The effect of the Revenue Reconciliation Act of 1993 on real estate owners.
This article will discuss the effect of these changes on the real estate industry and offer planning recommendations.
A PAL generally is not deductible from active income for taxpayers who do not materially participate in the conduct of a trade or business (e.g., limited partner in a limited partnership). Under pre-RRA law, "passive activity" included all rental activities (with two exceptions), regardless of the level of the taxpayer's participation. Congress considered this situation to be unfair, and modified the PAL rules to provide relief to real estate professionals.(1) Taxpayers involved in a real property trade or business who meet special eligibility requirements can offset losses from rental real estate activities against nonpassive income (e.g., wages, interest and dividends).(2)
* Eligibility requirements
This special treatment is allowed only for a real property trade or business (rental real estate), defined in Sec. 469(c)(7)(C) as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage activity. The rental of personal property (e.g., computers, copiers) does not qualify for the special treatment.
To qualify, the taxpayer must materially participate in the rental real estate activity. According to the RRA Conference Report, material participation has the same definition as under prior law, i.e., the taxpayer must be involved in the operation of the activity on a regular, continuous and substantial basis.3 Participation generally includes any work customarily performed by the taxpayer or his spouse in an activity owned by the taxpayer.(4) However, if the work is not customarily performed by the owner and its main purpose is to avoid the disallowance of passive losses or credits, it will not be treated as participation, nor will work performed in an individual's capacity as an investor (e.g., reviewing financial reports in a nonmanagerial capacity).(5)
The RRA provisions apply to taxpayers who perform (1) more than 50% of their personal services during the tax year in the rental real estate business in which they materially participate (the 50% test), and (2) more than 750 hours of services during the tax year in the rental real estate business in which they materially participate (the 750-hour test).(6)
Example 1: D, who is semiretired, works 700 hours a year in his profession. He spends another 800 hours a year related to the operation of an office building in which he is a 40% owner. Since D spends 53% (800 hours / (700 professional hours + 800 real estate hours)) of his personal service hours related to the office building, he satisfies the 50% test. In addition, by performing more than 750 hours of service related to the management and operation of the office building, he meets the 750-hour test. Because D satisfies both tests, he will be allowed to deduct a loss from the office building against his nonpassive income (e.g., professional salary, interest or dividends).
If D's professional service increases to 900 hours, he would be spending only 47% (800 / 1,7001 of his personal service hours related to the office building. Having failed the 50% test, D would no longer be an eligible taxpayer.
In applying the eligibility test, an employee's personal service is not treated as performed in a real property trade or business unless the employee is at least a 5% owner in the employer's business.7
Example 2: R is employed by a real estate business in which she owns a 1% interest. She works 2,000 hours a year for the business and has no other job. Even though R meets the 50% and 750-hour tests, she is not eligible for the passive loss exception because she is an employee who owns less than a 5% interest in the business.
Under pre-RRA law, closely held C corporations (other than personal service corporations) could offset PALS against active income, but not against portfolio income. The RRA allows eligible closely held C corporations to offset qualified rental real estate losses against portfolio income, as well as against active income. A closely held C corporation will satisfy the eligibility test if, during the tax year, more than 50% of the corporation's gross receipts were derived from a real property trade or business in which the corporation materially participated.(8)
A married couple filing a joint return will meet the eligibility requirements only if, during the tax year, one spouse separately satisfies both the 750-hour and 50% tests. However, the modification of the law does not change the current rule that participation of a taxpayer's spouse is taken into account in determining material participation.(9)
Example 3: H, who is retired, is a 30% owner of an apartment building. He spends 730 hours performing services related to the building, which is more than 50% of his personal service hours for the year. W, who is semiretired, is a 10% owner of the same apartment building, and spends 100 hours performing services related to it, which represents 40% of her personal service hours for the year. H and W are married, so that their personal service hours are combined to satisfy the material participation test. However, because neither spouse has performed more than 750 hours related to the apartment building, and they are not eligible to combine their personal service hours to meet the 750-hour test, H and W are not eligible for the special real estate passive loss exception. However, if H works 760 hours, he would be eligible, and both H and W would be eligible on their joint return.
