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(or housing financed or assisted by direct loan or tax abatement under similar provisions of State or local laws) where a portion of the gain from the sale or exchange of such property is subject to recapture under both the prior recapture rules and the new recapture rules.

In addition, the Act provides that where real property is disposed of by reason of foreclosure or similar proceedings, the monthly percentage reduction of the amount of accelerated depreciation subject to recapture are to terminate as of the date on which such proceedings were begun. The application of this provision can be illustrated by the following example:

Example.-Assume that on June 1, 1976, the taxpayer acquired certain low-income rental property which qualified for the special recapture treatment discussed above (i.e., a one percent per month reduction after 100 months). On April 1, 1987 (130 months after the property was placed in service) foreclosure proceedings were instituted with respect to the property and on December 1, 1988 (150 months after the property was placed in service) the property was disposed of pursuant to the foreclosure proceedings. The applicable percentage reduction will be 30 percent rather than 50 percent since the percentage reduction would cease to apply on April 1, 1987 (the date that foreclosure proceedings were instituted).

Effective date

The provisions relating to the complete recapture of depreciation apply to accelerated depreciation attributable to taxable years beginning after December 31, 1975. The provisions relating to the percentage reduction in the case of dispositions pursuant to foreclosure or similar proceedings shall apply with respect to proceedings which begin after December 31, 1975.

Revenue effect

It is estimated that this provision will result in an increase in budget receipts of $9 million for fiscal year 1977, and $56 million for 1981. c. Five-Year Amortization for Low-Income Rental Housing (sec. 203 of the Act and sec. 167 of the Code)

Prior law

Under the code, special depreciation rules are provided for expenditures to rehabilitate low income rental housing (sec. 167 (k) of the code). Low-income rental housing includes buildings or other structures that are used to provide living accommodations for families and individuals of low or moderate income. Under current Treasury regulations occupants of a dwelling unit are considered families and individuals of low or moderate income only if their adjusted income does not exceed 90 percent of the income limits described by the Secretary of Housing and Urban Development (HUD) for occupants of projects financed with certain mortgages insured by the Federal Government. The level of eligible income varies according to geographical

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Under the special depreciation rules for low income rental property, taxpayers can elect to compute depreciation on certain rehabilitation

10 The current income limits prescribed by the Secretary of HUD for a family of four are $15,400 in Washington, D.C., $13,700 in Chicago, and $11,900 in Los Angeles. Thus, 90 percent of these limits are $13,800, $12,330, and $10,710 respectively.

expenditures under a straight-line method over a period of 60 months if the additions or improvements have a useful life of 5 years or more. Under prior law, only the aggregate rehabilitation expenditures as to any housing which do not exceed $15,000 per dwelling unit qualified for the 60-month depreciation. In addition, for the 60-month depreciation to be available, the sum of the rehabilitation expenditures for two consecutive taxable years-including the taxable year-must exceed $3,000 per dwelling unit.

Reasons for change

In the Housing and Community Development Act of 1974, the Congress expressed its desire to stimulate construction in low-income rental housing to eliminate the shortage in the area. However, the special tax incentive for rehabilitation expenditures for low-income rental housing under present law expired on December 31, 1975. Without this incentive the remodeling of many high-risk low-income projects would have been curtailed. In order to avoid discouraging this rehabilitation, the Congress believed that the special depreciation provision for low-income housing should be extended.

Explanation of provision

The Act provides a two-year extension of the special 5-year depreciation rule for expenditures to rehabilitate low-income rental housing and increases the amount of rehabilitation expenditures that can be taken into account per dwelling unit from $15,000 to $20,000.

Under the Act, rehabilitation expenditures that are made pursuant to a binding contract entered into before January 1, 1978, would qualify for the 5-year depreciation rule even though the expenditures are actually made after December 31, 1977.

In addition, the Act modifies the definition of families and individuals of low and moderate income by providing that the eligible income limits are to be determined in a manner consistent with those presently established for the Leased Housing Program under Section 8 of the United States Housing Act of 1937, as amended.

Effective date

The provisions relating to the 2-year extension apply to expenditures paid or incurred with respect to low-income rental housing after December 31, 1975, and before January 1, 1978 (including expenditures made pursuant to a binding contract entered into before January 1, 1978). The provisions increasing the amount of expenditures that can be depreciated under the special 5-year rule apply to expenditures incurred after December 31, 1975.

