WARNING: NEW CAPITAL GAINS
PROVISIONS AND REAL ESTATE
PARTNERSHIPS

By Neil Tipograph, CPA, Imowitz, Koenig & Co., LLP

By now, it has become crystal clear that the Taxpayer Relief Act of 1997 (the "1997 Tax Act") provides little relief to tax professionals. The 1997 Tax Act is arguably the most complicated tax package in recent times. Nearly 1,000 IRC sections have been created or amended as a result of this legislation. The reasons behind this massive rewrite are noble--to cure faults in the tax law and foster economic development. Unfortunately, many of the changes will create unintended results for taxpayers, uncertainty for tax planners, and onerous compliance issues for tax preparers and their clients. IRC section l(h) dealing with the new maximum capital gains rate is a prime example.

Prior to the 1997 Tax Act, the capital gains rate structure was quite simple--in many cases, gains from the sale of capital assets were taxed at a single favorable tax rate. Under the new capital gains regime, transactions involving capital gains property held more than one year can be taxed under one of four rates: 10%, 20%, 25%, and 28%. Starting in the year 2001, two additional rates, 8% and 18% will apply. Three holding periods now apply: short-term, mid-term, and long-term. Various types of property are subject to special treatment such as real property, collectibles, and qualified small business stock. The calculation of the tax on capital gains is subject to separate ordering rules--one for purposes of determining whether the 10% or 20% rate applies and another for purposes of netting capital losses into capital gains. The alternative minimum tax (AMT) system now requires a special calculation for capital gains.

Tax professionals, especially those dealing in the area of real estate partnerships, will find that close inspection of the new capital gains provision uncovers a number of troubling issues. Questions arise regarding the interplay of section 1(h) with sections 751, 1245, and 1250. For example, is any portion of the gain on the sale of a partnership interest subject to the 25% capital gains rate? Furthermore, does section 1(h) override the ordinary income recapture rules of sections 1245 and 1250? The answers are not entirely clear without further guidance from Congress and the IRS.

Sale of Real Estate Used in a Trade or Business

Section 1(h)(6) provides that the portion of the gain on the sale of real estate attributable to depreciation (referred to as "unrecaptured section 1250 gain") is subject to a maximum rate of 25%. Unrecaptured section 1250 gain is the amount of long-term capital gain that would be treated as ordinary income if --

* depreciable real estate were subject to the recapture rule under section 1245 (i.e., all depreciation is recaptured); and,

* in the case of gain taken into account after July 28, 1997, only gain from depreciable real estate held for more than 18 months was taken into account. In the case of gain taken into account after May 6, 1997 and before July 29, 1997, only gain from depreciable real estate held for more than 12 months was taken into account.

The amount of unrecaptured section 1250 gain cannot exceed the amount that would be treated as section 1231 gain under prior law.

It is critical that tax professionals understand that section 1(h) deals exclusively with the capital gains rate; it does not alter sections 1245 and 1250. In terms of tax compliance, section 1(h) will cause significant changes to Schedule D, especially the capital gains tax worksheet, while Form 4797 should not be affected.

The gain from the sale of depreciable real estate held for more than 18 months (12 months, if the transitional rule applies) will be taxed in the following order:

Step 1. The gain will be subject to section 1250 recapture or section 1245 recapture. Recapture under sections
1250 and 1245 is treated as ordinary income subject to the standard tax rates;

Step 2. Gain remaining after step 1 is likewise treated as ordinary income subject to the standard tax rates to the extent of nonrecaptured section 1231 losses
for the five most recent preceding
taxable years;

Step 3. Gain remaining after step 2 is subject to the maximum 25% capital gains rate to the extent of depreciation not already subject to recapture in step 1. In many cases this portion of the gain, the unrecaptured section 1250 gain, will equal the accumulated straight-line depreciation claimed on the property; and

Step 4. Gain remaining after step 3 is subject to the maximum 20% capital
gains rate.

The language in the House's proposed Technical Corrections Acts, discussed below, clearly provides for the above
treatment.

Example 1: The Ross Partnership owns a single asset, a residential apartment building, which was purchased in December 1985 for $1,000,000 ($100,000 for the land and $900,000 for the building). The property was sold in December 1997 for $1,100,000. The partnership does not have any nonrecaptured section 1231 losses. The property was depreciated pursuant to the 19-year real property ACRS prescribed tables, and the accumulated depreciation at date of sale was $635,625. The amount of accumulated depreciation using the straight-line method was $572,211. The gain on the sale, $735,625, will flow to the partners as follows: section 1250 ordinary income recapture, $63,414 ($635,625­$572,211), and section 1231 gain, $672,211, of which $572,211 (the unrecaptured section 1250 gain which equals the accumulated straight line depreciation) will be taxed to the partners at the maximum rate of 25% and $100,000 will be taxed at the maximum rate of 20%.

