this effort proved successful. In fact, neither the bill that Archer introduced in June (H.R. 2014) nor the Senate's version of the tax cut bill (S. 949) contained a provision to eliminate the program. Thus, at least for the time being, the program continues to operate under existing law.

Section 1031 "like-kind" exchanges

Congressional tax-writing committees also had been looking to change the like-kind exchange rules in a way that would have eliminated their applicability to many real estate transactions. They considered such changes as a way to generate revenues to pay for additional tax cuts.

The current like-kind exchange rules, described in Section 1031 of the tax code, permit the tax-free transfer of one real property interest for another. They are interpreted broadly and permit the trade of dissimilar property types. For example, they would permit the trade of frozen, oil-rich Alaska tundra for a luxury apartment project in Alexandria, Virginia, or the trade of a New York City office tower for a shopping center in Austin, Texas. This type of transaction is used frequently to avoid the substantial taxes an owner incurs when selling a property.

Congress first authorized the nonrecognition of gain or loss on real property exchanges through this mechanism as far back as 1924. It stemmed from the belief that it was unfair to impose a tax on what is, in effect, a theoretical gain. In an exchange transaction, the taxpayer merely swaps one property for another and does not realize a change in economic position and receives no cash with which to pay a tax or to reinvest. The tax code includes several provisions to ensure that the rule is not abused.

The proposal to change the like-kind exchange rules would have replaced the current standard with one that would have required that exchanged properties be almost identical in type and use. This would have severely limited the use of this mechanism, greatly restricted capital formation for real estate investment and added to administrative costs and complexity.

Due to industry lobbying, Congress determined to look elsewhere for the revenues it needed to pay for its desired tax cuts. Thus, the law signed by President Clinton on August 5 does not contain provisions to change or eliminate the like-kind exchange rules contained in Section 1031 of the code.

New rules regarding REITs

MBA worked closely with the National Association of Real Estate Investment Trusts to gain approval of a set of legislative changes to the existing REIT rules in the Internal Revenue Code. The legislation, known as the Real Estate Investment Trust Simplification Act of 1997 (H.R. 1150) represented the first broad-based package of reforms for the REIT industry since the comprehensive tax bill of 1986 was enacted. The legislation was intended to address several complex provisions regarding the tax treatment of REITs and correct several rules that could cause a REIT to lose its tax status if voluntarily or involuntarily breached.

The bill also would have amended provisions for REIT qualification to put them on par with rules governing mutual funds and made several other technical corrections. The bill was introduced by Rep. E. Clay Shaw Jr. (R-Florida) and was co-sponsored by a bipartisan group of 17 other members of the Ways and Means Committee.

The provisions of H.R. 1150 were relatively noncontroversial. Most important, the Joint Committee on Taxation estimated that the requested changes would have no significant budgetary impact. Thus, most of the REIT reform provisions included in H.R. 1150 were included in the legislation that became law on August 5.

Individual retirement accounts

During the past eight years, there have been many efforts either to waive the penalty for early withdrawal of IRA funds for use by first-time homebuyers or to expand the deductibility of IRAs above the current caps. Other proposals were also considered, such as creating a tax credit for first-time homebuyers or permitting IRA funds to be invested in, or loaned, for the purchase of a first home. All such past efforts had been unsuccessful.

Former rules. Provisions in effect prior to passage of the new law permitted taxpayers to make an annual deductible contribution to an individual retirement account of up to $2,000 and, if married, up to $4,000. If, however, the taxpayer (and/or spouse) is a participant in an employer-sponsored retirement plan, the deductible amount is phased out at the following levels: $40,000 to $50,000 of adjusted gross income (AGI) for married couples; and $25,000 to $35,000 of AGI for single taxpayers. The income limits do not apply if neither the individual nor his or her spouse is an active participant in an employer-sponsored retirement plan. Taxpayers may make nondeductible contributions to the extent they are not permitted to make deductible contributions.

No tax is imposed on the earnings on contributions until withdrawn. However, any amount withdrawn before the taxpayer reaches the age of 59 1/2 is subject to applicable income taxes, plus a 10 percent early-withdrawal penalty. The penalty (but not the income tax) is waived if the taxpayer is older than 59 1/2, if the withdrawal is made to pay for qualified catastrophic medical expenses or when workers experience long-term unemployment, or if the withdrawal is made upon the taxpayer's death or disability.

