On March 28, 2022, the Biden Administration proposed changes to the taxation of real property.
Restrict Deferral of Gain for Like-Kind Exchanges under Section 1031
The Biden Administration has proposed to limit the gain that can be deferred under a like-kind exchange of real estate under section 1031 to $500,000/year for individual taxpayers (or $1 million/year for married individuals filing jointly).[1] Taxpayers will be required to recognize gain in excess of the $500,000/$1 million threshold in the year the real property is exchanged. The proposal does not apply to real estate investment trusts (“REITs”) or C corporations, and therefore it appears that individuals are unrestricted in their ability to benefit from like-kind exchanges through these entities.
If the proposal is enacted, one would expect to see increased use of Up-REITs, “mixing bowls”, and long-term net leases. These arrangements all allow tax-deferral while reducing a taxpayer’s economic risk in the underlying real estate. An Up-REIT is a structure under which a REIT owns a partnership that holds real property. Investors contribute appreciated property to the partnership in a tax-free exchange for a partnership interest and the ability to exchange the partnership interest for an interest in the REIT. Up-REITs allow deferral, diversification, and (for publicly-traded REITs) liquidity. In a mixing bowl transaction, a taxpayer contributes appreciated real estate to a partnership and, after a specified period of time (typically seven years), the real estate is distributed to another partner and the contributing partner retains an economic interest in the partnership’s other assets. In a long-term lease, the taxpayer locks-in a fixed economic return over a long-term period. These transactions would not be affected by the Biden Administration proposal.
Treat 100% of Depreciation Recapture on the Sale of Section 1250 Property as Ordinary Income
The Biden Administration has proposed to treat all gain on section 1250 property held for more than a year as ordinary income to the extent of cumulative depreciation deductions taken after December 31, 2022. Depreciation deductions taken on section 1250 property prior to December 31, 2022 would continue to be subject to current rules (and subject to recapture only to the extent the depreciation exceeds the amount that would be allowable under a straight-line method). Any gain on the sale of section 1250 property in excess of depreciation recapture would continue to be treated as section 1231 gain. Any unrecaptured gain on section 1250 property would continue to be taxable to noncorporate taxpayers at a maximum 25% rate.
Under current law, section 1250 requires a certain amount of the gain from the sale or disposition of certain depreciable real property used in a trade or business to be “recaptured”, or recharacterized as ordinary income, to the extent of prior depreciation deductions taken on that property.[2] For property held for one year or less, the amount of gain recaptured is all prior depreciation deductions. For property held for more than one year, the amount of gain recaptured is the amount of depreciation that exceeds the amount that would have been allowable under a straight-line method. Accordingly, only gain attributed to deductions equal to the difference between those taken under an accelerated depreciation method or bonus depreciation and those allowable under a straight-line method is recaptured and taxed at ordinary rates. This would be changed under the Biden Administration proposal. For noncorporate taxpayers, gain that is attributable to straight-line depreciation, or “unrecaptured 1250 gain,” is taxed at a maximum rate of 25%. This rule would remain under the Biden Administration proposal.
In addition, under section 1231, noncorporate taxpayers treat section 1231 losses as ordinary losses and section 1231 gain as long-term capital gain. This rule would remain under the Biden Administration proposal.
The Biden Administration proposal would not apply to noncorporate taxpayers with an adjusted taxable income below $400,000 (or $200,000 for married individuals filing separately). These income amounts would be calculated before applying the proposed 100% depreciation recapture on section 1250 property.
Under the Biden Administration proposal, flow-through entities would be required to compute the character of gains and losses on the sale or disposition of section 1250 property and report to the entity owners the amounts of ordinary income or loss, capital gain or loss, and unrecaptured section 1250 gain under both existing and proposed rules. Owners with income of at least the $400,000/$200,000 threshold amount would report tax items calculated under the proposed rules.
The proposal would be effective for depreciation deductions taken on section 1250 property in taxable years beginning after December 31, 2022, and sales or dispositions of section 1250 property completed in taxable years beginning after December 31, 2022.
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[1] All references to sections are to the Internal Revenue Code or the Treasury regulations.
[2] For this purpose, “sale or disposition” includes sale, exchange, involuntary conversion, transfer by corporation to shareholder, transfer in a sale-leaseback transaction, and transfer upon foreclosure of a security interest. Treasury regulations section 1.1250-1(a)(4).
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