Tax reform standstill sweet and sour for real estate investors

New York /
Dec.December 13, 2013 03:00 PM

For one of the least productive congressional sessions in modern history, the final word about tax reform last week was entirely in character: Nothing’s happening. But is that good news or bad news for homeowners, buyers and small-scale real estate investors? A bit of both.

When House Ways and Means Committee Chairman Dave Camp, R-Mich., announced that not only will he not reveal the details of his long-awaited comprehensive tax reform bill this year but he also will not seek passage of a so-called “extenders” bill for expiring tax code benefits, it was a sweet and sour mix for real estate interests.

Camp’s big reform bill, which would attempt to lower individual and corporate income tax rates to a maximum of 25 percent, is expected to call for significant cutbacks — and possibly the elimination — of prized real estate deductions for home mortgage interest, local property taxes and other write-offs in order to pay for lower marginal rates. With major changes like these now pushed back well into 2014 for even preliminary debate — in the middle of a re-election year for Congress — homeownership advocates are at least moderately relieved.

But there’s a key negative here as well: The failure of tax writers to put together an extenders bill means that important expiring Internal Revenue Code provisions affecting large numbers of homeowners — especially relief from taxation on mortgage debt forgiveness by lenders in most states, plus current deductions for mortgage insurance premiums and energy-saving home improvements — will lapse Dec. 31. California owners are not affected by the debt forgiveness expiration because state law exempts them from taxation when lenders cancel mortgage principal debt as part of short sales. The IRS has announced that it will not levy taxes on such transactions in California even if the federal exemption for owners elsewhere expires.

Complicating matters even more: Though they were tucked away in eye-glazing discussion drafts and attracted little attention before Thanksgiving, Senate tax writers’ reform-bill proposals for real estate should be unsettling for anyone owning residential investment property, such as rental houses.

Senate Finance Committee Chairman Max Baucus, D-Mont., would terminate one of the oldest financial planning techniques used by real estate investors — tax-deferred exchanges under Section 1031 of the code. In a 1031 exchange, property owners can defer taxes indefinitely when they swap “like kind” investment real estate within specified time periods following IRS regulations. Under current law, investors can exchange rental real estate without incurring immediate tax liability — even if they’ve racked up huge paper gains on their properties. Taxes generally are not due until the investors actually sell their real estate for money.

Baucus also would sharply increase the depreciation period for residential investment real estate from the current 27.5 years to 43 years. Stretching out the depreciation schedule means investors would be able write off less per year on their properties than at present.

On top of that, the Senate reform proposal would also tax so-called “recapture” of depreciation — where the IRS requires payback of a portion of an investor’s earlier write-offs — at property owners’ ordinary income tax rates, rather than at lower capital gains rates, as at present.

Under Baucus’ plan, mom-and-pop real estate investors — people who’ve purchased a small portfolio of rental houses or condos — could be hit hard. Besides the depreciation deduction stretch-out, the inability to exchange properties tax-free for others of similar or greater value would put a severe crimp on their ability to grow and manage their investments over time.

William Horan, president of Realty Exchange Corporation of Gainesville, Va., says “if Section 1031 of the code is repealed, then small investor owners would be facing massive taxes and most likely would not sell their properties. [Real estate] values for everyone would be lowered by removing vital investors from the market.”

A more immediate concern for homeowners, however, is Congress’ inability — or unwillingness — this year to extend key tax laws. Tops on the list is the mortgage debt forgiveness law. Unless Congress agrees to a retroactive extension, large numbers of owners could face big tax bills following short sales, foreclosures or loan modifications next year when lenders cancel a portion of the balances owed them. To bring that home: A $100,000 debt cancellation could lead to $28,000 in additional taxes for a short seller — all solely because Congress could not get its act together to extend a popular, pro-consumer law.

Kenneth R. Harney is a syndicated real estate columnist.


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