2008 Federal Taxation Committee
National Association of REALTORS®
2008 Midyear Legislative Meetings & Trade Expo
Omni Shoreham
Ambassador Room, Lower Level
Wednesday, May 14, 2008
10:00 AM - 12:00 PM

Chair: Dennis Patillo, TX
Vice Chair: Mike McGrew, KS
Committee Liaison: Steve Brown, OH
Committee Executive: Linda Goold, DC

Purpose: The Federal Taxation Committee will update a variety of tax issues that remain in various stages of resolution, including mortgage cancellation, like-kind exchange, homebuyer tax credit and IRS matters.

I. Call To Order

II. Approval of Previous Meeting's Minutes

III. Unfinished Business

A. Like-kind Exchange -- Qualified Intermediary

C.A.R. Policy:  That C.A.R., in conjunction with NAR, look into the issue of accommodators/qualified intermediaries of 1031 exchanges and how to safeguard exchanging taxpayers and our industry members vis-à-vis the practice of accommodators/qualified intermediaries.

If a real estate investor utilizes a 1031 exchange, the profits from the sale of one property are directly used to purchase a second property and capital gains taxes are deferred until that property is sold. 

However, the business of 1031 exchange accommodators is largely unregulated at the federal and state levels of government with hundreds of independent exchange accommodators across the country. 

In March 2007, a Santa Barbara law firm filed a lawsuit charging two exchange accommodators, Qualified Exchange Services and Southwest Exchange, of stealing more than $95 million from 130 investors in 12 states. 

NAR is currently working with the Federation of Exchange Accommodators (FEA), which is the governing association for many of the accommodators on the issue.  The FEA is looking to tighten their regulations and set new requirements. 

B. Like-kind Exchange -- Farm Provision
Included in the Farm Bill, H.R. 2419, are provisions related to endangered species and habitat incentives.  However, also included in H.R. 2419 is section 12504, concerning like-kind exchanges of agricultural property for non-agricultural property.

This provision changes the current 1031 exchange rules and disallows an exchange of "improved real property" for "unimproved agricultural real property". While"improved" and "unimproved" are not defined by themselves, "unimproved agricultural real property" is defined as unimproved land that is used for farming (including crops, livestock, trees, and storage or handling of non manufactured farm products). 

Additionally, the owner of the unimproved land must receive payments under specified farm subsidy programs and/or utilizes the Commodity Credit Corporation loan system.

At the November 2007 NAR meetings, NAR took a position to oppose any changes that would limit the 1031 exchange provisions, including those found in section 12504.

C. Like-kind Exchange -- Tenants in Common
Tenant in Common is a form of co-ownership in real estate which, due to a 2002 IRS ruling, have increasingly been sold as private placement securities offerings.

In 2002, the IRS provided guidance on how the TIC ownership structure, which is often used by sponsors to attract investors to own a partial interest in real property, may be used in section 1031 tax deferred like kind exchanges.

Those TICs sold as securities generally meet the Supreme Court's definition of an investment contract. Though TIC securities are real estate, securities laws and regulations prohibit securities broker dealers from either directly or indirectly compensating non broker dealers.

NAR has developed a proposal being considered by the Securities and Exchange Commission (SEC) that would allow, under limited circumstances, real estate professionals to provide real estate advisory services to clients and derive an advisory fee from the sponsor. 

NAR is hopeful that the SEC will respond favorably to NAR's request to allow real estate professionals to advise on TIC securities transactions by the end of the year.

NAR has taken the policy that, "The sale of Tenant in Common interests are fundamentally real estate transactions and as such NAR believes that consumers are best served by having the opportunity to use and rely on the expertise of real estate professionals, REALTORS®, and the protections of state real estate laws.

In some instances the sale of Tenant in Common interests may also constitute the sale of securities. In such cases, securities professionals must also be involved to advise consumers on the securities issues as well as to comply with applicable state and federal securities laws."

D. Carried Interests -- Capital Gains
C.A.R. Policy:  C.A.R. took no policy at our October 2007 meetings on carried interest.  Both the taxation and the Federal Issues Committee choose not to take policy on the issue.  NAR opposes any proposal that would eliminate capital gains treatment for any carried interest of a real estate partnership.

Under most real estate partnerships when a private equity partnership is developed there are two categories of participants.  There is the general partner (GP) and the limited partner(s) (LP).  The LPs are the ones who contribute the capital to fund the projects.  The GP either puts up a small (usually 1-2%) amount of capital, or none, but handles the financial dealings of the partnership and brings their expertise and experience to the project. 

