Probate & Property Magazine: March/April 2009, Vol. 23, No. 2
Real Property|Trust & Estate
Emily R. Vivian is an associate in the Dixon, Illinois, office of Ehrmann Gehlbach Badger & Lee.
On July 30, 2008, in response to rising foreclosure rates and declining house values, President Bush signed the Housing Assistance Tax Act of 2008 (the "Housing Ac") as part of the larger Housing and Economic Recovery Act of 2008, H.R. 3221, Pub. L. No. 110-289. The Housing Act provides several important tax law changes that are advantageous to individuals, including a temporary tax credit for first-time homebuyers, a new property tax deduction for people who do not itemize, and an increase in the low-income housing tax credit. At the same time, the Housing Act includes some tax provisions disadvantageous to individuals, such as a new restriction on the ability of a homeowner to exclude from income the capital gain on the sale of a principal residence.
Tax Credit for First-time Homebuyers (Housing Act § 3011)
As an incentive for people to buy instead of rent homes, the Housing Act provides that a first-time homebuyer can receive a temporary tax credit equal to 10% of the purchase price of the home, up to $7,500 ($3,750 for married persons filing separately), if purchased after April 9, 2008, and before July 1, 2009. This tax credit must be claimed on a 2008 or 2009 income tax return, and taxpayers cannot apply their credits toward their down payments. A "first-time homebuyer" is anyone who has had no ownership interest in a principal residence during the three-year period immediately before the purchase of the new home. The tax credit phases out for single taxpayers with modified adjusted gross incomes (AGI) between $75,000 and $95,000 and married couples filing jointly with modified AGI between $150,000 and $170,000. Specifically, for a single taxpayer, the taxpayer's credit is reduced by the taxpayer's modified AGI in excess of $75,000, with that result divided by $20,000. If an unmarried individual had a modified AGI of $85,000, for example, his or her credit would be reduced by 50% (($85,000–$75,000)/$20,000). Thus, this individual would receive a tax credit of $3,750.
Taxpayers who receive a credit under this provision must repay the tax credit, albeit interest-free. In essence, the tax credit is an interest-free loan from the government. Repayment of the tax credit is deferred for the first two years following the purchase of the home. After the first two years, the credit is recaptured by increasing the homeowner's taxes each year for the next 15 years by 6 ²⁄3% of the credit amount. If a taxpayer sells or otherwise disposes of his or her principal residence before the end of the repayment period, the taxpayer must pay the remaining balance in the year in which he or she disposes of the residence. The amount required to be repaid, however, cannot exceed the gain on the sale of the property. For example, suppose Taxpayer A, a first-time homebuyer, purchases a home to be used as a principal residence for $150,000 and receives a credit of $7,500. A few years later, Taxpayer A sells his principal residence for $154,000. In this example, Taxpayer A has only repaid $1,500 of his tax credit and still owes $6,000. Because Taxpayer A's gain on the sale of his principal residence is only $4,000, Taxpayer A will be required to pay only $4,000 to the U.S. Treasury; $2,000 of his "tax credit loan" is forgiven.
The Housing Act also provides that, if the person who received the tax credit dies before the tax credit is repaid, the IRS will disregard the remaining balance owed. Other exceptions exist for involuntary conversions, transfers between spouses, and transfers incident to divorce.
New Property Tax Deduction for Non-itemizers (Housing Act § 3012)
Under the Housing Act, individuals who do not itemize (that is, those who use the standard deduction) may increase this deduction for state and local real property taxes. A non-itemizer's standard deduction will be increased by the lesser of (1) the amount of real property taxes paid during the year or (2) $500 ($1,000 for married couples filing jointly). Before the enactment of the Housing Act, only individuals who itemized their deductions were entitled to deduct their real property taxes. The new deduction under the Housing Act is available only for the 2008 tax year. Beginning in 2009, individuals who do not itemize will again be unable to deduct real property taxes.
New Restriction on Exclusions of Gain from Home Sales(Housing Act § 3092)
One of the most disadvantageous provisions in the Housing Act is the new restriction on the exclusion of gain from home sales. Under current law, a taxpayer can exclude up to $250,000 in gain ($500,000 for married couples) from the sale of a residence if the taxpayer has both owned and used the home as the taxpayer's principal residence for at least two of the five years before the sale. Thus, a taxpayer could move into a nonqualifying property (in other words, a vacation or rental property) and, after meeting the two-year residence requirement, sell the property and take advantage of the entire exclusion.
The new restriction is intended to substantially restrict tax-free home sale gains for any taxpayer who benefits from the exclusion after he or she has converted a vacation home or rental property to his or her principal residence. After December 31, 2008, gain from the sale of a principal residence will not be excluded from income to the extent the property was used for a nonqualified use, as defined under Code § 121(b)(4), as amended by Housing Act § 3092. This new restriction only applies to nonqualified uses occurring after December 31, 2008. A nonqualifed use consists of any period, beginning after December 31, 2008, in which the property is not used as the principal residence of the taxpayer.
