Chairman Dave Camp of the House Ways and Means Committee published a discussion draft of a comprehensive tax reform proposal on February 26th. The 979 page legislative draft adopts the policy strategy of broadening the tax base, while lowering income tax rates. These changes are approximately revenue neutral according to the Joint Committee on Taxation.
In practice, this approach means the elimination or modification of many deductions, credits, exemptions, exclusions and other rules in exchange for lower income tax rates. While there is approximately no net revenue change for the government and little change for average taxes paid by all income classes of taxpayers, there are many winners and losers within those classes in terms of changes in tax liability due to the many changes involved in the proposed reform.
NAHB is examining the proposal in its entirety to evaluate its impact on the housing industry, including home builders, multifamily developers, remodelers, and homeowners and homebuyers. Some changes represent negatives for housing, while others may offer benefits.
What follows is list of proposed changes to existing federal tax law that should be of interest to the greater housing and real estate industry. In the weeks ahead, we will quantify the impacts of many of these changes as part of an effort to evaluate the economic impact of the draft. For example, our next post on this tax reform draft will examine the dynamic (macroeconomic) analysis produced by the Congressional Joint Committee on Taxation, which indicates the impact of this comprehensive tax reform proposal on jobs, GDP, and the business capital stock.
Individual Taxpayer Issues and Pass Thru Entity Rules
Income Tax Rates
The existing tax rate system would be replaced with, effectively, a three tier tax rate system: 10%, 25% (beginning at $71,200 for joint returns), and 35%, which is made up of the 25% rate and a 10% surtax on AGI amounts in excess of $450,000 ($400,000 for single returns).
The 10% rate is phased out for AGI in excess of $300,000 ($250,000 for single returns).
The additional 10% surtax would allow deductions for the calculation of that excess for a number of items including charitable deductions for itemizers and “qualified domestic manufacturing income,” which includes receipts derived from construction of real property. This definition does not, however, include receipts from residential rental activity.
It is important to keep in mind that individual income tax rates are business tax rates for pass thru entities, such as S Corps and LLCs, which make up most real estate related businesses.
Capital gain and dividend income would be subject to ordinary income tax rates, although allowed an above-the-line deduction equal to 40 percent of that income. As the 3.8% net investment income tax remains in place in the draft, with the 40% exclusion, the top capital gains tax rate would be 24.8%.
Future tax bracket dollar thresholds would be determined by chained CPI, rather than CPI-U as under present law. This would reduce the inflation adjustments and lead to lower bracket thresholds in the future relative to present law.
The individual Alternative Minimum Tax is repealed.
To claim the mortgage interest deduction, taxpayers must itemize – that is, have total Schedule A deductions in excess of the standard deduction. The draft proposal would raise the standard deduction significantly to $22,000 ($11,000 for single taxpayers). However, the standard deduction is phased out for taxpayer’s with AGI in excess of $513,600 ($356,800 for singles). Such taxpayers would also have their itemized deductions phased out. This phaseout would replace the present law Pease phaseout of itemized deductions, which acts as a marginal tax rate increase.
More fundamentally, the significant increase in the standard deduction amount would reduce the number of taxpayers who itemize from 30% to approximately 5%. Due to other proposed changes, the mortgage interest deduction and the charitable deduction, which itself is proposed to be subject to a 2% AGI floor to claim the deduction in the draft, would effectively be the only remaining itemized deductions allowed for most taxpayers. For homeowners to itemize, these two sources would need to sum to an amount greater than the standard deduction.
For 2014, taxpayers may claim personal exemptions for members of their household in the amount of $3,950 per qualified person. These exemptions would be repealed and replaced by the larger standard deduction.
The child tax credit increases from $1,000 to $1,500, in part to make up for the loss of the personal exemptions for qualified children.
Mortgage Interest Deduction (MID)
The present law $1 million principal cap for a first and a second home is reduced over four years to a new cap of $500,000 (not indexed to inflation). The new cap would not apply to existing mortgages, just new purchases. Refinancings of existing mortgages would be governed by the $1 million cap, provided the refinancing did not increase the amount of principal owed. Home equity interest deductions are disallowed, although home improvement loans would continue to qualify as acquisition indebtedness, similar to present law AMT rules. Additional IRS reporting requirements would apply, including the amount of outstanding principal and the date of origination.
Real Estate Tax Deduction
The deduction for property taxes paid on owner-occupied homes would be eliminated, along with other state and local income, sales, and personal property tax deductions.
Capital Gain Exclusion for Principal Residences
For the purposes of the $500,000/$250,000 gain exclusion for the sale of principal residence, the draft extends the ownership and use period test, from two years out of five (as under present law) to five years out of eight. The exclusion can only be used once every five years. And finally, the exclusion is phased out by income dollar for dollar for AGI in excess of $500,000 ($250,000 if single).
