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What does RRA '93 mean to real estate?

On August 10, 1993, President Clinton signed into law the Revenue Reconciliation Act of 1993 (the "act"). A majority of the tax increases in the act are aimed at higher income individual taxpayers. The act does provide some relief for the real estate industry. This article will focus on the real estate provisions of the act.

Real Estate Investments

Passive Activity Loss Relief

Generally under existing law, losses from passive activities may not be used to offset other income such as wages, portfolio income or other business income. Passive losses may only offset passive income or be carried forward and deducted when the passive activity is disposed of. This limitation was considered to be unfair to people who generate income from performing a majority of their personal services in a real property trade or business and also incur losses from rental estate activities in which they materially participate.

The act allows certain taxpayers who provide more than half of their personal services in a real estate trade or business in which they materially participate to have rental real estate activities automatically treated as passive activities. The real estate trades or businesses covered by the legislation include real property development, redevelopment, construction, acquisition conversion, rental, operation management leasing or brokerage. The new provision is effective for taxable years beginning after December 31, 1993.

Eligible Taxpayers

A taxpayer meets the eligibility requirements if more than half of the personal services they perform during the taxable year are in real property trades or businesses in which they materially participate.

50% of Personal Services: The time spent performing personal services in real property trades or businesses must include more than 750 hours of time during the taxable year on activities in which the taxpayer materially participates. Personal services performed as an employee are not included as related to a real property trade or business unless the person performing the services has more than a 5% ownership interest in the activity. The 50% test is determined separately for each spouse when a joint return is filed. It is not necessary that both spouses meet the 50% test, nor that they meet the test on a combined basis.

Material Participation: This determination is the same under the act as under the prior law. Unlike the 50% test, the participation of a spouse is taken into account in determining whether the taxpayer materially participates.

Passive Loss Carryovers

For activities that are not considered passive for a given taxable year but were considered passive in a prior year, the amount of passive loss and credit carryovers attributable to that activity can be used to offset the current year income and related tax. Any remaining carryover continues to be treated as a passive loss carryover to subsequent years.

The losses allowed by reason of the special provision for the $25,000 allowance for certain taxpayers appears to be determined after the application of this provision.

Election to Aggregate Rental Real Estate Activities

The new rental real estate rules are generally applied to each interest in rental real estate as a separate activity. An election can be made, however, to treat all rental real estate activities as one activity. This election will impact the amount of total income which can be used to offset prior year passive carryovers and the amount of losses available for current deduction.

Example of General Provisions

Assume Taxpayer X meets the new eligibility requirements relating to real estate trades or businesses for the year 1994. Taxpayer X owns five rental real estate properties which have always been considered passive activities for prior years. Assume the information for 1994 is as follows:
 Suspended 1994
 Loss Carryover Income/(Loss) Participation

Property A $2,000 $5,000 Material
Property B $10,000 $8,000 Material
Property C $20,000 ($7,000) Material
Property D $0 ($3,000) Passive
Property E $4,000 $6,000 Passive


For Property A, Taxpayer X is a material participant and therefore the $5,000 income is not combined with any of the other properties. Since X has a $2,000 suspended loss carryover allocated to this property, he may reduce his current year income from the property to $3,000.

Taxpayer X is also a material participant in Property B. X may use $8,000 of the suspended loss carryover allocated to this property to offset the current year income generated; however, the remaining $2,000 suspended loss may only be used to offset other passive income of X in the current year or be carried forward to 1995.

The new passive loss provisions will allow X to deduct the current year loss from Property C since he is a material participant in the activity; however, none of the $20,000 loss carryover can be used to increase the amount of the loss. This loss carryover can be used against any other passive income X has or may be carried forward to future years.

X is considered a passive participant with respect to Property D. Therefore, based on this property alone, X would not be allowed to deduct any of the $3,000 current year loss. The passive loss can only be used to offset other passive income or be carried over.