Sale of a Partnership Interest--
A Potential Tax Nightmare

IRC section 741 provides that a sale or exchange of a partnership interest is treated as a disposition of a capital asset except as otherwise provided in section 751. Section 751 treats the portion of the gain or loss realized on the disposition of the partnership interest attributable to certain assets (known as section 751 assets) as ordinary income. Section 751 assets consist of unrealized receivables and inventory items of the partnership. Unrealized receivables include the amount of ordinary income that the partnership would be required to include in income under the various IRC recapture provisions including sections 1245 and 1250 if the partnership were to sell all of its assets.

Example 2: Using the facts in example 1, the Ross Partnership decides not to sell the apartment building. Instead, Rachel, a 50% partner from inception, decides to sell her partnership interest during December 1997 for $550,000. Rachel's basis in the partnership is $182,188. Under the general rule, the gain of $367,812 resulting from the disposition of the partnership interest will be treated as capital gain. However, since the partnership owns a section 751 asset (measured by the additional depreciation claimed on the apartment building), a portion of the amount realized by Rachel is attributable to the section 751 asset. Accordingly, Rachel will treat $31,707 of gain as a section 751 gain (ordinary income) and the remainder of the gain, $336,105, as a long-term capital gain. The partnership will report the sale of the partnership interest to the IRS by attaching Form 8308 to its 1997 Form 1065 and provide a copy of the form to the seller of the partnership interest.

The critical issue is determining whether any part of Rachel's capital gain is taxed at the 25% rate. In example 1, the direct sale of the property would trigger to Rachel, as a 50% partner, $31,707 of ordinary income, $286,105 of 25% capital gain income, and $50,000 of 20% capital gain income.

With respect to the gain on the sale of a partnership interest, as presently written, all gain in excess of the section 751 gain is taxed at the maximum rate of 20%. Thus the capital gain of $336,105 in Example 2 will be taxed at the maximum rate of 20%. Section l (h)(6) dealing with real estate gains as originally enacted, does not provide "look-thru" treatment with respect to the sale of a partnership interest. It should be noted that section 1(h)(5) dealing with collectible gains provides that any gain from the sale of an interest in a partnership attributable to the unrealized appreciation in the value of collectibles shall be subject to the special 28% capital gains rate applicable to collectibles.

Unfortunately for real estate owners and their tax professionals, it appears that Congress intends to bring about look-thru treatment with respect to gains on the sale of interests in partnerships with underlying real estate assets. The House version of the proposed Technical Corrections Act (H.R. 2645) apparently provides look-thru treatment for the sale of real estate partnership interests. By simply changing the term "section 1250 property" in section l(h)(6)(A)(ii) to "property," the scope of the provision is expanded to apparently include the sale of partnership interests. If this is the intention of Congress, the question is why clear language similar to the look-thru rule applied to collectible partnerships was not inserted in the provision dealing with real estate partnerships. As of the writing of this article, it remains unclear when H.R. 2645 will be enacted, and what the effective date of its amendments will be.

The problem with look-thru treatment, with respect to gains on the sale of real estate partnerships, is that such treatment raises a series of complicated issues:

1. Do new partners share in the
accumulated depreciation from the time the property is placed in service or from the time the partners enter into the
partnership?

2. How do special allocations of depreciation under sections 704(b) and 704(c) affect the allocation of gain subject to the 25% rate?

3. How do the basis adjustments pursuant to elections under sections 754 and 108(c) affect the calculation of the gain subject to the 25% rate? Likewise, how does the principle of substituted basis resulting from transactions under sections 1031 and 1033 operate within the new capital gains regime?

4. How do partnerships, especially large public partnerships, report the accumulated depreciation information to their partners?

5. Is a separate reporting of accumulated AMT depreciation required?

Treasury Regulations to the Rescue (Maybe)

The final paragraph of section l(h) authorizes the Treasury to prescribe such regulations as are appropriate in the case of sales and exchanges of interests in pass-thru entities. Therefore, it is entirely possible that the Treasury will promulgate regulations that require or clarify that gains from the sale of real estate partnership interests are subject to look-thru treatment and therefore, a portion of such gains may be subject to the 25% capital gains rate. Hopefully, such regulations will provide guidance related to the various difficult issues discussed above.