This includes finding the property, taking care of the leasing, paying the taxes, and more.  They are not simply day-to-day property managers, but handle all the financial aspects of the partnership and the property. 

When that property is sold, the profits are divided, primarily among the LPs.  However, there is a common practice in partnerships, including real estate partnerships, that gives the GP a portion of the profits.  This is separate from his annual management fee which covers his salary and overhead. 

This part of the profit is known as carried interest.  The carried interest (which can be up to 20% of the profit from the investment) is part of the setup of the partnership and is done to give the GP an incentive to push for the success of the partnership venture and is a return on their "sweat equity."
  

The House has introduced H.R. 2834, which is currently in the House Ways & Means Committee with 26 cosponsors. H.R. 2834 would eliminate taxing carried interest at capital gain rates (currently 15%) and instead tax them at the standard income rates (currently up to 35%). 

The Senate has introduced S. 1624, which is currently in the Senate Committee on Finance with four (4) cosponsors.  S. 1624 currently focuses on private equity groups and does not specifically include real estate carried interest in the language of the bill, but it is expected that this will be amended in the future to include real estate and mirror H.R. 2834.

E. Leasehold Improvements -- 15-year Life
A temporary rule permitting the cost of leasehold improvements to be recovered over 15-years has been in place since 2004 but expired as of December 31, 2007. Prior to the enactment of this provision, these costs had to be recovered over the 39-year statutory life of the underlying property, even if the lease had a substantially shorter term.

The 15-year leasehold improvement provision is included in the larger tax extenders legislation.  There is no controversy about the merits of the 15-year life for leasehold improvements or any of the other expired provisions. However, there is substantial disagreement between the House and Senate and among the two parties as to whether the extender legislation should be "paid for."
 

The House Democrats, especially the Blue Dog Democrats, want to make sure that the extenders are offset, especially the AMT provisions.  Last years AMT provisions were not offset after a showdown between the House Democrats and the Senate Republicans. 

It appears as if this showdown will continue, with the Senate Republicans refusing to offset the extenders (and the Senate Democrats requesting no offsets as they know the provisions wouldn't pass) and the House Democrats trying to hold to the fiscally responsible PAYGO rules.  The leasehold improvement extension may be caught in this legislation fight and be delayed, or potentially not passed if an agreement cannot be made.

F. Second Home "Pay-for"
During the debate on mortgage debt forgiveness, there was a discussion on modifying rules governing second homes that are converted into primary residences.  Currently, if a second home is converted to a primary residence and is used as a primary residence for at least two out of the past five years, the homeowner is allowed to use the $250,000/$500,000 capital gains exemption. 

Under the proposal, gain received once the house became a primary residence would be excluded from capital gains taxes (up to the same limits); however, it would now tax gains attributed to the time when the house was not a primary residence.  Since the proposal would not have been retroactive, any gain realized prior to 2008 is still allowed in calculating the exemption.  The new calculations will be a formula; it will be years the property was used as a primary residence (from 2008 onward) over the years the residence was owned (from 2008 onward).

It does not eliminate the capital gains exemption of $250,000/$500,000; rather it just changes the calculations to determine how much gain is exempted from capital gains taxes.  If a homeowner (assuming married) gains $1,000,000 and lives in the second home as a primary residence for 5 of the 10 years owned, they would still be allowed to exempt the entire $500,000.
 

This provision was pulled out of the mortgage debt forgiveness bill before passage.  While not included in other bills at the moment, this issue could arise again as a PAYGO offset for a future housing bill.

G. FIRPTA -- Social Security Numbers
C.A.R. Policy: In the January 2005 meetings C.A.R. adopted policy which stated, "That C.A.R. in conjunction with N.A.R., "SUPPORT legislation that would permit a seller to provide the information required by the Foreign Investment in Real Property Tax Act (FIRPTA) to escrow or another settlement provider as an alternative to providing that information to the buyer."

Over the past several years as identity theft has become more of a concern for everyone, sellers have grown increasingly uneasy with providing their taxpayer identification numbers.  The concern has become so great that some sellers are refusing to provide the required non-foreign affidavit to the buyer or are providing an affidavit with the seller's taxpayer identification number removed. 

This creates a dilemma for buyers 'who may be liable for the sellers' tax liability from the sale of the real property if they do not receive a fully completed sellers' affidavit. 