Although each interest a taxpayer has in rental real estate is a separate activity, a taxpayer may elect to treat all interests in real estate as one activity.(10)
Example 4: S, who is retired, owns a 30% interest in two apartment buildings, A and B. He spends 700 hours, which is more than 50% of his personal service hours during the year, related to the operation of A and 200 hours related to the operation of B. For each building, S fails the 750-hour test and, thus, will not qualify for the special rental real estate treatment unless he elects to treat all of his real estate activities as one activity. If S makes this election, he will pass both the 50% and 750-hour tests, and can deduct his rental real estate losses related to both buildings from other income.
* Suspended PALS
A suspended PAL may be carried forward and deducted in the future if the taxpayer has passive income or disposes of the activity. The suspended loss from a rental real property activity that is not considered passive because of the new rule is classified as a loss from a former passive activity.(11) Thus, the deduction for the suspended PAL is limited to income from the activity and cannot offset other income.
If the taxpayer disposes of a substantial part of an activity, he may treat the interest disposed of as a separate activity, provided that he can establish the amount of gross income, deductions and credits allocable to that part of the activity for the tax year.(12) This provision allows taxpayers to claim suspended PALS even though they have not disposed of their entire interest in an activity.
In determining a taxpayer's allowable PAL, the at-risk rules are applied before the PAL rules. Generally, to the extent that the total deductions from passive activities exceed the total income from such activities for the tax year, a disallowed PAL is suspended and carried forward as a deduction from passive activity income in the next succeeding tax year. Any unused suspended PALs are allowed in full when the taxpayer disposes of his entire interest in the activity in a fully taxable transaction.(13)
* Impact on other PAL calculations
Two pre-RRA exceptions related to real estate PALS remain in effect. The first exception, under a transition rule, permits PALS from certain investments in low-income housing (placed in service before Jan. 1, 1989) to be excluded from PAL treatment for a period up to seven years from the date of the original investment.(14) This exception was not changed by the RRA.
However, the second exception, slightly modified by the RRA, allows individuals to deduct up to $25,000 of losses from real estate rental activities against active and portfolio income. The annual $25,000 deduction is reduced by 50% of the taxpayer's adjusted gross income (AGI) in excess of $100,000. For the purpose of the phaseout, AGI is determined without regard to social security benefits, U.S. savings bond income used for payment of higher education tuition and fees, and IRA deductions. Thus, the entire deduction is phased out at $150,000 of AGI.(15) In addition, any PAL allowable under the new special rental real estate loss treatment is excluded from AGI.(16) This means that taxpayers who do not qualify for special rental real estate treatment cannot offset more than $25,000 of their real estate losses against active or portfolio income.
To qualify for the $25,000 exception, a taxpayer must actively participate in the real estate rental activity, i.e., own 10% or more (in value) of all interests in the activity during the entire tax year (or shorter period during which the taxpayer held an interest in the activity).(17)
Recommendation: Once an individual who owns and participates in a rental real estate business determines that there is a potential PAL from this business, he should be sure that both the 750-hour and 50% tests are satisfied. The individual may want to consider increasing the number of hours worked that involve activities normally performed to meet the 750-hour test. The taxpayer could perform customary tasks in the current tax year that are ordinarily completed during the early part of the next tax year. If personal service hours are not sufficient to satisfy the 50% test, the taxpayer could either increase the number of hours he performs customary activities or, if possible, decrease the other personal service hours.
In addition, if a taxpayer owns and participates in several rental real estate activities, he might want to elect to treat all interests as one activity. This may be especially beneficial if either the 750-hour or 50% test cannot be satisfied for the activity in which there most likely will be a loss, but these tests can be satisfied if all of the rental real estate activities are combined. A taxpayer who cannot meet these tests even by combining all rental real estate activities should take advantage of the exception that allows a deduction of up to $25,000 of rental real estate losses against active and portfolio income.
