Real Estate Tax Policy Presents Many Risks and Opportunities
(April 2011)
» Summary
» Tax Reform
» Tax Extenders
» Carried Interest
» FIRPTA Reform
» Summary (April 2011)
After enduring weakened market conditions the last three years, the commercial real estate industry is slowly recovering. Signs of stabilization are occurring across most property types as demand drives absorption. In the normally staid world of taxes, 2010 was downright tumultuous. So what lies ahead as the now-divided government takes power in 2011?
The tax legislative agenda in the 112th Congress will be driven by two factors: the historic level of the federal budget deficit and growing interest in reducing income tax rates and simplifying the Internal Revenue Code. Are we headed for two years of Clinton-like government with both sides seeking common ground in order to “get things done” . . . or two years of gridlock?
There are no crystal balls that answer that question clearly. And there are differing opinions on what course would be best for the country, and specifically for the struggling economy. Some economists make the case that a couple years of gridlock would provide some certainty and stability to a business community that has spent the last Congress bracing for the unknown with economic and tax policy used as political footballs in Washington.
A tax overhaul bill will be debated in 2011 because of the array of voices calling for it — from the President and his debt commission, to Fed Chairman Bernanke, leaders on both sides of the House and a bipartisan group of 18 Senators. However, it is not certain that this overhaul will be enacted in 2011 or 2012, due to the political implications for the 2012 elections, with some believing final enactment will come in 2013.
The President and leading members of Congress have stated that fundamental tax reform is a major policy objective for the 112th Congress. They assess that fundamental tax reform is needed to raise a large amount of additional revenue, which is necessary to reduce high forecast budget deficits and the sharply rising national debt. Congressional interest has been expressed in both a major overhaul of the U.S. tax system and the feasibility of levying additional taxes either in the form of a consumption tax or VAT. At a minimum, it appears there is a consensus to conduct a top-to-bottom review of the entire tax code, which would involve everything from individual and corporate rates, to possible elimination of the myriad assortment of tax deductions, incentives and credits.
Some argue that the tax base should be broadened by reducing or eliminating many tax expenditures. Tax expenditures are revenue losses resulting from federal tax provisions that grant special tax relief designed to encourage certain kinds of behavior by taxpayers or to aid taxpayers in special circumstances. If tax expenditures are cut substantially, or a consumption tax/VAT is levied – or both – then the marginal income tax rates could be reduced. An alternative to increasing tax revenues is cutting spending. Thus, lawmakers must consider the best mix of tax increases and spending cuts in order to reduce deficits and slow the growth of the national debt.
The agreement reached last December between the President and Congress to temporarily extend the 2001 – 2003 Bush tax cuts and business extenders took pressure off congressional tax-writers to produce a tax bill early in the session. It has also given the tax committees time to open up a robust and, very likely, a lengthy debate on fundamental tax reform. The House Ways and Means and Senate Finance committees have already begun a series of hearings on reform and what changes to the code need to be made to address the aforementioned questions.
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» Tax Reform
There has been considerable debate in recent years — within the business community, in Congress, within Treasury, and in special commissions — about the state of the U.S. corporate income tax. The President in his State of the Union address called for corporate tax reform: “In today’s high-tech, global economy that means the United States must be the best place to do business and the best place to innovate. That will take reforming our tax code, and I am calling for immediate action to rid the corporate tax code of special interest loopholes and to lower the corporate rate to restore competitiveness and encourage job creation — while not adding a dime to the deficit.”
The President’s FY 2012 budget does not include any specific proposals to achieve tax reform; however, it does include tax proposals that would increase net tax receipts by $647 billion over the next 10 years. All of these revenue raising proposals are items that proponents of tax reform would like to use to offset a reduction in the corporate tax rate.
The Congressional tax committees have embarked on what promises to be a lengthy series of hearings on tax reform. Senate Finance Chairman Max Baucus and Ways and Means Chairman Dave Camp have both vowed to look beyond the Administration’s call for corporate tax reform and examine our entire tax system. The Senate Finance Committee held it first hearing in a series of hearings on tax reform on whether the glory of the '86 Tax Act can be re-created. The '86 overhaul was possible in large part because Democrats and Republicans agreed on a revenue goal: tax reform was to be “revenue neutral,” raising neither more nor less money than the existing system. Former New Jersey Senator Bill Bradley, an early hero of the tax-reform effort, has been consulting with Treasury Secretary Timothy Geithner on the factors that led to the '86 success and the House tax committee has held its own series of hearings on individual and corporate tax reform. Camp has stated that he wanted to eliminate tax breaks and cut the top rate to 25%.