Revenue effect

It is estimated that the provision will result in a decrease in budget receipts of $1 million for fiscal year 1977, and $7 million for 1981. 2. Limitation of Loss to Amount At-Risk (sec. 204 of the Act and sec. 465 of the Code)

Prior law

Generally, the amount of depreciation or other deductions which a taxpayer has been permitted to take in connection with a property has been limited to the amount of his basis in the property. Similar

statutory limitation rules are found in sections 704 (d) and 1374 (c) (2) for owners of partnership interests and shareholders in subchapter S corporations where the partners and shareholders, rather than the entity, are taxed on the income or loss of the entity.

The starting point for determining a taxpayer's adjusted basis in a productive activity or enterprise is generally the taxpayer's cost for the assets used in the activity or enterprise (secs. 1011, 1012). In the case of a productive activity engaged in through a partnership or subchapter S corporation, the investor's adjusted basis in his stock or partnership interest is generally based on the amount of money and his adjusted basis in other property contributed to the enterprise (secs. 722, 358). The investor's basis in a partnership interest or subchapter S corporation stock is increased by his portion of the income of these entities, and decreased by his portion of their losses, in recognition of the fact that the income and losses are flowed through to the investor for tax purposes, rather than being taxed to the entity.

The liabilities of a productive activity may also have an effect upon an investor's adjusted basis in the activity. Thus, a taxpayer's basis in a property includes the portion of the purchase price which is financed even if the taxpayer is not personally liable on the loan and the lender must look solely to the financed property for repayment of the loan.

However, in the case of a subchapter S corporation, liabilities of the corporation increase a shareholder's adjusted basis in the stock only to the extent that the liability is owed to that particular shareholder (secs. 1374 (c) (2), 1376).

In the case of partnerships, in general, a partner's share of the liabilities of the partnership is considered to be a contribution of money by him to the partnership (sec. 752). Since a partner's contributions to the partnership increase the adjusted basis of his partnership interest (sec. 705), the partner's adjusted basis reflects not only his contributions in money and other property, but also his share of partnership liabilities. This rule applies regardless of whether the particular liability is owed to one or more of the partners or to an unrelated party. The rule is premised upon the assumption that the partner may be held personally liable for the debts of the partnership and since he may be called on to, in effect, make additional contributions of money to cover these liabilities, the adjusted basis of his partnership interest should reflect this potential risk of additional liability.

However, a limited partner in a limited partnership may not be held responsible for partnership debts, and his potential personal liability is confined to any additional amount he is required to contribute to the partnership by the partnership agreement. Since a limited partner does not have unlimited personal liability, the basis of his partnership interest is not usually increased to reflect borrowing by the partnership. There has been, however, an exception to this rule. The regulations provide that where none of the partners have personal liability for a partnership obligation, all of the partners, including limited partners share in the liability (Reg. § 1.752-1(e)). Since a limited partner is deemed to have a share of such nonrecourse liabilities, the adjusted basis of his partnership interest is increased under the generally applicable partnership provisions.

This approach to nonrecourse partnership liabilities arose from a judicially developed principle known as the Crane rule. The Crane

rule was derived from the Supreme Court's reasoning in Crane v. Commissioner, 331 U.S. 1 (1947), where it was held that an owner's adjusted basis in a parcel of real property included the amount of a nonrecourse mortgage on the property, under which the mortgagee-lender could seek a recovery of its loan only from the property. (It is because of the Crane rule that nonrecourse indebtedness has generally been included in an investor's adjusted basis, as indicated above, in a business or productive property.)

Also, in general, the existence of protection against ultimate loss by reason of a stop-loss order, guarantee, guaranteed repurchase agreement or similar arrangement does not generally impose a limitation on the amount of losses a taxpayer may deduct in the early taxable years of an activity.

Reasons for change

The typical tax shelter has operated as a limited partnership with individual investors participating as limited partners. Virtually all of the equity capital for the activity has been contributed by the limited partners with the major portion of the remaining operating funds (generally 75 percent or more of the total capital) for the partnership financed through nonrecourse loans.

When an investment had been solicited for a tax shelter activity, it had been common practice to promise the prospective investor substantial tax losses which could be used to decrease the tax on his income from other sources. The opportunity to deduct tax losses in excess of the amount of the taxpayer's economic risk had arisen under prior law primarily through the use of nonrecourse financing not only by limited partnerships, but also by individuals and subchapter S corporations. The ability to deduct tax losses in excess of economic risk had also arisen through guarantees, stop-loss agreements, guaranteed repurchase agreements, and other devices used by the partnerships, individuals and subchapter S corporations.