Discharge of Real Property Business Debt
Normally, the discharge of indebtedness will result in gross income to the debtor taxpayer, unless (1) he is insolvent, (2) the debt is extinguished in a Title 1 1 bankruptcy or (3) the debt discharged is qualified farm indebtedness.(18) The RRA added one other exception: after 1992, taxpayers (other than C corporations) may elect to exclude from gross income certain income from the discharge of qualified real property business indebtedness (RPBI).(19)
* Qualified RPBI
Qualified RPBI is debt incurred or assumed by the taxpayer in connection with real property actually used in a trade or business and secured by the collateralized real property.(20) Qualified RPBI does not include qualified farm indebtedness. Generally, acquisition indebtedness is treated as qualified RPBI. Qualified acquisition indebtedness is debt incurred or assumed to acquire, construct, reconstruct or substantially improve real property.21
Nonacquisition debt generally is not qualified RPBI unless it was incurred or assumed before 1993. However, debt incurred before 1993 on qualified real property that is refinanced does not qualify to the extent it exceeds the amount of original debt being refinanced.(22)
Example 5: G owns an office building with a secured mortgage of $50,000 on Dec. 31, 1992. In january 1993, G, decides to refinance the mortgage. Because this refinanced debt had originally occurred before 1993, and the debt did not exceed the refinanced amount ($50,000), G's refinanced debt, is qualified RPBI. However, if the refinanced loan obtained on the qualified real property was $60,000, the qualified RPBI would be limited to the refinanced portion of the new mortgage [$50,000). The remaining 10, 000 would not be qualified RPBI.
* Limitations on discharge of RPBI
The amount excluded may not exceed the excess of (1) the outstanding principal amount of the debt before the discharge over (2) the fair market value (FMV) of the business real property that serves as security for the debt reduced by the outstanding principal amount of any qualified RPBI secured by the property prior to the discharge.(23)
The excluded amount of qualified RPBI cannot exceed the aggregate adjusted basis (excluding farm indebtedness) of depreciable real property held before the discharge. Aggregate adjusted basis is determined as of the first day of the next tax year, or, if the property is disposed of, on the disposition date. Depreciable real property acquired in contemplation of the debt discharge is not aggregated. Aggregate adjusted basis is determined after reduction for previous discharges because of a Title 11 bankruptcy case or an insolvent taxpayer.(24)
Example 6: J owns several buildings used in his business with adjusted bases totaling $500,000. Building A (worth $35,000, adjusted basis, $ 42,0001 is subject to a $40,000 mortgage. J is neither bankrupt nor insolvent. He agrees with A's mortgagee that in return for paying off the mortgage early, the mortgagee will cancel $7,000 of the remaining principal. J's excluded amount is limited to $5,000 ($40,000 debt before discharge -- $35,000 worth of property). The $5,000 excluded amount does not exceed $500,000, the aggregate adjusted basis of all depreciable real property held before the discharge. The remaining $2,000 ($7,000 mortgage reduction -- $5,000 allowable exclusion) is included in J's gross income.
The basis of the property secured for the debt is reduced by the allowable exclusion.(25)
Example 7: Assume the same facts as in Example 6. J's basis for A after the debt discharge is $37,000 ($42,000 adjusted basis -- $5,000 excluded amount).
For the purpose of determining the amount of Sec. 1250 recapture because of the discharge of qualified RPBI, the reduction in the basis of the property is treated as a deduction allowed for depreciation purposes. However, the determination of the amount of depreciation that would have been allowable under the straight-line method is made without any reduction for the discharge of qualified RPBI. As a result, the amount of Sec. 1250 recaptured ordinary income decreases over the time the taxpayer continues to hold the property, because the taxpayer has a reduced basis for depreciation purposes.26
The determination of whether a debt is qualified RPBI (i.e., whether the indebtedness was incurred or assumed related to real property used in a trade) is made at the partnership level--not by the individual partners. In addition, the FMV limitation is applied at the partnership level.(27)
Once the debt is determined to be qualified RPBI at the partnership level, individual partners can decide whether to elect to exclude from gross income their share of the income from the discharge of qualified RPBI.
