pany, real property construction period interest and taxes are to be capitalized in the year in which they are paid or accrued and amortized over a 10-year period. A portion of the amount capitalized may be deducted for the taxable year in which paid or accrued. The balance must be amortized over the remaining years in the amortization period beginning with the year in which the property is ready to be placed in service or is ready to be held for sale.

The prepaid interest rules provided under the Act are to be applied first to determine the period to which the interest relates. If under that provision, interest is treated as allocable to the construction period, the 10-year amortization rule is then to apply to that portion of the interest (in effect, for the purposes of this provision the interest is treated as paid or incurred in the year to which it is allocated under the prepaid interest rules)."

Construction period interest includes interest paid or accrued on indebtedness incurred or continued to acquire, construct, or carry real property to the extent attributable to the construction period for such property. The construction period commences with the date on which the construction of a building or other improvement begins and ends on the date that the building or improvement is ready to be placed in service or is ready to be held for sale. For this purpose, the construction period is not to be considered to have commenced solely because drilling is performed to determine soil conditions, architect's sketches or plans are prepared, or a building permit is obtained. Generally the construction period will be considered to have commenced when land preparations and improvements, such as clearing, grading, excavation, and filling, are undertaken. However, the construction period will not be considered to have commenced solely because clearing or grading work is undertaken, or drainage ditches are dug, if such work is undertaken primarily for the maintenance or preservation of raw land and existing structures and is not an integral part of a plan for the construction of new or substantially renovated buildings and improvements. In the case of the demolition of existing structures where the construction period has not otherwise commenced, the construction period is considered to commence when demolition begins if the demolition is undertaken to prepare the site for construction. The construction period will not be considered to commence solely because of the demolition of existing structures if the demolition is not undertaken as part of a plan for the construction of new or substantially renovated buildings or improvements.

6

The provision is not to apply to any amount that is capitalized at the election of the taxpayer as a carrying charge (sec. 266). In addition, the provision is not to apply to interest or taxes paid or accrued

4 Since, except for subchapter S corporations and personal holding companies, this provision does not limit the deductibility of amounts paid or incurred by corporations, the provision is not to apply to corporations (other than subchapter S corporations and personal holding companies) which are partners in any partnership.

However, in any case where construction period interest is also investment interest. (ie., where the exception under sec. 163(d) (4) (D) for construction period interest does not apply), the construction period interest rules are to be applied first. Amounts allowable under the construction period rules for a taxable year are thus not to be subject to the investment interest provision until that year; if disallowed for that year unde rthe investment interest provision. these amounts can be deducted in succeeding years in accordance with the carryover rules of the investment interest provision.

For purposes of this provision the growing of trees or other crops is not to be considered an improvement in real property.

with respect to property that is not held (or will not be held) for business or investment purposes (e.g., the taxpayer's residence).

Separate transitional rules are provided for non-residential real estate, residential real estate, and government-subsidized housing. In the case of nonresidential real estate, this provision is to apply to property where the construction period begins after December 31, 1975, with respect to amounts paid or accrued in taxable years beginning after 1975. In the case of residential real estate (other than certain low-income housing), this provision is to apply to construction period interest and taxes paid or accrued in taxable years beginning after December 31, 1977, and, in the case of low-income housing, to construction period interest and taxes paid or accrued in taxable years beginning after December 31, 1981. For this purpose, low-income housing means government housing entitled to the special rules relating to recapture of depreciation (under sec. 1250 (a) (1) (B)).

In addition, the length of the amortization period is to be phased-in over a 7-year period. The amortization period is to be 4 years in the case of interest and taxes paid or accrued in the first year to which these rules apply. The amortization period increases by one year for each succeeding year after the initial effective date until the amortization period becomes 10 years (i.e., the 10-year period is fully phased-in for construction period interest and taxes paid or accrued in taxable years beginning in 1982, in the case of non-residential real estate; 1984, in the case of residential real estate; and 1988, in the case of government subsidized low-income housing). As a special transition rule for 1976 only, 50 percent of the amount paid or incurred may be deducted currently but, the remaining 50 percent is to be amortized over a 3-year period beginning in the year the property is ready to be placed in service or is ready to be held for sale.

