September 2, 2010
Presidential Advisory Panel Releases Report with Tax Reform Options - Some Options Offered of Interest to Real Estate and REITsReport and Options Do Not Represent Administration PolicyHighlights Executive SummaryOn August 27, the President's Economic Recovery Advisory Board (PERAB) released a report (PERAB Report) that outlines the pros and cons of options for changes in the current income tax system to achieve three broad goals: simplification; improvement in compliance; and reform of the corporate tax system. BackgroundHeaded by former Federal Reserve Chairman Paul Volcker, the PERAB was given a limited mandate. While the options it proposes were meant to achieve the three goals noted above, it specifically was not tasked with recommending "major overarching tax reform" such as the 1986 tax reforms; the reforms outlined by the Bush Tax Reform Panel; or a value-added tax in addition to or in lieu of the current income tax system. Furthermore, the PERAB was asked to exclude options that would raise taxes for families with incomes less than $250,000 per year. Finally, as the PERAB Report emphasizes, the Report "does not represent Administration policy... [It] is meant to provide helpful advice to the Administration as it considers options for tax reform in the future."[1] Significant Real Estate-Related ProposalsCorporate Tax Reform
Report at p. 65. In order to eliminate these perceived inefficiencies, the PERAB Report offers a number of options. In one group of options, the Report suggests broadening the corporate tax base by: i) requiring firms with certain "corporate" characteristics to pay the corporate income tax; ii) limiting the deductibility of net interest expense; and/or, iii) limiting so-called "tax expenditures," those specific deductions and credits that "substantially" narrow the business tax base (e.g., research and experimentation tax credit, low-income housing tax credit, accelerated depreciation, exemption of credit union income from gross income, etc.). None of these proposals mentions REITs or the dividends paid deduction (DPD) specifically. In another group of options, the Report proposes reducing the marginal corporate income tax rate by: i) reducing the top corporate income tax rate; and/or, ii) increasing the immediate expensing permitted for new investments. The most relevant of these options are discussed below. Impose Corporate Income Tax on "Corporate"-Like Entities The PERAB Report indicates that the growth of non-corporate businesses (which it describes as "non-C corporations"), including partnerships, limited liability companies (LLCs), S corporations, and other pass-through entities, is a factor that has contributed to the erosion of the corporate income tax base. The PERAB believes a reasonable tax reform goal in this area could be "tax neutrality with respect to organizational form." The Report then suggests several ways to achieve this neutrality.
Limit Deductibility of Net Interest In order to achieve a goal of broadening the corporate tax base, the PERAB Report provides an option limiting the deductibility of net interest (i.e., the excess of interest expense over interest income), such as by limiting deductibility of net interest to 90% of expense in excess of $5 million of expense per year (the first $5 million would be fully deductible). Current law encourages debt because interest is deductible while generally dividends are not. Limiting interest expense would reduce the disincentive against equity financing and could lead to reduced debt dependence as well as the chances of future financial distress. It also could create a more level playing field between those business projects that have easy access to debt financing and those that do not. With respect to REITs, this proposal could have advantages and disadvantages. If enacted, it could encourage increased equity investment to REITs. On the other hand, the proposal could result in limiting interest deductions by taxable REIT subsidiaries, thereby increasing their corporate tax liability. Increase Immediate Expensing for New Investment As a means of reducing the effective corporate tax rate, the PERAB Report provides an option with respect to the immediate expensing (deducting) of new investment. The Report notes that doing so could provide more investment per dollar of tax revenue lost than merely cutting the corporate tax rate because existing capital would not receive the "tax break." Immediate expensing also would put investments in physical capital, normally deducted over many years, on par with investments in certain intangible capital, which are deductible immediately. While in some sense REITs and the larger real estate industry could benefit from increased depreciation deductions, the PERAB Report does note some disadvantages to this proposal. For example, it notes first that it could benefit some capital-intensive industries over other industries that invest more in intangible assets. Increased expensing for new investment also would cause a reduction in value in older investments that would not benefit from expensing. Further, if the deductibility of interest expense remains unchanged, immediate expensing of new investment could maintain or even increase the incentives for debt financing. Of course, there are significant transition issues involved with respect to such an approach, especially with respect to old vs. new assets. Simplification of Capital Gains Taxation and Reform of Depreciation Recapture The PERAB Report contains a detailed discussion regarding the complexity applicable to the current taxation of capital gains, particularly relating to the various tax rates that apply to capital gains. For example, a maximum rate of 28% applies to gains from collectibles and sales of certain small business stock. On the other hand, real estate depreciation recapture under Section 1250 of the Internal Revenue Code is taxed at a maximum capital gains rate of 25%. Finally, the current law maximum tax rate for other capital gains is generally 15%, but is due to increase to 20% in 2011. Furthermore, the Report also mentions current law's complexity involving like-kind exchanges under Section 1031 of the Internal Revenue Code, including deferred exchanges through intermediaries. It states "[m]ost transactions that occur under Section 1031 only loosely resemble an exchange and instead effectively confer rollover treatment on a wide range of business property and investments. Rollover treatment is conferred only if the taxpayer complies with a series of complicated rules, and there is much uncertainty surrounding these transactions." [4] Harmonize 25% and 28% Capital Gains Rates The Report provides an option that would either tax Section 1250 recapture and collectibles at ordinary tax rates or tax them both at 25%, 28%, or at a rate between the 25% and 28%. The Report notes that eliminating or raising these "preferential" rates would disadvantage real estate held for investment. The argument for taxing Section 1250 recapture at a rate greater than that applicable to non-recaptured capital gain is that the relevant depreciation deductions reduced the tax applicable to income taxed at ordinary income tax rates. On other hand, a good argument can be made that existing depreciation useful lives are far in excess of many properties' true useful lives, and taxing Section 1250 gain at lower than ordinary income rates provides some recompense. Limit or Repeal Section 1031 Like-Kind Exchanges The Report contains a wide variety of options for reforming the taxation of like-kind exchanges. First, it provides an option to tighten the eligibility for Section 1031 treatment. Alternatively, it proffers disallowance of the deferral of gain from like-kind exchanges entirely. Finally, it opens the door to treating developed property and undeveloped property as separate property classes, thereby prohibiting the rollover of developed property into undeveloped property from qualifying as a like-kind exchange. The Report acknowledges that these proposals would raise tax rates on real property, and that current law provides "an escape valve" for the 35% corporate capital gains rate. If the like-kind exchange rules were limited, there would be additional pressure to lower the corporate tax rate as well as additional revenue to assist in doing so. Note that in 1989 the House of Representatives approved legislation to limit deferrals under Section 1031 to exchanges of properties that are "similar or related in services or use," but the limitation was not ultimately enacted.CLICK HERE to read the 1989 Conference Report.
Next StepsAs noted above, the PERAB Report does not reflect Administration policy. The PERAB also operated under constraints which do not apply to the Administration or to Congress. If you have any questions or thoughts about these issues, please contact Tony Edwards at tedwards@nareit.com or Dara Bernstein at dbernstein@nareit.com. |
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