1 Computed without reference to the tax tables.

2 $1,700 or 16 percent of AGI up to $2,400 for singles and heads of households and $2,100 or 16

3 Wage or salary and/or self-employment income.

percent of AGI up to $2,800 for joints.

III. GENERAL EXPLANATION OF THE ACT

A. TAX SHELTER PROVISIONS

1. Real Estate

a. Capitalization and Amortization of Real Property Construction Period Interest and Taxes (sec. 201 of the Act and sec. 189 of the Code)

Prior law

Prior to the Act, amounts paid for interest and taxes attributable to the construction of real property were allowable as current deductions except to the extent the taxpayer elected to capitalize these items as carrying charges (sec. 266).1 If an election was made to capitalize these items, the amount capitalized was deductible over the useful life of the building. The deduction for taxes (sec. 164) includes sales and real estate taxes paid or accrued on real or personal property during the construction period. The deduction for interest during the construction period includes amounts designated as "points" or loan processing fees so long as these fees were paid by the borrower prior to the receipt of the loan funds and were not paid for specific services.2 (Generally, construction period interest is not treated as investment interest for purposes of the limitation on investment interest (sec. 163 (d)).3

Reasons for change

Prior to the Act, the tax provisions relating to real estate construction were used by taxpayers in high marginal income tax brackets to avoid payment of income tax on substantial portions of their economic income. This was principally achieved by allowing current deductions for costs which many believe are attributable to later years. For example, during the construction period the interest paid on the construction loan and the real estate taxes were immediately deducted even though there was no income from the property. These deductions resulted in losses which were used by taxpayers to offset income from other sources, such as salary and dividends. In effect, a taxpayer was allowed to defer or postpone the payment of tax on current income, either by offsetting current income with loss deductions attributable to real estate or by receiving a tax-free cash flow from the real estate

1 Interest paid or accrued during the construction period was deductible under the provisions dealing with the deductibility of interest in general (sec. 163).

2 See Rev. Rul. 68-643 (C.B. 1968-2, 76), Rev. Rul. 69-188 (C.B. 1969-1, 54) and Rev. Rul. 69-582 (C.B. 1969-2, 29).

3 Construction period interest also was not treated as a tax preference for purposes of the minimum tax in computing the preference for excess investment interest which was subject to the minimum tax until 1972 when the excess investment interest limitation provision became applicable.

project, or both. This deferral was the equivalent of an interest-free loan from the government, the economic benefits of which could be very significant.

The allowance of a deduction for construction period interest and taxes is contrary to the fundamental accounting principle of matching income and expenses. Generally, a current expense is deductible in full in the taxable year paid or incurred because it is necessary to produce income and is usually consumed in the process. However, some expenditures are made prior to the receipt of income attributable to the expenditures and, under the matching concept, these expenditures should be treated as a future expense when the income "resulting" from the expenditure is received and the original investment is gradually consumed.

In the case of an individual who constructs a building and subsequently receives income in the form of rents from that building, the accounting concept of matching income against expenses should require that the expenses incurred during the construction period be deducted against the rental income which is received over the life of the building, to the extent the expenses are attributable to a depreciable or wasting asset. The general construction costs of the building are treated this way, being capitalized and subsequently deducted as depreciation expenses. (Similarly, certain pre-opening or start-up expenses for a new trade or business are required to be capitalized for tax accounting purposes.) The interest and taxes paid during the construction period, however, were not capitalized under prior law except to the extent that the taxpayer elected to treat these items as carrying charges chargeable to capital account.

The allowance of a deduction for construction period interest and taxes contributed to the development of tax shelters in the real estate industry. Real estate ventures which were formed primarily to obtain tax shelter benefits essentially represent a misuse of intended tax incentives of longstanding and major importance. In addition, many feel that tax shelters may cause serious distortions in real estate values and construction costs, resulting in investments being made in projects that are economically unsound, and interfering with the efficient allocation of the nation's resources. Although it has been argued that the provisions of prior law providing incentives are essential to attract investment in an industry already suffering from a shortage of capital. the Congress concluded that allowing the full, immediate writeoff of construction period interest and taxes in these cases was not compatible with the objectives set out above.

As a result of the concern over the tax sheltering in real estate, the Congress decided, after a transition period, to require the capitalization of construction period interest and taxes and provide for the amortization of these items over a 10-year period, which deals directly with the preference providing the shelter while retaining some of the tax incentives for real estate investment by providing a shorter amortization period (10-years) than the useful life of the building.

Explanation of provision.

Under the Act, in the case of a taxpayer other than a corporation which is not a subchapter S corporation or a personal holding com