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Weekly UpdatesINTRODUCTION
IF REAL ESTATE INVESTORS ARE TO MAXIMIZE AFTER-TAX profits and maintain appropriate levels of capital investment, they must have a working knowledge of the latest legislative changes enacted by the United States Congress that pertain to real estate. On July 30, 2008, President George W. Bush signed into law the Housing and Economic Recovery Act of 2008 (hereinafter Act). This sweeping piece of legislation contains, among other things, numerous amendments to the Internal Revenue Code. Several of the provisions of the Act have implications for real estate investors and/or real estate transactions.
The purpose of this article is to summarize the provisions of several of the important changes to the Internal Revenue Code that are now the law or that will soon become the law and that pertain to real estate transactions. Investors in real estate are urged to look closely at this tax legislation to seek ways in which they can significantly diminish their future income taxes. The following discussions focus on the major provisions of the new bill which, directly or indirectly, affect real estate transactions. Some suggestions for tax planning are also included in the discussions. To determine the particular effect, if any, each of these provisions will have on a particular investment, each investor should consult with his/her CPA, tax attorney or other tax professional.
LOW-INCOME HOUSING TAX CREDIT
The Act states that the low-income housing tax credit for new buildings placed in service after the date of enactment of this change (July 30, 2008) and before Dec. 31, 2013, shall be subject to a tax credit rate of not less than nine percent. The nine percent rate applies only to new construction and substantial rehabilitation projects that are not subsidized by the federal government. The applicable rate for new buildings that are federally subsidized or are existing buildings is four percent. The appropriate credit may be taken for 10 consecutive years on the low-income housing project. A loan including federal funds is not considered to be subsidized if the loan bears an interest rate that is at or above the prevailing Treasury interest rate.
The basis that is available for the credit is determined in three basic steps and one additional step. In step one, the eligible basis is determined. Eligible basis includes all depreciable construction costs and all depreciable "soft" costs such as architectural fees and engineering costs. Nondepreciable costs such as the cost of the land are excluded from the eligible basis. In step two, the fraction of qualified low-income housing units is determined. The applicable fraction is the lower of the percentage of low-income units to total units or the square footage occupied by low-income units out of the total square footage for the project. In step three, the basis amount that qualifies for the low-income housing credit is determined. In the additional step, the credit may be increased up to an additional 30 percent. This extra credit is only available for areas that are designated as Qualified Census Tracts (QCTs) or Difficult Development Areas (DDAs) by the U.S. Department of Housing and Urban Development (HUD). (1)
SAMPLE COMPUTATION:
A local real estate developer is proposing to build 100 rental units in Boomtown, U.S.A. The developer will not use any additional federal funds. The development will not be located in a DDA or a QCT. Forty-five percent of the units and forty percent of the square footage will be set aside for low-income households. The total development costs for the project are estimated as follows:
Generally, the value of the tax credit is calculated as follows:
* Eligible Basis = $8,000,000 (Total Development Costs - Land Cost)
* Qualified Basis = $3,200,000 (Eligible Basis x Applicable Fraction: $8,000,000 x 40%)
* Annual Credit = $288,000 ($3,200,000 x 9% Credit Rate)
* Total Amount of Housing Tax Credits = $2,880,000 ($288,000 x 10 years)
Tax Planning Tips: Since the above change is temporary and expires on Dec. 31, 2013, developers who wish to qualify for the low-income housing credit should make sure that construction projects are completed and the housing is placed in service prior to Jan. 1, 2014. Developers also should consider avoiding federally subsidized loans so that the projects qualify for the nine percent credit rather than the four percent credit.
