For example, assume Taxpayer A and Taxpayer B each has $250,000 of savings and no other debts when they purchase their principal residences for $500,000, respectively. Taxpayer A incurs $500,000 of acquisition indebtedness and leaves untouched the $250,000 of savings. Taxpayer B uses the $250,000 of savings as a down payment and incurs $250,000 of acquisition indebtedness. After these transactions, the two taxpayers are similarly situated with net worths of $250,000, but Taxpayer A may be able to offset future taxable income with a larger home mortgage interest deduction. 124 The same situation can arise under present law. Any effort to address this concern is beyond the scope of this proposal because it involves curtailing the present-law deduction for acquisition indebtedness. 124 Taxpayer A may also have more taxable income as a result of the return on the $250,000 of savings than Taxpayer B. F. Limit the Exclusion for Rental Value of a Residence Rented for Fewer Than 15 Days (sec. 280A) Present Law Gross income generally includes all income from whatever source derived, including rent from real property. Present law provides a de minimis exception to this rule if a dwelling unit is used during the taxable year by the taxpayer as a residence and is rented for fewer than 15 days during the taxable year. In this case, the rental income is not included in gross income. No deductions attributable to such rental use are allowed. Reasons for Change The present-law 15-day rule inaccurately measures economic income by excluding rental income earned by the taxpayer. The amount of the untaxed income can be significant even for fewer than 15 days' rental. A dollar limitation in conjunction with the 15-day rule would more accurately function as a de minimis threshold than a rule based exclusively on the rental period. Description of Proposal The proposal limits the total exclusion for the rental value of a residence rented fewer than 15 days to $2,000. Also the proposal allows certain deductions attributable to such rental use. Specifically, a taxpayer may claim the otherwise allowable deductions attributable to such rental use (e.g., depreciation) reduced in proportion to the ratio of excludable rental income to total rental income from the property. Effective Date The proposal is effective for taxable years beginning after the date of enactment. Discussion The following example illustrates the operation of the proposal: Taxpayer A rents his residence for fewer than 15 days during the taxable year. The taxpayer receives $5,000 in rent and has $2,000 of otherwise applicable deductions arising from such rental use. Under present law, none of the $2,000 is deductible and none of the $5,000 of rental income is included in gross income. Under the proposal, the allowable amount of the deduction is reduced by the ratio of excludable gross rental income to total gross rental income (i.e., $2,000/$5,000). This reduces the otherwise applicable deductions arising from such rental use by 40 percent from $2,000 to $1,200. After reducing the gross rental income of $5,000 by the amount of the allowable deductions the taxpayer's net rental income is $3,800. Of this amount, $2,000 is excludable so the taxpayer has $1,800 of taxable income from the rental of the residence. The principal justification for the present-law rule is that it reduces the administrative and record keeping burden on taxpayers and the IRS by excluding de minimis rental income attributable to the taxpayer's residence. The fact that there is no dollar limit, however, is incompatible with the simplification argument underlying the de minimis exception, as rentals of fewer than 15 days on certain residences can be several thousands of dollars. The exception should be capped to better fit the de minimis rationale. Any dollar limitation is arbitrary but an unlimited exception is not justified by the de minimis rationale. The de minimis exception provides for a less accurate measurement of income relating to the rental. It does this to alleviate the administrative and recordkeeping burden on the taxpayer and the IRS. This mismeasurement of income increases as the rental income rises even though the administrative and recordkeeping burden remains relatively constant. A dollar limitation would allow Congress to target the de minimis exception to taxpayers with relatively small amounts of rental income which is more consistent with the de minimis rationale. The proposal will increase administrative and recordkeeping burden for those taxpayers whose rental income exceeds the dollar limitation. Unlike present law, the proposal allows deductions for such taxpayers and consequently affects the basis in their homes for tax purposes. The burden of this additional basis calculation, however, is relatively small when weighed against the more accurate measurement of economic income for such taxpayers achieved by the proposal. G. Extend Pro-Rata Basis Allocation Requirement 125 (sec. 1011) Present Law A taxpayer that sells property to a charity for a price less than the fair market value generally must bifurcate the transaction into two parts (one part gift and the other part sale) under existing bargain sale rules. If a taxpayer makes a bargain sale of property and a charitable deduction is allowable for the