On February 9, 2016, the US Department of Treasury released its explanation of the tax proposals in the Obama Administration's FY2017 Budget (the Green Book), including both general tax proposals and the proposals reserved for revenue-neutral business tax reform. This Alert summarizes certain provisions that are relevant to the real estate industry.

Returning proposals

Increase in capital gain tax rate

The Administration proposes to increase the highest long-term capital gains and qualified dividend tax rate from 20% to 24.2% for high-income individual taxpayers. Because the 3.8% net investment income tax would continue to apply, the maximum total capital gains and dividend tax rate, including the net investment income tax, would rise to 28%. This proposal would be effective for capital gains realized and qualified dividends received in tax years beginning after December 31, 2016.

Trigger taxable gain at death

The Administration proposes to eliminate stepped-up basis for inherited property by generally treating transfers of appreciated property by a donor or deceased owner as a sale of the property. The donor or deceased owner of an appreciated asset would realize a capital gain at the time the asset is given or bequeathed to another. Under the proposal, decedents would be allowed a $200,000 per couple ($100,000 per individual) capital gains income exclusion, as well as a $500,000 per couple ($250,000 per individual) exclusion for personal residences. The proposal also would exclude tangible personal property, except for art and similar collectibles (e.g., bequests or gifts of furniture or other household items) from capital gains income. Families that inherit small, family-owned and operated businesses would not owe tax on the gains until the assets were sold or cease to be family-owned and operated, and closely held businesses would be allowed to pay the tax on gains over 15 years. Gifts or bequests to a spouse or to charity would not be subjected to capital gain tax until the recipient disposes of the asset or dies. This proposal would be effective for gains on gifts made and of decedents dying after December 31, 2016.

"Buffett rule"

The Administration proposes to subject individuals earning over $2 million a year to a 30% minimum federal tax rate. The "fair share tax" would be phased in starting at $1 million of adjusted gross income (AGI) ($500,000 in the case of a married individual filing a separate return) and would be fully phased in at $2 million of AGI ($1 million in the case of a married individual filing a separate return)(collectively, the AGI thresholds). A charitable credit equal to 28% of itemized charitable deductions allowed after application of the overall limit on itemized deductions (i.e., the Pease limitation) would apply. This proposal would be effective for tax years beginning after December 31, 2016, with the AGI thresholds being indexed for inflation beginning after 2017.

Decrease the benefit of itemized deductions to 28%

The Administration proposes to limit the tax value of specified deductions or exclusions from AGI and all itemized deductions. This limitation would reduce the value to 28% of the specified exclusions and deductions that would otherwise reduce taxable income in the 33%, 35%, or 39.6% tax brackets. The proposal would be effective for tax years beginning after December 31, 2016.

Limit like-kind exchange rules for real and other property

Section 1031 allows taxpayers to defer gain or loss when business or investment property is exchanged for "like-kind" business or investment property. The Administration proposes to limit the amount of capital gain deferred under Section 1031 to $1 million (indexed for inflation) per taxpayer per tax year, effective for like-kind exchanges completed after December 31, 2016.

Treat accrued market discount like OID and limit the accrual amount for distressed debt

Market discount generally arises when a bond (e.g., a mortgage note) is purchased in the secondary market for a price less than its principal amount. Market discount that accrues while a taxpayer holds a bond is recognized as ordinary income as the principal payments are received and when the bond is sold.

The Administration proposes to require taxpayers to take accrued market discount into income currently. Additionally, to prevent over-accrual of market discount on distressed debt, the accrual would be limited to the greater of: (1) an amount equal to the bond's yield to maturity at issuance, plus 5%; or (2) an amount equal to the applicable federal rate, plus 10%. The proposal would apply to debt securities acquired after December 31, 2016.

Eliminate deduction for contributions of conservation easements on golf courses

The Administration proposes to prohibit a charitable contribution deduction for any contribution of a partial interest in property that is, or is intended to be, used as a golf course. The Green Book indicates that it is often difficult to value such donations and the value of the return benefits provided to the donor. Additionally, the public good may not be clear in cases of private courses or courses surrounded by luxury neighborhoods. The proposal would be effective for contributions made after the date of enactment.

Restrict deductions and harmonize the rules for contributions of conservation easements for historic preservation

The Administration proposes to disallow a charitable contribution deduction for any value of a historic preservation easement associated with forgone upward development above an historic building. The reasoning offered is that it is difficult to determine the fair market value of such easements and may lead to abuse. The proposal would be effective for contributions made after the date of enactment.

Reform and expand the low-income housing tax credit

The Administration again proposes a number of changes to the low-income housing tax credit (LIHTC) program. See Tax Alert 2015-249 for a previous discussion of these proposals.

Tax partners' carried interests as ordinary income; other partnership proposals

The Administration again has included a proposal to tax as ordinary income a partner's share of income from an "investment services partnership interest" (an ISPI), regardless of the character of the income at the partnership level, effective for tax years ending after December 31, 2016. See a forthcoming Tax Alert for further information, as well as for coverage of other partnership-related proposals to: (i) expand the definition of substantial built-in loss under Section 743(d) for purposes of partnership loss transfers; (ii) extend partnership basis limitation rules under Section 704(d) to nondeductible expenses; and (iii) repeal the technical termination rules of Section 708(b)(1)(B).

Tax gain from the sale of a partnership interest by foreign persons on a look-through basis

Capital gains of a nonresident alien individual or foreign corporation generally are subject to federal income tax only if they are effectively connected with the conduct of a trade or business in the United States (ECI). Revenue Ruling 91-32, 1991-1 C.B. 107, treats gain or loss of a nonresident alien individual or foreign corporation from the sale or exchange of a partnership interest as ECI to the extent of the partner's distributive share of unrealized gain or loss of the partnership that is attributable to ECI property.

The Green Book suggests that taxpayers are taking positions contrary to the ruling because of the absence of explicit Code authority. Thus, the Administration proposes codifying the ruling and extending its application to certain distributions. In addition, the proposal would generally require the transferee of a partnership interest to withhold up to 10% of the amount realized on the sale or exchange of a partnership interest unless the transferor certified that it was not a nonresident alien individual or foreign corporation. Failure to withhold the appropriate amount would cause the partnership to be liable for any underwithholding, to be satisfied out of future distributions otherwise available for the transferee. The provision would be effective for sales or exchanges after December 31, 2016.

Modify and permanently extend the deduction for energy-efficient commercial building property

The proposal would update the energy-efficiency standard and would increase, modify and permanently extend the current deduction for energy-efficient commercial building property to $3.00 per square foot (for certain improvements), and increase or expand other components of the credit, effective for certified improvements made after December 31, 2016.

Implications

All of the proposals described above are returning proposals from last year's budget, although there have been slight modifications to some. Two proposals from prior years budgets (the proposal to exempt certain foreign pension funds from FIRPTA and the proposal to repeal the preferential dividend rule for publicly traded REITs) are absent, as they were enacted on December 18, 2015, under the Protecting Americans from Tax Hikes Act of 2015.

All of these provisions are merely proposals at this stage of the legislative process, and the prospects for further action on the proposals are unclear at this time. taxpayers and advisors, however, will want to monitor any developments with respect to these items, and plan accordingly.

The carried interest proposal has been subject to much legislative focus in recent years, and advisors will want to pay particular attention to any developments with this proposal. The proposal to limit deferral of gain from like-kind exchanges to $1 million per year is being taken very seriously by the real estate and like-kind exchange industries.

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