Recently Enacted And/Or Proposed Tax Changes May Affect Your Real Estate Business

The recent enactment of the American Recovery and Reinvestment Act of 2009 (the "Act") likely only represents a first step with respect to changes to the tax code relevant to the real estate industry that the new administration has in store. Below are just a few examples of changes to the tax code made by the Act or currently being proposed by the Obama administration.

Cancellation of Indebtedness Income

Unless certain exceptions apply, a debtor must recognize cancellation of indebtedness income ("COD Income") when all or a portion of its debt is discharged. A debt discharge includes any repurchase of the debt by the debtor or a related person at a price less than the outstanding principal amount plus accrued but unpaid interest. Under pre-Act law, taxpayers were required to recognize the full amount of the COD Income in the year of discharge. The Act permits taxpayers to elect to defer the recognition of certain COD Income until 2014. In order to qualify for the election, the COD Income must arise from the reacquisition of business-related debt in taxable year 2009 or 2010. If the taxpayer elects to defer the COD Income, it will be recognized ratably over a five year period beginning in the year 2014. For example, a calendar-year taxpayer with a $10,000,000 business debt who pays off such debt for $6,000,000 in 2009 would report no COD Income before 2014. The $4,000,000 of COD Income would be recognized ratably each year from 2014 to 2018, inclusive (i.e., the taxpayer would report $800,000 per year for each of the tax years 2014 through 2018).

Net Operating Loss Carry Back Period

A net operating loss ("NOL") arises when a taxpayer incurs more ordinary deductions and ordinary losses than gross income. Capital losses are not taken into account in calculating a taxpayer's NOL. A taxpayer with business-related NOLs may generally carry back the loss and deduct it against any taxable income earned over the previous two tax years. If the taxpayer reported taxable net income during either of the two preceding tax years, carrying back the loss could entitle the taxpayer to a refund of some or all of the taxes paid in such years. NOLs may also be carried forward for 20 years. The Act permits any business with $15,000,000 or less in average annual gross receipts for tax years 2005-2007 to elect to extend the carry back period to five years for NOLs arising in calendar year 2008 (and NOLs arising in tax years ending in 2009 for fiscal year taxpayers). Thus, an eligible calendar-year taxpayer generating an NOL in 2008 may elect to carry back the NOL as far back as its 2003 tax year. Additionally, President Obama recently released his proposed budget for fiscal year 2010. Although the details of the proposal are unclear at this time, it appears to include an extension of this provision for NOLs incurred in 2009 and 2010.

First-Time Homebuyer Tax Credit

Taxpayers who purchase their first home in the year 2009, prior to December 1, are eligible for a $8,000 tax credit (increased from $7,500). Taxpayers are no longer required to repay the credit unless the home is resold within 36 months of the original purchase date. (On a related note, the State of California's new budget includes a state income tax credit of up to $10,000 for certain purchasers of newly-built homes.)

Carried Interests and Other Changes to Federal Tax Rates

A carried interest is a right to receive a specified share of the profits ultimately earned by a business venture without contributing a corresponding share of the venture's capital. Under current law, to the extent a partnership (including an entity taxed as a partnership, such as an LLC) earns income that is taxed at long-term capital gains rates, a partner holding a carried interest is taxed on any long-term capital gains attributable to the carried interest at long-term capital gains rates. On several occasions in the past two years, the House of Representatives has passed legislation that would recharacterize gains attributable to a carried interest as ordinary income. On each occasion, the legislation has failed to obtain sufficient support in the Senate (in part due to the threat of a Presidential veto). The President's budget for fiscal year 2010 proposes treating gains attributable to a carried interest as ordinary income. The new administration's approval of this type of legislation, together with larger Democratic majorities in the Senate, makes passage of carried interest legislation a real possibility. Therefore, federal income taxes with respect to income attributable to a partner's carried interest could increase substantially. Additionally, the President proposes to allow certain portions of the Bush tax cuts relating to high-income taxpayers to expire in 2011, which would cause the highest federal income tax-bracket to revert back to 39.6% and the capital gains rate to revert to 20%.

Home Mortgage Interest Deduction

The President's budget proposal also includes a provision which would limit the tax rate at which high-income taxpayers can take itemized deductions to 28%. In effect, this proposal would reduce the tax benefit of home ownership for high-income taxpayers. Currently, not taking phase-outs of itemized deductions into account, a high-income taxpayer receives a tax benefit of 35% on each dollar of home mortgage interest she pays. If the proposed change is enacted, the same taxpayer would receive a benefit of only 28% on each dollar of home mortgage interest paid. Therefore, the proposal could have a negative effect on prices of higher end homes.

This E-Alert is only a brief overview of certain of the recent tax proposals relevant to real estate professionals. If you are interested in learning more about these issues or interested in taking advantage of any planning opportunities that may exist, please feel free to contact any member of the Allen Matkins tax department.