With respect to Property E, X is also considered a passive participant. Income and loss from passive activities must be combined for the taxable year in applying the passive loss provisions. Assuming that properties D & E are his only passive activities for the year, this gives X net passive income of $3,000. This income can be completely offset by utilizing portions of the passive loss carryovers from Properties B, C and E.

Under the current rules applicable to 1993, Taxpayer X would have generated net passive income of $9,000 from the combination of properties. This passive income would have been offset by passive loss carryovers, leaving an additional carryover of $27,000. Under the new rules effective for 1994, a net current non-passive loss of $4,000 is deductible and the remaining carryover is $23,000.

Election to Avoid Discharge of Indebtedness Income

Under present law, a taxpayer generally recognizes income upon the discharge of indebtedness. Exceptions to this rule include discharges in bankruptcy cases, discharges when the taxpayer is insolvent and certain types of farm indebtedness. The amount excluded from income under these exceptions is applied to reduce tax attributes of the taxpayer.

The Act provides a new exception to the general rule of income recognition. The new exception covers discharge of indebtedness for certain qualified real property indebtedness. The new provision is effective for discharges occurring after December 31, 1992, in taxable years ending after that date.

Eligible Taxpayers

The new exception is available to taxpayers other than C corporations and is limited to discharges of qualified real property business indebtedness.

Qualified Real Property Business Indebtedness

Qualified real property business indebtedness is indebtedness which is:

* incurred or assumed in connection with real property used in a trade or business;

* is secured by that real property; and

* for which the taxpayer has elected to treat as qualified real property business indebtedness.

Indebtedness incurred or assumed on or after January 1, 1993, is not eligible for the election unless one of the following conditions apply:

* It is indebtedness incurred to refinance qualified debt originally incurred before January 1, 1993. An amount equal to the original indebtedness being refinanced is the maximum amount eligible for this election; or

* The debt incurred or assumed after January 1, 1993, is qualified acquisition indebtedness.

Qualified Acquisition Indebtedness

Qualified acquisition indebtedness is debt incurred to acquire, construct or substantially improve real property that is secured by such debt. Debt incurred as a result of refinancing qualified acquisition indebtedness is also eligible for the new election but only to the extent of the amount of the original debt being refinanced.

Amount of Exclusion

The amount eligible for exclusion may not exceed the excess of the outstanding principal amount immediately before the discharge over the fair market value of the business property which is security for the debt. The fair market value of the property is to be reduced by the principal amount of any other qualified real property indebtedness secured by the property immediately before the discharge.

The amount excluded under this new provision may not exceed the adjusted basis of the depreciable real property held by the taxpayer immediately before the discharge. The amount excluded reduces the basis of other business real property held by the taxpayer as of the beginning of the taxable year following the taxable year in which the discharge occurs.

By so electing, taxpayers are essentially deferring the recognition of income by reducing future depreciation deductions or by deferring gain until the properties whose basis is reduced are disposed of in a taxable transaction. The income as a result of the discharge will be recognized upon such a disposition as a result of a larger gain or lesser loss on the disposition of the properties whose basis has been reduced.

Example: Assume that a taxpayer holds two properties with the following FMV, basis and qualified indebtedness.
 Property 1 Property 2

FMV 2,000,000 3,000,000
Basis 1,000,000 1,500,000
Qualified indebtedness 3,500,000 -0-
Debt forgiven 2,000,000 -0-


If the taxpayer realizes discharge of indebtedness on Property 1 of $2,000,000, only $1,500,000 can be excluded from income under the new election (the excess of the qualified indebtedness of $3,500,000 over the FMV of the property of $2,000,000). The basis of Property 2 would be reduced to $1,000,000 since the remaining basis available on Property 1 was only $1,000,000.

An issue which is left uncertain until regulations are issued is to what extent individual partners may elect to utilize the new election in the event an election is not available at the partnership level. For example, using the facts above for Property 1 only, a partnership would have been unable to fully utilize the new election in the event an election is not available at the partnership level, had it not had other depreciable real property with basis to reduce. To what extent an individual partner in a partnership could reduce the basis of other depreciable property he holds is uncertain.