To calculate the amount of gain that is allocated to periods of nonqualified use, the total amount of gain is multiplied by the following fraction: the aggregate periods of nonqualified use while the property was owned by the taxpayer divided by the period the taxpayer owned the property. Nonqualified use, however, does not include any portion of the five-year period that occurs after the last date the property is used as the principal residence of the taxpayer. For example, suppose John buys a home on January 1, 2009, for $400,000 and uses it as rental property for two years, claiming $20,000 of depreciation. On January 1, 2011, John begins using the property as his principal residence. On January 1, 2013, John moves out of the house and sells it for $700,000 on January 1, 2014. John used the property for a nonqualifying use for the first two years he owned it. The year after John moved out, however, is treated as a qualifying use. Therefore, 40% (two out of five years owned), or $120,000, of John's $300,000 gain is not eligible for the exclusion. The balance of the gain, $180,000, may be excluded. In addition, John must include $20,000 of the gain attributable to depreciation as ordinary income (unrecaptured Code § 1250 gain).
Nonqualified use also does not include any period during which the taxpayer or the taxpayer's spouse is serving on qualified official extended duty (not to exceed an aggregate period of 10 years), nor does it include any other period of temporary absence because of change of employment, health conditions, or other unforeseen circumstances as may be specified by the IRS (not to exceed an aggregate period of two years).
The Housing Act is intended to restrict gain exclusion when property is transferred from a nonqualifying use to a principal residence, so the new provisions do not restrict gain exclusion when property is transferred from a principal residence to a nonqualifying use. Again, this provision only applies to nonqualified uses beginning January 1, 2009.
Increase in the Low Income Housing Tax Credit (Housing Act § 3001)
The Low Income Housing Tax Credit (LIHTC) was established under the Tax Reform Act of 1986. The LIHTC program provides incentives in the form of tax credits to private investors that develop affordable rental housing for low-income households. If a project is determined to be "qualified," the developer is awarded federal housing tax credits. To raise capital or equity for the project, the developer sells these tax credits to investors. As a result, the availability of tax credits reduces the developer's actual costs, facilitating the development of affordable housing for low-income families. The tax credit is then claimed over 10 years. Under Housing Act § 3001, the ceiling for each state's housing credit increases to $2.20 per state resident for the years 2008 and 2009, an increase of $0.20 per resident. The minimum annual cap also is increased for certain small population states by 10%. In 2010, however, the limits will revert to the previous levels, as this provision sunsets. Although several other amendments were made to the LIHTC program in an attempt to simplify many of its provisions, a full discussion of such amendments is beyond the scope of this article.
Modifications to the Tax-exempt Housing Bond Rules (Housing Act § 3007)
Several changes were made to help simplify and clarify the rules regarding tax-exempt housing bonds. State and local governments issue tax-exempt housing bonds to fund affordable housing projects. The interest earned on these housing bonds is exempt from federal income taxation but the interest may be subject to state income tax. Many of the simplifications under Housing Act § 3007 were designed to parallel the rules surrounding the LIHTC.
Election to Accelerate AMT and Research Credits in Lieu of Bonus Depreciation (Housing Act § 3081)
Under the Economic Stimulus Act of 2008, Pub. L. No. 110-185, corporations can receive an additional 50% bonus depreciation for qualified property placed in service in 2008. Under Housing Act § 3081, corporations can elect to forego the bonus depreciation. Instead, they can use accumulated alternative minimum tax (AMT) and research and development credits equal to 20% of the difference between the aggregate depreciation that would have been allowed if the 50% bonus deduction was being claimed and the aggregate depreciation that will be taken without the 50% bonus deduction being claimed. The amount of bonus depreciation for any taxable year, however, cannot exceed the lesser of $30 million or 6% of (1) the business credit increase amount, plus (2) the AMT credit increase amount, less (3) the bonus depreciation amounts for all preceding taxable years. This provision applies to taxable years ending after March 31, 2008.
Reforms Related to Real Estate Investment Trusts (Housing Act §§ 3031, 3032, and 3033)
A real estate investment trust (REIT) is a corporation that invests in real estate and elects to be taxed as a REIT under special rules rather than as a corporation. To qualify as a REIT, a corporation must meet stringent requirements. See 26 U.S.C. § 856. A REIT must be jointly owned by no fewer than 100 persons, and no more than 50% of the REIT interests can be held by five or fewer individuals. Id. §§ 856(a), (h), 542(a)(2). In addition, at least 75% of a REIT's total investment assets must be real estate. Id. § 856(c)(4). Moreover, a REIT must distribute at least 90% of its income annually. Id. § 857(a)(1). It must have at least 95% of its income derived from real-estate related income described in Code § 856(c)(2), including dividends, interest, and property income, and have at least 75% of its gross income derived from the types of income described in Code § 856(c)(3), including rents, mortgage interest, and gains from the sale of real property. Id. § 856(c). Although Code § 856(c) does not specifically include foreign currency gains, the Housing Act clarifies the ability of a REIT to treat foreign exchange gains attributable to foreign real estate investments as qualifying REIT income.
In addition, Housing Act § 3041 increases from 20% to 25% the percentage of REIT assets that can be represented by securities of a taxable REIT subsidiary.
If a REIT derives net income from a prohibited transaction, it is subject to a tax equal to 100% of the net income. The Internal Revenue Code contains a safe harbor rule, which provides that sale of property that has been held by a REIT for two years (previously four years) will not constitute a prohibited transaction.
The Housing Act was passed with the intent of improving the rapidly declining real estate market. It offers some temporary tax advantages for homebuyers and homeowners but also contains a new restriction on the capital gains exclusion that could be disadvantageous for some homeowners. Now, however, in addition to rising foreclosure rates and declining real estate values, legislatures confront additional challenges. As demonstrated by substantial daily fluctuations in the stock market, our country is facing an economic crisis. Whether or not these changes in the Housing Act help address this crisis remains to be seen.Return To Issue Index