While the recommended details and methods for a fix differ, the consensus view among lawmakers and policymakers seems to be that corporate tax rates must be reduced to keep the United States competitive in the global marketplace. This agreement would suggest the possibility of beginning tax reform efforts with the corporate income tax. However, the real estate community and other companies organized as pass-through entities are paying keen attention to the recent hearings and rhetoric regarding tax reform.
Three factors could work against a corporate-tax-only reform and leave individual tax reform to another Congress. First, a significant amount of business activity in the U.S. is taxed under the individual income tax as S corporation, pass-through entity (such as partnerships), or sole proprietorship income. A corporate tax reform that resulted, even temporarily, in a corporate income tax rate dramatically lower than the top individual rate could be seen as disadvantaging these businesses and would change the relative desirability of operating in corporate form.
Second, a revenue-neutral tax reform would likely require the elimination of tax benefits that are enjoyed by both corporations and unincorporated businesses.
Third, reforming corporate taxes and lowering corporate rates while leaving individuals burdened with the uncertainty of potential tax rate increases in 2013 (when the latest extension of the Bush tax cuts is scheduled to expire) could be politically difficult.
Although the current debate over tax and spending reform will challenge Washington in ways that past legislative battles have not, the battle itself is not new. And in many ways, the parameters of this debate are not new. Pursuant to President Reagan’s instruction, the Treasury Department issued a three-volume study on tax reform that set out the arguments for and against the various alternatives. These included the tax consequences of an effort to broaden the base and lower the rate, a federal consumption tax like a VAT, a national sales tax, and a flat tax.
Thirty years later, these options continue to be discussed. The political environment, coupled with short-term and long-term deficits, have increased the magnitude of the challenge significantly. Interestingly, the other two major modern changes to the tax code — the tax increases of 1993 and the tax cuts of 2001 — were both the products of presidential campaigns. Perhaps a 2012 election fought over tax and spending reform is a necessary precursor to definitive action. Certainly, Congress will have difficulty moving major reform without the active engagement and advocacy of the executive branch.
At this stage, it is still too early to know what our tax system will look like in the future, but we know that the decisions made now will go far to determine how taxes are paid and collected for the coming generation.
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» Tax Extenders
The debate over legislation to extend expiring tax code provisions could be very different this year in that every proposed provision will likely be put through a rigorous process of review. In previous years, it was rare for any extender to be dropped from the package (in December, several extenders were dropped, a possible precursor of things to come). And while the examination of tax expenditures at least initially is linked to tax reform, the need for revenue to offset new or extended tax provisions, or to address the deficit, could also put some tax expenditures in jeopardy this year, even in the absence of reform.
Timing issues are of possible concern. While tax writers are hoping to address extenders early in the year, they will also likely be embroiled in the larger debate over tax reform. Thus it may be difficult to effectively move away from the reform debate to deal with traditional tax issues (whose enactment may be seen by some members as undermining the overall goal of fundamental reform). The tax agenda that is now coming together is challenging, and the commercial real estate community would do well to assume that every tax expenditure is on the table. In such a climate, we would need to demonstrate that particular tax preferences help advance important economic and social goals, especially job creation, and do so in a cost effective way.
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» Carried Interest
After seemingly dying down at the end of 2010, the debate over a proposed carried interest tax hike has resurfaced as part of the FY 2012 budget plan from the White House. Under the proposed budget, the tax on carried interest would be at ordinary income rates, rather than capital gain, representing a more than doubling of the current rate for most general partners. The budget proposes tax to management capital gains in an investment partnership (“carried interest”) as ordinary income.
The projected revenue loss is $14 billion over ten years, compared to $23.9 billion for the proposal in the FY 2011 budget. Specifically, taxing as ordinary income a partner’s share of income on an “investment services partnership interest” (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. The partner would have to pay self-employment taxes on such income, and gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not as capital gain (so-called “enterprise value”).
In general, an ISPI would be defined as a carried interest in an investment partnership that is held by a person who provides services to the partnership. The way the proposal is written the carried interest earned by family limited partnerships is also taxed at ordinary rates.
A change to ordinary income rates would impose a higher tax rate than legislation proposed in 2010, which generally included blended rates at either 50/50 or 75/25 (assuming an extended holding period), rather than 100% ordinary rates. That said, the prior legislative proposals were unable to get through the Senate, so this budget proposal will most likely be considered in that historical context.
Although much of the public discussion of that legislation focused on how managers of investment funds ought to be taxed on their shares of fund income, the legislation would have applied broadly to partnership interests in a wide range of industries. Moreover, the legislation would have applied to more than what are typically considered to be “carried interests” (i.e., profits interests received in exchange for risks and sweat equity). Instead, it would have applied to some partners who have contributed money or property to a partnership.