The Treasury has specifically been authorized to issue regulations necessary to prevent abuse of the new provision through the use of cross collateralization or other means.

Increased Recovery Period for Depreciation of Nonresidential Real Property

The act increases the recovery period for which depreciation deductions are allowed for nonresidential real property to 39 years. The depreciation method will continue to be on the straight line basis. The change was intended to make the tax deductions more accurately reflect the actual decline in the value of the property. Depreciation deductions on nonresidential real property for alternative minimum tax purposes will remain at 40 years on a straight line basis.

The provision applies to property placed in service on or after May 13, 1993. The new rule does not apply to property placed in service before January 1, 1994, as long as a binding contract to purchase or construct the property was in place, or actual construction had commenced before May 13, 1993.

Qualified Mortgage Bonds and Credit Certificates

The act permanently extends the qualified mortgage bonds and mortgage credit certificates programs retroactively from July 1, 1992. These programs are intended to enable individuals who would otherwise be unable to do so to buy their own homes. In addition, modifications were made that will expand the types of loans that qualify for the program.

Low-Income Housing Tax Credits

One of the few remaining tax shelters is the low-income housing tax credit program, which was retroactively reinstated and made permanent. In addition, modifications to the program should improve the operation and compliance of the credit program.

This credit can be used as a dollar-for-dollar credit against your regular tax liability. There are some dollar restrictions for closely-held C corporations, and upper tax bracket individuals may now use up to $9,900 (up from $7,750) of low-income housing tax credits even if they have no passive income. Investors should find these low-income tax credit properties attractive since they generally produce a 15-25% after-tax return on investment.

Real Estate Investments by Pension Funds

Generally, qualified pension trusts are taxed on income from a trade or business unrelated to their exempt purpose. An exception existed under prior law for income from debt-financed property subject to certain restrictions. As outlined below, the act loosens some of those restrictions and generally makes it more favorable for pension trusts to invest in real estate without facing a tax on unrelated business income (effective 1/1/94):

* Leaseback of debt-financed real property to the seller or other disqualified persons would be allowed. The leaseback must be no more than 25% of the leasable floor space and on "commercially reasonable terms."

* Authority is granted to Treasury Department to issue regulations that would provide guidance for utilizing seller-financing.

* Greater ability for pension trusts and other similar organizations to participate in acquisitions of property from financial institutions through a relaxation of fixed price and participating loan restrictions which currently govern financial institutions.

* Income from investments in publicly traded partnerships will no longer automatically be treated as unrelated business income.

* Title-holding companies are allowed to generate a de minimis amount of unrelated business income without losing their tax exempt status under certain circumstances.

* An exception is provided to the rules which treat gains and losses from the sale of assets held primarily for sale to customers as unrelated business income. This exception relates to certain real property and mortgages acquired from financial institutions in conservatorship or receivership.

* Income generated from loan commitment fees and premiums from unexercised options, purchase, sale or lease of real estate is excluded from treatment as unrelated business income.

* Pension trusts are no longer considered a single owner for purposes of the "five or fewer rule" related to real estate investment trust (REIT) qualification requirements. This will allow for so-called "private" REITS to be controlled by pension trusts.

Summary

This article summarizes many of the real estate provisions of the act. Unquestionably, the new provisions are complicated. During the next few months we will find out how much relief was given to the real estate industry by the Revenue Reconciliation Act of 1993.

Randy D. Abeles is a partner at McGladrey & Pullen in Chicago.
COPYRIGHT 1993 National Society of Public Accountants
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Title Annotation:Back to School: The Revenue Reconciliation Act of 1993
Author:Abeles, Randy D.
Publication:The National Public Accountant
Date:Nov 1, 1993
Words:2415
Previous Article:Business taxation under RRA '93.
Next Article:Get with the program! The IRS ELF.
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