The battle lines have been drawn in Congress over the federal budget for fiscal year 2007, which officially begins Oct. 1. Some industry experts fear casualties of the standoff will be bedrock tax breaks for the commercial real estate industry, if the new Democratic Congress tinkers with or fails to renew them to balance the budget. Programs that may be affected include 1031 exchanges, the 15-year leasehold depreciation period for tenant improvements, and capital gains tax rates.

That's in part because Democrats say they'll comply with so-called pay-go rules. Since 1990, Congress has been required to offset increases in spending or decreases in revenue with other spending decreases or revenue increases. For years, Congress waived pay-go requirements, but that approach has fallen out of favor. Democrats have vowed to adhere to pay-go, and that means budget cuts.

Enormous budget pressures

Congress is required to introduce appropriations bills in May. However, Congress often misses its own budget deadlines, making it difficult to predict when Congress will reach agreements on specific budget provisions.

Congress is “in a box,” explains Steve Renna, senior vice president and counsel to The Real Estate Roundtable, a trade group in Washington, D.C. It's under pressure to come up with money to pay for tax breaks the Democrats may introduce and to cover the cost of renewing existing tax breaks scheduled to expire this year.

Among breaks that expire in 2007 are the 15-year depreciation period for tenant improvements and the Terrorism Risk Insurance Act (TRIA). Under current rules, property owners can depreciate the cost of improvements to walls, floors, ceilings, lighting, and plumbing on a 15-year basis. If the leasehold depreciation provision is allowed to expire, owners will be forced to depreciate such improvements over 39 years.

TRIA provides federal reinsurance as a backstop that enables insurers to cover acts of terrorism without charging exorbitant premiums. It was intended to help the insurance industry recover from the terrorist attacks on Sept. 11, 2001 by giving insurers time to develop their own terrorism insurance products. Without TRIA, property insurance would likely skyrocket.

The fate of both programs is up in the air. On TRIA, for instance, “The [U.S.] Treasury Department is really dug in, not wanting to further extend it,” says Linda Goold, tax counsel at the National Association of Realtors in Washington, D.C. “But a lot of the commercial interests are working hard to get Congress to say, ‘Sorry Treasury, we don't care what you think.’” It's too early to predict the outcome, says Goold.

Jason Todd, director of federal affairs for the Building Owners and Managers Association International in Washington, D.C., is optimistic because BOMA is hard at work lobbying Congress to extend TRIA. “Some form of TRIA will get extended,” he predicts.

A common way to raise revenue is to tighten or let existing tax breaks lapse. Take 1031 exchanges. “I have a list of a dozen things Congress could do to like-kind exchanges,” says Goold. Any modifications to timing and holding requirements could dramatically limit the number of allowable exchanges, according to Goold, who declined to elaborate further for fear of putting ideas in Congressional staffers' heads.

One proposal that's been floated in the past has been limiting the definition of a like-kind property. Currently, the rules allow any real property to be exchanged for any other real property. For example, an apartment building could be exchanged for a strip shopping center. One proposed change would be to mandate that the replacement property be in the same asset class. “We've been able to tamp that down,” says Renna. “Will it come up again? It certainly could.”

Waive pay-go?

Pay-go rules may lead Congress to implement incremental, or temporary, fixes for expiring tax breaks, says Todd. Leasehold depreciation is an example. “If the leasehold provision gets extended, will it be for only a year or a couple of months?” asks Todd of BOMA. “Congress might not extend the provision as long as it might have if pay-go wasn't in play.”

But Congress has waived pay-go requirements in the past. “A senior Congressional tax staffer thinks Congress won't allow these provisions to lapse but will find a way to extend them,” says The Real Estate Roundtable's Renna. “It's too early to say Congress will waive pay-go, but it may have to.”

Complicating the budget process may be the 2008 presidential race, says Todd. “It's possible Congress could play it safe and stick with popular programs that aren't real negative in a tax sense.” Goold doesn't predict any resolution to budget issues before fall.

Expect the unexpected, concludes Renna, pointing out that Congressional tax-writing staffs are busy seeking ways to raise revenue. “What's been considered will be reconsidered.”

G.M. Filisko is a reporter and attorney based in Chicago who writes regularly on legal and real estate issues. She can be contacted at gabifil@rcn.com.