FIRST-TIME HOMEBUYER CREDIT
The Housing and Economic Recovery Act of 2008 offers a first-time homebuyer credit. This credit is available to a first-time homebuyer of a principal residence in the United States during a taxable year. The credit is refundable in a manner similar to the earned income credit. In other words, the taxpayer will receive the credit in the form of a refund even if the tax liability for the year is zero. The credit is an amount equal to 10 percent of the purchase price of the principal residence, up to a maximum of $7,500. This credit is equivalent to an interest-free loan because taxpayers receiving the credit must repay any amount received under this provision back to the federal government over 15 years in equal installments. The provision applies to homes purchased on or after April 9, 2008, and before July 1 2009. This credit begins to phase out for taxpayers with an adjusted gross income in excess of $75,000 ($150,000 in the case of a joint return).
The repayment provision of the Act calls for repayment to begin in the second taxable year after the taxable year during which the home is purchased. For example, if the taxpayer purchases a home in 2008, the credit is allowed on the 2008 tax return, and repayment begins with the 2010 tax return. If the taxpayer sells the home prior to complete repayment of the credit, any remaining credit repayment amount is due on the tax return for the year during which the home is sold (or ceases to be used as the principal residence). No amount is recaptured after the death of a taxpayer. In the case of an involuntary conversion of the home, recapture is not accelerated if a new principal residence is acquired within a two-year period. In the case of a transfer of the residence to a spouse or to a former spouse because of divorce, the transferee spouse (and not the transferor spouse) will be responsible for any future recapture. (2)
Tax Planning Tips: An individual or married couple who has had no ownership interest in a principal residence during the three-year period ending on the date of the purchase of a principal residence will qualify as a first-time homebuyer. Also, a residence that is constructed by a taxpayer is treated as purchased by the taxpayer on the date the taxpayer first occupies the residence.
ALTERNATIVE MINIMUM TAX CHANGES
The alternative minimum tax (AMT) can increase the cost of implementing housing programs. Under current tax law, the interest on tax-exempt housing bonds is subject to the AMT. The potential taxability of this interest under the AMT limits the marketability and the incentive effect of these bonds. In addition, under current tax law, both the low-income housing tax credit and the rehabilitation tax credit (the rehabilitation credit applies to costs incurred for rehabilitation and reconstruction of historic structures and buildings built before 1936) cannot be taken as offsets against the AMT. Thus the incentive effects of these credits are limited.
The Housing and Economic Recovery Act of 2008 eliminates these impediments imposed by the AMT on housing programs. The bill would allow the low-income housing tax credit and the rehabilitation tax credit to be used to offset the AMT and would ensure that interest on tax-exempt housing bonds is not subject to the AMT. This portion of the Act applies to interest on tax-exempt housing bonds issued after the enactment date of the Act (July 30, 2008). The low-income housing credit amendment is effective for buildings placed in service after Dec. 31, 2007. The rehabilitation credit amendment is effective for qualified rehabilitation expenditures properly taken into account for periods after Dec. 31, 2007. (3)
Tax Planning Tip: Many parts of the Act are temporary and designed to help stimulate the real estate market in the short term. These AMT changes are an actual permanent repeal of the applicable provisions.
REAL ESTATE INVESTMENT TRUST REFORMS
The Housing and Economic Recovery Act of 2008 contains a number of provisions to liberalize the rules regulating real estate investment trusts (REITS). REITs are subject to several complex rules that can limit the ability of these businesses to adjust to changing market conditions and to properly manage risk. The Act relaxes these rules in several ways. (4) First, the Act shortens the prohibited transactions (i.e., a sale of property held primarily for sale to customers in the ordinary course of business, or "dealer property") safe harbor holding period from four years to two. A REIT is potentially subject to a tax equal to 100 percent of the net income derived from a prohibited transaction. Under prior law, the safe harbor rules applied to a sale of real property if, among other requirements, the REIT held the property for at least four years for the production of rental income, and the aggregate expenditures made by the REIT during the four-year period preceding the date of sale that were capital expenditures did not exceed 30 percent of the net selling price of the property. The Act shortens the minimum holding period under the safe harbor and the period during which the limit on capital expenditures applies from four years to two years. This gives REITs more flexibility to dispose of properties without risk of the 100 percent tax being imposed, provided the other requirements of the safe harbor are met. (5)
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