donated portion of the property, then the adjusted basis used to determine the taxpayer's gain from the sale portion generally is an amount that equals the same percentage of the property's entire adjusted basis as the percentage that the sales price is of the fair market value of the property. For example, assume a taxpayer bought 100 shares of stock for $1,000 and sold those shares to a charity for $5,000 when the fair market value of the shares was $10,000. The taxpayer's adjusted basis for purposes of determining gain from the sale portion is $500, which is 50 percent ($5,000 sales price divided by $10,000 fair market value) of the entire adjusted basis of $1,000. The taxpayer's gain from the sale portion, therefore, is $4,500, and a charitable deduction of $5,000 - the amount by which the fair market value exceeds the sales price - may be available. This pro rata basis allocation rule for bargain sales to charities does not apply to part-gift, part-sale transactions for which a charitable deduction is not permitted. Instead, in determining the transferor's gain from the sale portion of such a transaction, the entire adjusted basis of the property transferred is used to offset the sales price. 126 Under this rule, if the taxpayer in the example described above transferred the stock to his or her child instead of to a charity, the adjusted basis used to determine the taxpayer's gain from the sale portion would be the entire adjusted basis of the stock, $1,000, and the taxpayer's gain would be only $4,000. If this basis rule applies, the transferee's basis generally is the amount paid for the property ($5,000 in the example) or the transferor's adjusted basis at the time of the transfer ($1,000 in the example), whichever is greater, plus any increase under section 1015(d) for Federal gift tax paid on the transfer. 127 Reasons for Change 128 In general, when a taxpayer sells part of a larger property, the taxpayer is required to allocate basis to the portion sold based on that portion's fair market value. Present law governing bargain sales to charities is consistent with this principle. Present law for other 127 Treas. Reg. sec. 1.1015-4(a). For determining loss, however, the transferee's basis is limited to the fair market value of the property at the time of the transfer. 128 Treas. Reg. sec. 1.61-6(a). bargain sales, however, departs from this general rule and allocates the entire basis to the sale portion, thereby reducing the taxable gain for taxpayers making those sales. As a result, similar transactions are treated differently. Description of Proposal The proposal extends to all part-gift, part-sale transfers the present law pro-rata basis allocation rule applicable to bargain sales to charities. Consequently, for determining gain from any bargain sale, the proposal requires a taxpayer to allocate to the sale portion of property an amount of basis equal to that portion's pro rata share, based on respective fair market values, of the entire property's adjusted basis. Under the proposal, the transferee's basis in property acquired in a part-gift, part-sale transaction is (1) the cost (sales price) of the purchased portion of the property plus (2) the transferor's basis in the gift portion of the property. In the example above of a bargain sale to a taxpayer's child, the basis of the stock is allocated to the portion of the stock sold and the portion transferred as a gift based on the respective fair market values of the two parts so that the tax result is the same as if the taxpayer sold 50 shares and made a gift of 50 shares. The taxpayer recognizes a gain of $4,500, not $4,000 (the present-law result). Effective Date The proposal is effective for transfers made on or after the date of enactment. Discussion Under the proposal, a taxpayer's taxable gain recognized on any bargain sale equals the taxpayer's gain that would be recognized on the disposition for fair market value of a portion of the property. Under present law, by contrast, taxpayers are permitted to shift gain to certain transferees. A taxpayer may, for example, sell a $100,000 painting for its adjusted basis of $5,000 and thereby shift the entire $95,000 appreciation in the painting to the transferee. This shift results in reduced tax liability if the transferee is in a lower tax bracket than the transferor. Even in the absence of tax rate differences, shifting of gain may create valuable tax deferral. Present law thus produces different tax results for two economically similar transactions. A taxpayer may choose to sell a portion of property for its fair market value and then transfer the remaining part of the property by gift. Alternatively, the taxpayer may choose to sell the entire property at a bargain price. Under the proposal, the tax treatment of the two transactions is the same. Basis allocation is required in a bargain sale to a charity because the charity's subsequent sale of the property generally will not be taxed to the charity. To reduce the amount of gain that escapes taxation altogether, therefore, the sale to a charity must result in the proper measurement of gain. The same policy applies, however, to a bargain sale to a buyer that is not a charity. The basis allocation rules should measure properly the amount of gain for both parties to any part |