New provisions. The new law expands the eligibility requirements for existing deductible IRA accounts. For example, it increases the maximum income phase-out levels for deductible IRAs to between $80,000 and $100,000 of AGI for joint filers and $50,000 to $60,000 for single filers. It also provides that an individual is not a member of a qualified employer-sponsored retirement plan merely because one's spouse is a member of such a plan. The new law also increases the phase-out level for the maximum allowable contribution of such a couple (filing jointly) to between $150,000 and $160,000 of AGI.

The new law also creates a new form of IRA called a "Roth IRA" (named for Senate Finance Committee Chairman Bill Roth [R-Delaware] who championed the legislation) and retains the current nondeductible IRA. Eligibility for contributions to the new Roth IRA accounts phases out for taxpayers with AGI of between $95,000 and $110,000 for individuals, and between $150,000 and $160,000 for joint filers. However, a taxpayer's annual contributions to all of his or her IRA accounts, combined, cannot exceed $2,000 (indexed to inflation).

Qualified distributions from a Roth IRA account will not be includable in income provided (1) they are made after the taxpayer's Roth IRA account has been in existence for five or more years and (2) they are made (a) by a taxpayer who is at least 59 1/2, (b) to a beneficiary after the taxpayer's death, (c) due to the taxpayer's disability or (d) to assist in purchasing a first home. Thus, qualified distributions from these new IRA accounts made by first-time homebuyers to purchase a home are not subject to income tax. Nor are they subject to the 10 percent early-withdrawal penalty.

The new law provides that early withdrawals can be made to assist first-time homebuyers without paying the 10 percent early-withdrawal penalty from existing forms of IRA accounts as well. No such waiver is made, however, for any distributions made for the purchase of a first home, from any tax on the income generated by such savings while held in the IRA. The tax waiver does not apply to distributions for first-time homebuyers under the existing forms of IRA accounts. It is important to note that "first-time homebuyer" is defined to include any person (and such person's spouse) who has not owned a home within the past two years. This definition is applicable to all forms of IRAs. Furthermore, the tax and penalty early-withdrawal waivers are limited to $10,000 in the aggregate for the lifetime of the taxpayer.

Environmental "brownfield" clean-up costs

MBA has long sought legislation to permit property owners to deduct environmental clean-up costs in the year they are incurred and to encourage the environmental remediation of contaminated sites in urban areas (referred to as "brownfields"). The tax bill signed into law on August 5 includes a provision, supported by MBA, that encourages the cleanup of brownfield sites. It does this by permitting the costs associated with such cleanups to be deductible in the year paid or incurred rather than requiring them to be charged to a taxpayer's capital account.

The expenditure must be made in connection with the abatement or control of hazardous substances at a qualified contaminated site. Such sites are defined to include the federally designated empowerment zones and enterprise communities as well as 76 brownfield pilot sites designated by the U.S. Environmental Protection Agency (EPA). Deductions for qualified environmental remediation expenditures would be subject to recapture as ordinary income upon sale or other disposition of the property. The deduction sunsets after three years. Thus, it applies only to qualified expenditures made prior to January 1, 2001.

Comprehensive tax reform

The 104th Congress began to focus attention on proposals to replace the federal income tax with a flat tax or one that is based on individual consumption. Although interest in the subject seemed to peak during the middle of last year's presidential campaign, it is possible and perhaps likely that the issue of comprehensive tax reform will return to the forefront of the national agenda late in the 105th Congress or sometime during the 106th.

In the wake of recent hearings by the Senate Finance Committee regarding abuses by the IRS, Ways and Means Committee Chairman Archer reissued his call for replacing the code with a new tax system. This could, he suggested, virtually eliminate the ability of the IRS to carry out many of the abuses described in the Finance Committee hearings.

The flat tax idea came under a lot of fire last year, and many recognize that it will be difficult to completely replace the income tax with a new system of taxation. Even so, there is enough interest among key legislators to reform the tax code to continue discussions regarding the topic, albeit at a slower pace. No provisions addressing tax reform were included in the legislation signed by the president in August.

Republican leaders, including Ways and Means Committee Chairman Archer and Senate Finance Committee Chairman Roth, have stated they intend to push for additional tax cuts next year, followed by a comprehensive overhaul of the existing tax code. Both Archer and Roth have suggested they may hold hearings on comprehensive tax reform next year.

With Congress apparently willing to consider placing new restrictions and/or limiting benefits to such "entitlement" programs as Medicare, the chance they may look to changes in other entitlement programs, such as the mortgage-interest deduction, becomes more real.

Robert G. Josephs is director and associate legislative counsel at the Mortgage Bankers Association of America in Washington, D.C. For a more detailed explanation of the provisions described in this article or questions about other tax legislative issues, call MBA at [phone].