Residential Energy Credits
The proposal would retain the sunset or eliminate all housing related energy efficiency tax credits, including the section 25C energy-efficient remodeling credit, the 25D residential power credit (for solar, wind turbines, etc, which expires at the end of 2016), the 45L $2,000 new energy-efficient home tax credit, and the 179D commercial and multifamily retrofit deduction.
Net Earnings from Self Employment and S Corps/Partnerships
Under the proposal, self employment income for FICA taxes would now include an S Corporation shareholder’s (or partnership equivalent) pro rata share of income. Individuals with no material participation would continue to exclude the income from self employment tax, with participation defined by similar rules as the tax code’s passive loss rules. All other shareholders could claim a deduction equal to a share of the income, with the share determined by the lesser of 30% of the sum of the relevant pass thru income and wages from the S Corporation or pass-thru net earnings from self employment. This share is intended to capture the historical portion of U.S. GDP due to non-labor income.
The above-the-line deduction for moving expenses, when relocating for a new job, is repealed.
Repeal of the Exception to the 10% Penalty for IRA Withdrawals
The ability to withdrawal some funds from a tax preferred retirement account for a first-time home purchase is repealed.
Corporate and Other Business Tax Reform Issues
Low Income Housing Tax Credit
The legislative draft retains the LIHTC, but makes several changes to the affordable housing credit. Credits will now be allocated by cost basis, rather than credits as under present law. Next, the 130% basis boost option is repealed. The national unused housing credit pool would be repealed. A significant change involves extending the 10 year credit claim period to 15 years, which will reduce syndicated credit prices. However, the 70% present value formulation is adjusted to remain 70% over the 15 year period. The draft repeals the 30% present value credit (the 4% credit).
Like Kind Exchanges
The nonrecognition of capital gain due to like kind exchanges is repealed for all transactions, with the exception of certain binding contracts entered into during 2014.
Private Activity Bonds
The legislative draft eliminates the tax exemption for PABs, including multifamily rental bonds and mortgage revenue bonds. The draft also eliminates the mortgage credit certificate option.
C Corporation Tax Rate
The proposal lowers the C Corp tax rate to 25% after tax year 2018. The lower rate is phased in between 2014 and 2018.
The proposal requires treating certain capital gain income due to a carried or promoted interest as ordinary income for tax purposes. However, capital gain income due to a carried interest associated with real estate (i.e. section 1231 property) retains its character as a capital gain.
Contributions of Capital
All contributions of capital are included in gross income, other than contributions of money or property for exchange of stock or interest in an entity. Under present law, contributions in aid of construction are taxable, with the exception of certain water and sewer items. Under the proposal all such contributions would become taxable.
Residential rental real estate is subject to a 27.5-year depreciation life. The proposal would extend the depreciation period for newly developed real property to 40 years. An inflation adjustment would be allowed, that would increase depreciation deductions somewhat. The Treasury Department would be instructed to develop depreciation periods for other forms of tangible property.
Completed Contract Accounting
The tax code’s long term accounting rules require use of the percentage of completion method of tax accounting for contracts lasting more than one tax year. A notable exception to this rule is the home construction contract rule, which the home building industry obtained after the 1986 reform effort to prevent builders from having to finance tax payments as part of the development process. The draft repeals this exception, but leaves in place the small construction contract exception for businesses with gross receipts of less than $10 million (three year average, not indexed for inflation).
Under the draft, 50% of advertising expenses must be capitalized and thus no longer available for immediate write off. The capitalized expense would be amortized over a ten year period. Taxpayers with less than $1 million in advertising in a given tax year would be exempt from the capitalization requirement.
Small Business Expensing
Section 179 small business expensing would be made permanent for a maximum of $250,000, which is reduced by the amount that the qualified property investment exceeds $800,000. Both amounts are indexed to inflation.
Installment tax accounting is permitted for certain dealer dispositions of timeshares and residential lots under present law. The legislative draft repeals these exceptions to the more general prohibition against installment sale accounting to report gains income.
The rule allowing brownfield expenses to be expensed would be repealed, although over a number of years.
Exit Tax (section 1250 gain)
Under the proposal, a taxpayer must recapture the gain on disposition of section 1250 property as ordinary income to the extent of earlier depreciation deductions taken. Recapture of depreciation attributable to periods before January 1, 2015, is limited to the depreciation adjustments only to the extent that they exceed the depreciation that would have been available under the straight-line method.
The tax credit for historic rehabilitation of rental properties is repealed.
The draft expands the exception to the uniform capitalization rules for certain small taxpayers. Any business that produces or acquires real or tangible property with average annual gross receipts of less than $10 million is not subject to the UNICAP rules under the proposal.
Independent Contractor Status
The proposal provides a safe harbor under which if certain requirements are met. These include a written contract and certain tax withholding.
Section 199 Domestic Production Activities Deduction
The legislative draft gradually phases out the existing deduction for domestic economic activity, including construction, with final repeal in tax year 2017. The existing deduction is equal to nine percent of qualified income.