According to the RRA House Report, each partner's share of the excluded amount of qualified RPBI is his proportionate interest in the depreciable real property held by the partnership.(28)
Example 8: ABC partnership has a $30,000 qualified excludible amount from qualified RPBI. Each partner has a one-third proportionate interest in the partnership's depreciable real property. Thus, each partner can decide to exclude $10,000 ($30,000 / 3) from income.
The depreciable basis of the real property held by the partnership must be reduced by the amount the partner(s) elect under Sec. 108(c) to exclude from income.(29)
Example 9: If partners A and B make the Sec. 108(c) election in the ABC partnership (from Example 8), ABC's basis in the depreciable real property must be reduced by $20,000 ($10,000 x 2). The RRA House Report implied that the partnership basis for the property will not be decreased for C's share unless he makes the Sec. 108(c) election.
The House Report also discussed treatment of the deemed distribution under Sec. 752 from the reduction in the partner's share of partnership liabilities resulting from the discharge of the partnership dept. The deemed distribution will require a reduction under Sec. 733 of the partner's basis in his partnership interest. The partner's share of the debt discharge income allocated to him results in his basis in the partnership being increased by the amount allocated.(30)
* S corporations
The election to exclude income from the discharge of qualified RPBI is made by the S corporation.(31) In addition, the exclusion and the basis reduction are both made at the S corporation level.32 Consequently, there is no adjustment to the shareholders' bases in their stock in the year the debt discharge income is excluded at the S corporation level.(33)
Because of the reduction in the basis of the corporation's depreciable property, S income over the remaining life of the property will increase as a result of the reduced depreciation expense. Additional income (or smaller loss) will also be recognized on the disposition of the property. The increase in the S corporation's income will flow through to the shareholders and result in an increase in the shareholders' bases as the additional income is recognized. Thus, the S corporation provision delays the recognition of income by the shareholders.(34)
Recommendation: After 1993, if there is a discharge of qualified real property debt that was incurred before 1993, the taxpayer should consider making the election to exclude part or all of the discharge from gross income. However, if this election is made, the taxpayer must reduce the basis of the property by the amount of the allowable exclusion.
Low-Income Housing Credit
The low-income housing credit has been permanently extended retroactively to after June 30, 1992. The RRA modified several provisions of the credit, to extend its application to housing units that are completely occupied by certain full-time students and to units that receive assistance under the HOME Investment Partnerships Act. Other changes allow the use of developmental and operating costs in the allocation of the credit; permit allocation between the buyer and seller in the month of disposition; and provide for penalty waivers related to tenant occupancy and income recertification. Additional changes involve tenant protection, maximum rent election and deep-rent skewing.(35)
* Full-time students
Housing units occupied entirely by full-time students after June 30, 1992 can now qualify for the low-income housing credit if the students are single parents with their children (none of whom are dependents of another individual) and married students who file a joint return.(36) The pre-RRA provisions regarding individuals enrolled in qualified job training programs or receiving Aid to Families with Dependent Children [AFDC) payments are still in effect.(37) This expanded definition of students should allow additional housing units to qualify for the credit.
* Developmental and operational costs
After June 30, 1992, the housing credit agency is required to consider the reasonableness of the developmental and operational costs of a particular project when determining the appropriate low-income housing tax credit to be allocated to that particular project.(38) However, the Conference Report indicated that this provision is not intended to create a national standard of reasonableness.(39)
* Income recertification and tenant protection The annual requirement of a third-party recertification of income of tenants in buildings entirely occupied by low-income tenants may be waived in certain situations after Aug. 10, 1993.(40) This annual verification of a tenant's or prospective tenant's income may be waived if the tenant's combined assets do not exceed $5,000 and he signs a sworn statement to that effect.41 This change in recertification requirements should reduce the operating costs of qualified buildings.