Nonrecourse leveraging of investments and other risk limiting devices which produce tax savings in excess of amounts placed at risk substantially alter the economic substance of the investments and distort the workings of the investment markets. Taxpayers, ignoring the possible tax consequences in later years, can be led into investments which are otherwise economically unsound and which constitute an unproductive use of investment funds.

Congress believed that it was not equitable to allow individual investors to defer tax on income from other sources through losses generated by tax sheltering activities. One of the most significant problems in tax shelters was the use of nonrecourse financing and other risk-limiting devices which enabled investors in these activities to deduct losses from the activities in amounts which exceeded the total investment the investor actually placed at risk in the activity. The Act consequently provides an "at risk” rule to deal directly with this abuse in tax shelters.

Explanation of provision

To prevent a situation where the taxpayer may deduct a loss in excess of his economic investment in certain types of tax shelter activities, the Act provides that the amount of any loss (otherwise allowable for the year) which may be deducted in connection with one of

these activities cannot exceed the aggregate amount with respect to which the taxpayer is at risk in each such activity at the close of the taxable year. This "at risk" limitation applies to the following activities: (1) farming 1; (2) exploring for, or exploiting, oil and gas resources; (3) the holding, producing, or distributing of motion picture films or video tapes; and (4) equipment leasing. The limitation applies to all taxpayers (other than corporations which are not subchapter S corporations or personal holding companies) including individuals and sole proprietorships, estates, trusts, shareholders in subchapter S corporations, and partners in a partnership which conducts an activity described in this provision.2

The at risk limitation is to apply on the basis of the facts existing at the end of each taxable year. The at risk limitation applies regardless of the method of accounting used by the taxpayer and regardless of the kind of deductible expenses which contributed to the loss.

The amount of any loss which is allowable in a particular year reduces the taxpayer's at risk amount as of the end of that year and in all succeeding taxable years with respect to that activity.3

Losses which are suspended under this provision with respect to a taxpayer because they are greater than the taxpayer's investment which is "at risk" are to be treated as a deduction with respect to the activity in the following year. Consequently, if a taxpayer's amount at risk increases in later years, he will be able to obtain the benefit of previously suspended losses to the extent that such increases in his amount at risk exceed his losses in later years.

The at risk limitation is only intended to limit the extent to which certain losses in connection with the covered activities may be deducted in the year they would otherwise be allowable to the taxpayer. The rules of this provision do not apply for other purposes, such as the determination of basis. Thus, a partner's basis in his interest in the partnership will generally be unaffected by this provision of the committee amendment. However, for purposes of determining how much, if any, of his share of a partnership loss from the enumerated activities a partner may deduct in any year, this provision of the Act overrides the existing partnership rules of section 704 (d) and related provisions, including regulations section 1.752-1(e).

5

For purposes of this provision, a taxpayer is generally to be con

1 For purposes of this section, the definition of "farming" is the definition used in the farming syndicate rules (discussed below). Thus, the at risk provision does not apply to forestry or the growing of timber.

2 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 would not apply to a partnership in which all the partners are corporations (other than subchapter S corporations or personal holding companies). Similarly, if a partnership is comprised of both individual partners and corporate partners (other than subchapter S corporations and personal holding companies), the at risk provision applies to the individual partners but not the corporate partners.

3 The at risk limitation does not affect a taxpayer's utilization of the investment credit. Also, the amount of investment tax credit claimed by a taxpayer with respect to an activity does not reduce the amount the taxpayer is at risk with respect to the activity. For example, the basis of a partner's interest in a partnership is reduced by the full amount of any losses which would be allowable but for this provision. However, upon disposition of his interest in a partnership, a partner is to be treated as becoming at risk with respect to the amount of any gain from the disposition. As a result, a partner will be able to deduct any suspended losses at the time of disposition.

5 If no partner is personally liable to repay any part of a debt obligation incurred by the partnership, no partner may treat such part of the debt as part of his capital at risk in the partnership for purposes of this provision. Similarly, even if one or more partners is personally liable on part or all of a partnership debt, other partners who have no personal liability may not treat any part of the debt as part of their risk capital. In case of a partnership, special allocations of deductions by agreement among the partners may not increase the amount of a loss deduction allowable to any partner for a taxable year beyond the amount which that partner is "at risk" in the partnership for the

the

same year.

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