How does the Taxpayer Relief Act affect real property? Relatively few of the amendments made by this summer's "Taxpayer Relief Act of 1997" expressly relate to real property. This article surveys certain provisions of the Act that expressly relate to the ownership or use of real property or are otherwise likely to affect such activities.
Capital Gain Rates. The state maximum rate of tax for individuals on capital gains recognized with respect to property held for more than 18 months has been reduced to 20%. The maximum rate on capital gains is further reduced, to 18%, with respect to gain from the sale of property which is acquired after the year 2000 and held for more than five years. The new rates do not apply with respect to gain attributable to property held for 18 months or less.
The new rates do not apply, in general, to long-term capital gains attributable to real property. To the extent of all depreciation claimed with respect to that property. Such gains will generally be taxed at a rate of 25%.
Sale Principal Residence. The longstanding "rollover" provision with respect to gain from the sale of a principal residence has been repealed, and a new provision has been added that excludes from gross income gain from the sale or exchange of property if, during the five-year period ending on the date of disposition, the property was owned and used by the taxpayer as the taxpayer's principal residence for at least two years.
Generally, the maximum amount of gain excluded under this provision with respect to a sale is $250,000. This exclusion is increased to $500,000 if (i) a husband and wife file joint return for the year of the sale; (ii) either spouse meets the two-year ownership requirement; (iii) both spouses meet the two-year use requirement; and (iv) neither spouse is ineligible for the benefits of the exclusion by reason of the separate rule for the benefits of the exclusion by reason of the separate rule that precludes the application of the exclusion to more than one sale within a two-year period (the one-sale-in-two-years rule).
An election may be made not to have the exclusion apply to a particular sale. This election may be helpful in ameliorating the impact of the one-sale-in-two-years rule.
Some sales that would have come within the old rollover rule may not qualify under the new exclusion. If a sale of a principal residence fails to meet the ownership and use tests or the one-sale-in-two-years rule, a portion of the exclusion will nonetheless apply if the sale is by reason of a change in employment, health, or, to the extent provided in regulations, "unforeseen circumstances."
Prudent homeowners will maintain records regarding improvements affecting basis, so as to minimize any gain potentially subject to tax where the new provision is not effective to shelter the entire gain.
Tenant Construction Allowances. New Code section 110, effective for leases entered into after Aug. 5, 1997, provides a safe harbor for the exclusion from a tenant's income of payments received from a lessor for the purpose of the tenant's construction of certain improvements. The safe harbor is quite narrow, however, applying only to amounts received in cash (or treated as a rent reduction) by a tenant (a) under a lease for 15 years or less of "retail space," (b) for the purpose of the tenant's constructing or improving "qualified long-term rent property" for use in the tenant's trade or business, and (c) only to the extent that such amounts do not exceed the amount expended by the tenant for such construction or improvement.
"Qualified long-term real property" is nonresidential real property which is "part of, or otherwise present at," the retail space to which the lease relates and which reverts to the landlord at the termination of the lease. "Retail space" is real property used by the tenant in selling tangible personal property or services to the general public.
Other Provisions. Many other provisions of the Act will affect investment in real estate. These provisions include changes made to the provisions relating to real estate investment trusts, or "REITs," largely with the intent of resolving certain technical issues and facilitating the continued quali fication of such entities for favorable tax treatment.
Amendments relating to partnerships include changes in the manner of allocating basis between properties distributed by a partnership and extensive changes to the partnership unit procedures.
In addition, Code section 1234A was amended to apply for the first time to rights and obligations relating to interests in real property. That section now characterizes as capital gain or loss any "[g]ain or loss attributable to the cancellation, lapse, expiration, or other termination of ... a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer..."
Section 1234A deals with a problem that arises because the Internal Revenue Code applies favorable capital gains rates only where gain is realized upon the "sale or exchange" of an asset. If a right or obligation is canceled, extinguished, or otherwise terminated, the recipient of a payment may not have a capital gain, because the right or obligation was "extinguished," not "sold or exchanged." Section 1234A reverses this result.
The one real estate case that the Congress clearly had in mind was "the tax treatment of amounts received [by a landlord] to release a lessee from a requirement [in a lease] that the premise [sic] be restored on termination of the lease." That kind of payment to a landlord will now be given capital gain treatment. The language of section 1234A may cover much more than this example, however, and is likely to engender much debate and uncertainty. For example, the amendment to section 1234A was apparently not intended to confer capital gains treatment on ordinary lease nomination payments made by a lessee to a lessor, but the language of the statute has created some uncertainty as to the treatment of such payments. Just how broadly this provision can and will be read remains to be seen.
Ronald A. Morris and Elliot Pisem, members of the New York bar, are partners in the law firm of Roberts & Holland LLP, New York City and Washington, D.C.
* State maximum rate of tax for individuals on capital gains has been reduced to 20% and has been further reduced to 18% with respect to gain from the sale of property which is acquired after the year 2000 and held for more than five years. * 'Rollover' provision has been repealed, and a new provision has been added. * New Code section 110, effective for leases entered into after Aug. 5., provides tenant construction allowances.