The RRA amended the provision on tenant protection. Extended low-income housing commitments must contain a provision that prohibits the refusal to lease to a holder of a voucher or certificate of eligibility under Section 8 of the Housing Act of 1937, effective Aug. 10, 1993.(42)
* HOME funds
A building will not be deemed "federally subsidized" solely because it receives HOME Investment Partnerships Act assistance if at least 40% of the residential units are occupied by qualified individuals after Aug. 10, 1993 whose income is 50% or less than the area's median gross income.(43) Under this provision, projects are eligible for the 70% or 30% credits, but not for the 91% or 39% credits.(44)
Example 10: A building located in city X receives HOME funds. X's median income is $30,000. The 10 tenants in the building have the following incomes for the year: A, $20,000; B, $12,000; C, $17,000; D, $18,000; E, $14,000; F, $16,000; G, $2 1,000; H, $1 1,000; I, $19,000; and J, $15,000. Individuals B, E, H and J are qualified because their annual income is $15,000 or less ($30,000 X 50%). As a result, at least 40% of the residents are qualified individuals. Therefore, the building will not be treated as federally subsidized and, thus, is eligible for the 70% or 30% credits.
However, if the building is located in a city with at least five boroughs and a population in excess of five million, the percentage limitation is reduced to 25% or more.(45) This change should allow more buildings to qualify for the 70% or 30% low-income housing credit.
* Special elections
Before Feb. 7, 1994, an owner of a low-income building receiving a credit allocation prior to 1990 could irrevocably elect to meet the 200% rent restriction rather than the 300% rent restriction. This election applies to both current and future tenants. However, if this election was made, the current tenants' rents may not be increased.(46)
Also prior to Feb. 7, 1994, an owner of a low-income building placed in service before 1990 could elect to determine maximum allowable rent using either apartment size or family size. The owner, however, had to agree to compliance monitoring. This election applies only to tenants first occupying a unit after the election date.(47)
The buyer and seller of a low-income building may agree to use either the mid-month convention or the exact number of days in the month of disposition to determine the division of the allowable credit.(48)
Recommendation: Individuals who will be constructing housing units near universities should consider using the low-income housing credit. To qualify, the units have to be occupied by eligible full-time students.
Low-income housing owners should keep in mind that under the RRA, their administrative expenses can now be reduced by eliminating the required annual third-party recertification of the tenants' income if the building is entirely occupied by low-income tenants whose assets do not exceed $5,000. To avoid this annual verification, the taxpayer must maintain a signed sworn statement from each tenant indicating that his assets do not exceed $5,000.
Depreciation of Nonresidential Real Property
The recovery period for depreciation of nonresidential real property, such as office buildings or manufacturing plants, has been increased from 31.5 years to 39 years for property placed in service on or after May 13, 1993.(49) This change in recovery period does not apply to nonresidential real property placed in service before 1994 if (1) there was a binding written contract to purchase or construct the property before May 13, 1993 or (2) construction of the property was started by or for the taxpayer before May 13, 1993.(50)
The Conference Report clarified that this change in recovery period does not apply for alternative minimum tax (AMT) purposes. The depreciation life for AMT purposes remains at 40 years.(51)
Recommendation: It is now more important that the taxpayer properly segregate building costs (39-year life) from costs of tangible personal property (five- or seven-year life) because of the increase in the required depreciable life of
nonresidential buildings. Proper allocation of these costs will allow for maximum depreciation deductions on tangible personal property.