On April 17, 2007 the House passed H.R. 1677, The Taxpayer Protection Act by a vote of 407-7.  Thanks to the help and efforts of Congressman Mike Thompson (D-CA), C.A.R. and NAR were able to get FIRPTA language attached as an amendment to H.R. 1677.

C.A.R. has been working diligently with NAR and House Ways & Means staff on getting a FIRPTA fix introduced that would allow the seller to provide the non-foreign affidavit to a settlement provider instead of the buyer.  So far, H.R. 1677 has not moved in the Senate.

Additionally, the same FIRPTA amendment has been added to H.R. 5720, the "Housing Assistance Tax Act of 2008"  H.R. 5720 is the house version of housing tax legislation that is being moved by Chairman Rangel. 

IV. New Business

A. Housing Stimulus Legislation -- H.R. 3221, H.R. 5720
H.R. 3221 is the Senate housing bill, the "Foreclosure Prevention Act of 2008".  The Senate took a house passed energy bill, stripped the language, and inserted their housing bill language.  Included in H.R. 3221 is: 

• Modernization of the FHA loan program and a permanent increase in the loan limit rate to $550,000;
  
• Would allow homeowners to claim a standard property tax deduction of $500 for single filers and $1000 for married filers;
• A one-year/one-time $7,000 tax credit (to be claimed over two-years) for homebuyers who purchase a home in foreclosure;
• $4 billion in funds to help states and local governments purchase abandoned properties;
  
• Modifications to mortgage bonds to allow them to be used to refinance qualified subprime loans, up to $10 billion worth;
• Extensions of energy efficient tax credits and;
  
• A carryback tax provision that allows companies (including home builders) to apply losses in 2008 and 2009 to taxes paid in the previous four years and receive some of those paid taxes back (estimated cost of $25 billion through 2010).
  

H.R. 3221 passed the Senate on April 10, 2008 by a vote of 84-12.

H.R. 5720, the "Housing Assistance Tax Act of 2008", is one of the House's housing bills.  H.R. 5720 contains the housing tax provisions and may be incorporated into the larger housing bill being pushed by Rep. Frank.    

H.R. 5720 includes:

• A temporary increase in volume cap for low-income housing tax credit;
  
• A First-time homebuyer tax credit on principle residence of 10% of the purchase price, up to $7,500.  Income limitations apply and the capped amount is reduced by a formula when an individual makes over $70,000 AGI or a joint filer makes over $140,000 AGI;
  
  Creates a standard deduction of $350 for individual or $700 for joint filer for property taxes;
  
• Allows for $10 billion in housing mortgage bonds for state and local authorities to refinance qualified subprime loans and;
• Includes the FIRPTA fix that C.A.R. and NAR have been advocating for.
  

H.R. 5720 was marked up out of the House Ways & Means Committee on April 9, 208 by a vote of 35-5.

B. Second Homes -- Tax Court Case
MOORE V. IRS, U.S. TAX COURT, 2007: In this case there was the sale of a vacation property and it was used for a 1031 exchange.  However, the IRS disallowed the 1031 exchange because they said the vacation property did not meet the criteria to be considered an investment property (which is needed for a 1031 exchange). 

The tax court ruled in favor of the IRS and this case was the impetus for an IRS Revenue Procedure which stated what qualifications must be met for a vacation home to have safe harbor in a 1031 exchange (see next topic for further details on the safe harbor qualifications).

C. Like-kind Exchange -- Vacation Home Safe Harbor

In March 2008 the IRS released a Revenue Procedure concerning the involvement of 1031 exchanges and vacation homes.  Revenue Procedures lay out what the taxpayer must to do receive a certain result from the IRS in this case what needs to be done in order for the IRS to NOT dispute the investment nature of a taxpayer's vacation home.  This ruling was prompted by a decision last year in the U.S. Tax Court that disallowed a taxpayer's exchange from one vacation home to another; prompting the question of what has to be done to qualify a vacation home for a 1031 exchange.

First, there is a 24 month holding period whether the old property is a vacation home, the new property is going to be a vacation home, or if moving from one vacation home to another.  For each 12 month block during this period you must have rented the vacation home for at least 14 days at a fair market rent and the owner cannot use the property for the greater of 14 days or 10% of the days rented during each 12 month block.

This is a safe harbor ruling, meaning that if you can meet these requirements your exchange should not be challenged.  If you do not meet this test your exchange is not immediately denied.

However, if you do not meet these requirements your exchange will likely been scrutinized and possibly denied.

D. FIRPTA - Best Practices 

V. Adjournment