The application of the general transitional rules and the phase-in of the amortization period can be illustrated by the following example. Assume that $120,000 of interest and taxes are paid or accrued in 1980 with respect to the construction of residential real estate (other than government subsidized low-income housing) and that the property is ready to be placed in service in 1982. For taxable year 1980, the $120,000 must be capitalized under this provision, but a deduction is to be allowed for $20,000 (% of the amount capitalized). The remaining $100,000 (i.e., 5% of the total) is to be deducted ratably over a 5year period beginning in 1982 (the year in which the property is ready to be placed in service). Thus, $20,000 is to be allowed as a deduction for taxable year 1982 and in each of the next succeeding 4 years.

In the case of a sale or exchange of real property, the unamortized balance of the construction period interest and taxes is to be added to the basis of the property for purposes of determining gain or loss on the sale or exchange. In the case of nontaxable transfer or exchange (i.e., a transfer to a partnership or controlled corporation, a like-kind exchange, or a gift), the transferor is to continue to deduct the unamortized balance allowable over the amortization period remaining after the transfer.

Effective date

In the case of nonresidential real estate, this provision is to apply only to property where the construction period begins after Decem

ber 31, 1975, and only with respect to amounts paid or accrued in taxable years beginning after 1975. In the case of residential real estate (other than certain low-income housing), this provision is to apply to construction period interest and taxes paid or accrued in taxable years beginning after December 31, 1977, and, in the case of low-income housing to construction period interest and taxes paid or accrued in taxable years beginning after December 31, 1981. In each of these cases, phase-in rules of the amortization period are provided, as indicated above.

Revenue effect

The revenue gain from this provision is estimated to be $102 million for fiscal year 1977 and $149 million for fiscal year 1981.

b. Recapture of Depreciation on Real Property (sec. 202 of the Act and sec. 1250 of the Code)

Prior law

Generally, net gains on the sale of real property used in a trade or business (with certain exceptions) are taxed as capital gains, and losses are generally treated as ordinary losses. However, gain on the sale of depreciable real property (buildings) is generally "recaptured" and taxed as ordinary income rather than capital gain to the extent that the gain represents accelerated depreciation allowed or allowable in excess of the amount computed under the straight-line method of depreciation.

The provisions relating to depreciation recapture were first enacted in 1962 to prevent deductions for accelerated depreciation from converting ordinary income into capital gain. In general, the 1962 recapture provision (sec. 1245 of the code) provided that gain on a sale of most personal property would be taxed as ordinary income to the extent of all depreciation taken on the property after December 31, 1962. In 1964, recapture rules were extended to real property (buildings) to provide, in general, that gain on a sale would be taxed as ordinary income to the extent of the depreciation (in most cases only the accelerated depreciation) taken on that property after December 31, 1963. This provision (sec. 1250 of the code), however, had a gradual reduction of the amount to be recaptured. If the property had not been held for more than 12 months, all of the depreciation was recaptured. However, if the property had been held over 12 months, only the excess depreciation over straight-line was recaptured and the amount recaptured was reduced after an initial 20-month holding period at the rate of one percent per month. Thus, after 120 months (10 years) there was no recapture of any depreciation.

In the Tax Reform Act of 1969, the recapture rules on real property were further modified as to post-1969 depreciation. In the case of residential real property and property with respect to which the rapid depreciation for rehabilitation expenditures has been allowed, post1969 depreciation in excess of straight-line was fully recaptured at ordinary income rates (to the extent of gain) if the property has been held for more than 12 months but less than 100 months (8 years and 4

7 There was no change in the rule providing for recapture of all depreciation (including straight-line) if the property is not held for more than 12 months.

months). For each month the property was held over 100 months, there was a one percent reduction in the amount of post-1969 depreciation that was recaptured. Thus, there was no recapture of any depreciation if the property was held for 200 months (16 years and 8 months). In the case of non-residential real property, all post-1969 depreciation in excess of straight-line depreciation is recaptured (to the extent there is gain) regardless of the length of time the property is held. In addition, in the case of certain Federal, State, and locally assisted housing projects constructed, reconstructed, or acquired before January 1, 1976, such as the FHA 221(d) (3) and the FHA 236 programs, the pre-1969 recapture rules on real property were retained. However, if the property was constructed, reconstructed, or acquired after December 31, 1975, the regular post-1969 rules previously discussed above with respect to residential property were to apply (i.e., a one percent reduction per month after 100 months).

Reasons for change

Generally, deductions for accelerated depreciation exceed the actual decline in the usefulness of the property. Further, accelerated methods of depreciation make it possible for taxpayers to deduct amounts in excess of the those required to service the mortgage during the early life of the property.