The authority of state and local governments to issue QMBs has been expanded after Aug. 10, 1993 to include certain newly constructed two-family housing units. To qualify, one of the units must be occupied by the owner of the units.(52)
Previously, multi-family housing units (two to four) qualified for QMBs only if the property was first occupied at least five years before the mortgage was obtained. Now, newly constructed two-family units may qualify for QMBs if the housing units are located in a targeted area.(53) The Conference Report indicated that the target area should be in an economically distressed area.(54)
In addition, the owner's family income has to be 140% or less than the applicable area's median family income.(55) The possibility of obtaining QMBs for construction of certain two-family housing units in economically distressed areas should encourage increased construction of these units.
Generally, the RRA has substantially affected real estate owners by liberalizing the rules applicable to PALs, exclusion of income from discharge of debt, the low-income housing credit and QMBs. The changes in the PAL rules provide needed relief to real estate professionals. The permanent extension of the low-income housing credit and relaxation of the requirements should stimulate the building of additional low-income housing units. The special treatment pertaining to the discharge of qualified real estate indebtedness allows some relief for those individuals whose real estate investments have gone sour. However, the lengthening of the depreciation recovery period may discourage acquisition or construction of nonresidential real property. Finally, moderate income families in targeted economically distressed areas may be encouraged to construct two-family housing units as a result of the modifications related to the issuance of QMBs. (1) WMCP: 103-11, 103d Cong., 1st Sess. 175 (1993) (hereinafter, the "House Report"). (2) Sec. 469(c)(7)(A)(i). (3) Sec. 469(h)(1). (4) Sec. 469(h)(5). (5) Temp. Regs. Sec. 1.469-5T(f)(2). (6) Sec. 469(C)(7)(B). (7) Sec. 469(c)(7)(D)(ii). (8) Sec. 469(c)(7)(D)(i). (9) Sec. 469(c)(7)(B), flush language. (10) Sec. 469(c)(7)(A), flush language. (11) House Report, note 1, at 176. (12) Prop. Regs. Sec. 1.469-4(k). (13) House Report, note 1, at 176. (14) Section 502 of the Tax Reform Act of 1986. (15) Sec. 469(i)(3). (16) Sec. 469(i)(31(E)(iv). (17) Sec. 469(i)(6)(A). (18) Sec. 108(a)(1). (19) Sec. 108(a)(1)(D). (20) Sec. 108(c)(3). (21) Sec. 108(c)(4). (22) Sec. 108(c)(3), flush language. (23) Sec. 108(c)(2)(a. . (24) Sec. 108(c)12)(B). (25) Sec. 108(c)(1)(A). (26) House Report, note 1, at 18 7. (27) Sec. 108(d)(6). (28) House Report, note 1, at 186. (29) See. 108(c)(1)(A). (30) House Report, note 1, at 186. (31) Sec. 1363(c)(1). (32) Sec. 108(d)(7)(A). (33) Sec. 108(d)(7)(C). (34) House Report, note 1, at 187. (35) H. Rep. No. 103-213, 103d Cong., 1st Sess. 37 (1993) (hereinafter, the "Conference Report"). (36) Sec. 42(i)(3)(D)(ii). (37) Sec. 42(i)(3)(D)(i). (38) Sec. 42(m)12)(B)(iv). (39) Conference Report, note 35, at 38. (40) sec. 42(g)(8)(B). (41) Conference Report, note 35, at 37. (42) Sec. 42(h)(6)(B)(iv). (43) Sec. 42(i)(2)(E)(i). (44) House Report, note 1, at 174. (45) Sec. 42(i)(2)(E)(ii). (46) RRA Section 13142(c). (47) Id. (48) Id. (49) Sec. 168(c)(1). (50) RRA Section 13151 (b)(2). (51) Conference Report, note 35, at 54. (52) Sec. 143(k)(7), flush language. (53) Id. (54) Conference Report, note 35, at 3 1. (55) Sec. 143(i)(1)(C).
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|Author:||Sage, Lloyd G.|
|Publication:||The Tax Adviser|
|Date:||Aug 1, 1994|
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