On November 21, 2013, Senate Finance Committee Chairman Max Baucus released the third package in a series of "Staff Discussion Drafts" containing proposals to reform the tax code. This third set of proposals focuses on reforms to cost recovery and tax accounting rules. Included within those proposals are a number of provisions that could significantly impact the real estate industry.

Some of the most important provisions affecting real estate in these proposals are:

• Complete repeal of the deferral of gain for like-kind exchanges.
• Lengthening of depreciable life of real property, including residential rental and non-residential property, to 43 years for both new and prior real estate investment.
• Recapture of previously claimed depreciation deductions taxed at ordinary income rates upon sale or other disposition of real property.

PROPOSED REPEAL OF SECTION 1031

The proposed reforms to cost recovery and tax accounting rules include a proposal to repeal Section 1031 of the Internal Revenue Code (Code) in its entirety. The proposed repeal would apply to exchanges made in taxable years beginning after December 31, 2014.

Section 1031 currently allows taxpayers to defer realized gain upon disposition of real estate or other qualifying property held for productive use in a trade or business or for investment if such property is exchanged for other property of a "like-kind" that is to be held for productive use in a trade or business or for investment. The realized gain in such case is deferred, generally until the taxpayer disposes of the replacement property in a taxable transaction.

The like-kind exchange rules have existed and largely been left intact with only minor modifications over time almost since the inception of our tax system. Legislative proposals to narrow the scope of Section 1031 have been offered in the past, but previous proposals typically stopped well short of an outright repeal. Instead, past proposals generally have focused on ways to restrict the application of Section 1031. For example, a 1984 amendment to Section 1031 disallows exchanges involving partnership interests and imposes tighter rules on the timing of deferred exchanges. Subsequent proposed amendments to Section 1031 that were not enacted generally focused on certain limited aspects of Section 1031 such as the holding period requirements for relinquished and replacement property and possibly narrowing the like-kind standard (such as replacing it with the more restrictive "similar or related in service or use" standard that generally applies in the context of involuntary conversions under Section 1033).

However, more recent attention to Section 1031 from both Congress and the Administration have focused on outright repeal. In particular, the President's Economic Recovery Advisory Board issued a report in 2010 outlining some pros and cons to limiting or repealing Section 1031. In 2011, the Congressional Budget Office issued a report on spending and revenue options that included an option as part of a larger plan to raise tax rates on capital gains under which taxpayers could no longer defer gains under Section 1031. The Chairman's proposals from last month re-introduce the concept of outright repeal of Section 1031, and further provide detailed statutory provisions to modify the Code in order to accomplish the same. This provision merits careful monitoring in that it is now "on the shelf" and potentially available as a revenue-generating measure that could be considered as part of any future tax legislation.

LENGTHENING OF REAL PROPERTY COST RECOVERY PERIOD

Another one of the Chairman's proposals would extend the depreciable life of all residential rental property and nonresidential real property to 43 years. This represents a four year increase from the present 39 year cost recovery period for nonresidential property. In the case of residential rental property, the increase is a much larger 15.5 years from the 27.5 year cost recovery period under present law. In addition, the recovery period for qualified leasehold improvements also would be extended to 43 years from 15 years under current law. A further change is that land improvements such as sidewalks, driveways, parking lots, lighting, and fences would be reclassified from 15-year property under current law to 20-year property under a newly-proposed pooled asset recovery system. As under current law, cost recovery of depreciable real property basis would be under the straight-line method.

Real property that is already placed in service in a taxable year beginning prior to January 1, 2015 would still be subject to the new longer recovery period, but would be eligible for a transition rule. Thus, residential rental or non-residential real property would be affected regardless of when it was placed in service, with the remaining adjusted basis of such property to be depreciated over a term of 43 years reduced by the number of taxable years that the property has already been depreciated. The effect is that not only new, but also existing real estate investments, would have lengthened depreciation lives and, as a result, reduced annual depreciation deductions going forward if the proposal is enacted into law.

RECAPTURE OF PRIOR DEPRECIATION DEDUCTIONS TAXABLE AT ORDINARY INCOME RATES

The Chairman also proposes that upon sale or other disposition of real property, taxpayers must recapture and treat as ordinary income any gain to the extent of previously claimed depreciation or amortization deductions with respect to the property. For individuals, this represents a substantial potential increase in the rate of tax on such gain. Under current law, gain to the extent of previously claimed depreciation deductions is subject to a special 25-percent federal tax rate for individuals. However, under the Chairman's proposal, the tax rate on such gain for individuals would be increased to a person's marginal rate on ordinary income which, under current law, could be as high as 39.6 percent. This represents a potential tax increase of almost 60 percent on such gain.

The Chairman's proposals could have very significant effects on real estate owners, developers, investors, and other clients and friends in the real estate industry and beyond. BakerHostetler will continue to closely follow the track of these proposals and other developments in this area.