This year, with a new Congress in session, the Republican-controlled House is likely to be less amenable to increased taxes of any kind. In the Senate, where 60 votes are generally needed to pass major legislation, the new Congress has a reduced Democratic majority. This change in the composition of Congress might be expected to diminish considerably the prospects of carried interest legislation in the short term.
However, it would be a mistake, to declare the legislation dead. The legislation continues to have its supporters in Congress, and significant revenue-raising provisions are rarely forgotten when future legislation requires a revenue offset. Proponents of carried interest legislation will continue to publicly question the current treatment of carried interests in the investment management context.
But the renewed debate may be tougher to fight. House Republicans want to address the deficit. And while carried interest would be a drop in the bucket (in terms of plugging deficit holes), if Democrats agree to spending cuts within the budget debate, in return, they will seek closure of perceived loopholes as part of the bargain. Thus, The Roundtable will continue to monitor the issue as the budget or other tax vehicles that could include the CI proposal make their way through the legislative process.
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» FIRPTA Reform
The case and support for reforming the current Foreign Investment in Real Property Tax Act (FIRPTA) is strong. House and Senate members have repeatedly stated: it's timely; it's necessary; and it's the right thing to do. However, the issue is caught up in the ebb and flow of Congressional procedures. Specifically, Senators Menendez (D-NJ) and Hatch (R-UT) and their staffs are still focusing on what should be included in a possible FIRPTA reform bill and the revenue and political impacts of their inclusion. As previously reported, we are promoting two general revisions to the FIRPTA rules.
1. Reversal of the 2007 IRS ruling that treated liquidating distributions as subject to the FIRPTA tax.
2. Increase to 10% from the current law 5% limit on portfolio investors in publicly traded REITs
Also, as reported earlier, a bill introduced by Congressman Joe Crowley (D-NY) passed the House of Representatives in 2010 with 410 “yes” votes. The bill raised the amount that a foreign organization can invest in a REIT from the previous 5 percent to 10 percent, before being subject to FIRPTA. This was scored from a revenue perspective as costing the government around $900M over 10 years. Crowley found a non-controversial way to “offset” this amount.
The good news is this bill passed with a bipartisan vote of 410 in favor and no one raised the political issues of why are we benefiting foreigners at the expense of U.S. taxpayers. The bad news, since this is a new Congress, is that bill is null and void and a new bill needs to be reintroduced. In this new Congress, numerous in-depth conversations have taken place with senior Republican members of the House Ways and Means Committee, who have agreed to seriously explore the issue with the intention of introducing a bill containing the 5% exception increased to 10% and a repeal of IRS 2007-55. Congressman Joe Crowley will most likely be a cosponsor of the bill.
On the Senate side, we continue our discussions with Senators Menendez (D-NJ), Schumer (D-NY), Enzi (R-WY) and Hatch (R-Utah). The key question is how big of a FIRPTA bill to introduce. Most likely the legislation will include an increase from 5%-10%; repeal 2007-55; and possibly include a proposal addressing concerns of private REITs. All domestically controlled REITs avoid FIRPTA on sales of stock; therefore, what the private REITs care most about is that capital gains distributions not be subject to FIRPTA. Most senators on the Finance Committee agree that something should be done in regards to FIRPTA.
While FIRPTA reform promotes foreign investment, legislation has been introduced to incentivize domestic investment in real estate. HR 1147, “The Community Recovery and Enhancement (CRE) Act of 2011”, was introduced in the U.S. House by Rep. Devin Nunes (R-CA) and Rep. Shelley Berkley (D-NV). It is designed to attract new equity capital to commercial real estate, with the requirement that new funds be used to pay down outstanding debt on the asset, reducing the excessive debt ratios that threaten both the commercial real estate and banking sectors, as well as the broader economy. Similar legislation was introduced last summer but saw no action.
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The Roundtable’s Tax Policy Advisory Committee (TPAC) is working to address these issues, while exploring other modifications to the tax code that would encourage the investment in real estate.
This year TPAC is led by Frank G. Creamer, Jr. (FGC Advisors, LLC) as chairman, and Fred Witt, Jr. (Deloitte Tax LLP) as vice chairman. TPAC members are leading experts on tax issues affecting commercial and multifamily real estate, and include representatives from the major national real estate trade associations.
For additional information on TPAC issues, please contact David F. Pearce, Jr., Vice President and Counsel, The Real Estate Roundtable at (202) 639-8400.