When the property is sold, the excess of the sales price over the adjusted basis was treated as capital gain to the extent that the recapture provisions did not apply. Under prior law, by holding residential rental property for 16 years before sale, the taxpayer could arrange to have all gain resulting from excess depreciation (which was previously offset against ordinary income) taxed at the capital gain rates without any recapture. The tax advantages for converting ordinary income into capital gain increase as the taxpayer's marginal income tax rate increases.

To reduce the opportunities to avoid income taxes as a result of allowing accelerated depreciation for real property to convert ordinary income into capital gain, the Congress decided that it is appropriate to extend the application of the present recapture rules on residential real estate. Under the Act, when residential real estate is sold, any gain will be recognized as ordinary income to the extent of accelerated depreciation previously allowed or allowable. In the case of low-income housing, however, the Congress decided that it is not desirable to require full recapture. In this way, in incentive is provided for owners of such housing to retain their ownership and operation of the properties for longer periods of time.

In addition, it came to the attention of the Congress that certain taxpayers have taken dilatory action to postpone foreclosure (or similar proceedings) on real property for the principal purpose of reducing the applicable percentage of accelerated depreciation that will be recaptured upon foreclosure (or similar proceeding). As a result of

That is, with respect to these projects, accelerated depreciation will be fully recaptured at ordinary income rates only if the property has been held for not more than 20 months. (If the property is sold within 12 months, all of the depreciation is recaptured.) For each month the property is held over 20 months, there is a 1 percent per month reduction in the amount of accelerated depreciation recaptured. Thus, there will be no recapture if the property is held for a period of 120 months (10 years).

In the case of certain Federal, State, and locally assisted housing projects constructed. reconstructed, or acquired before January 1, 1976, there will be no recapture if the property is held for 10 years before sale.

this, the Congress decided to make the recapture rules apply in the case of real property from the date foreclosure proceedings are commenced.

Explanation of provision

In the case of residential real estate (other than certain low-income rental housing), the Act provides for the complete recapture of all post-1975 depreciation in excess of straight-line depreciation. (This rule already applies in the case of nonresidential, i.e., commercial property.) As under prior law, all of the depreciation taken, including straight-line depreciation, is recaptured as ordinary income if the property is not held for more than 12 months. Under the Act, all accelerated depreciation (depreciation in excess of straight-line) attributable to periods after December 31, 1975, will be fully recaptured to the extent of any depreciation in excess of straight-line regardless of the date the property was constructed. Special rules are provided in the case where a portion of the gain from the sale or exchange of property is subject to recapture under both the former recapture rules and the new recapture rules. Under these special rules, first, accelerated special rules, first, accelerated depreciation attributable to periods after December 31, 1975, will be recaptured (to the extent of any gain); second, accelerated depreciation attributable to periods after December 31, 1969, and before January 1, 1976, will be recaptured (to the extent of any additional gain not recaptured under the new rules); and third, accelerated depreciation attributable to periods after December 31, 1963, and before January 1, 1970 (to the extent of any remaining gain not recaptured).

The new rules providing for complete recapture of accelerated depreciation do not apply to 4 categories of low-income rental housing: (1) Federally assisted housing projects with respect to which a mortgage is insured under section 221(d)(3) or 236 of the National Housing Act (or housing financed or assisted by direct loan or tax abatement under similar provisions of State or local laws); (2) lowincome rental housing held for occupancy by families or individuals eligible to receive subsidies under section 8 of the United States Housing Act of 1937, as amended, or under the provisions of State or local law authorizing similar levels of subsidy for lower income families; (3) low-income rental housing with respect to which a depreciation deduction for rehabilitation expenditures was allowed under section 167(k); and (4) Federally assisted housing with respect to which a loan is made or insured under title V of the Housing Act of 1949. As to these 4 categories of real property, all depreciation will be recaptured if the property has not been held for more than 12 months. However, if the property has been held for more than 12 months, no more than the excess depreciation over straight-time will be recaptured. For each month the property is held over 100 months, there will be a one percent per month reduction in the amount of accelerated depreciation attributable to periods after December 31, 1975, which is recaptured. Thus, after 200 months (1623 years) there will be no recapture.

Special rules similar to those discussed above are provided for Federally assisted housing projects with respect to which a mortgage is insured under section 221(d) (3) or 236 of the National Housing Act