Balanced-budget package provides some real estate relief The tax portion of the budget-balancing package approved by Congress and President Clinton provides some relief for real estate, though not as much as the industry was hoping for.

The bill reduces the top capital gains rate from 28% to 20% for assets held at least 18 months, but real estate investors will get the 20% rate only for the portion of the gain that represents appreciation in property value. The gain attributable to depreciation recapture will be taxed at 25%. Real estate advocates tried unsuccessfully to have the 20% rate applied to the entire gain. For assets held at least five years beginning on Jan. 1, 2001, the gain attributable to appreciation will be taxed at 18%, rather than 20%.

REITs will be able to hold foreclosure property for a longer period, giving them a better chance of timing sales to upswings in the market. Specifically, property can be held until the end of the third year after the year of acquisition, rather than two years from the date of acquisition. The three-year holding period can be extended for up to three years with the permission of the Internal Revenue Service.

In a de minimis exception to the restriction on service income, REITs will also be able to receive income from impermissible tenant services in an amount up to 1% of the gross income from a rental property and still treat income from the property as rent.

The bill also repeals the 30% limit on income from the sale of stock or securities held for less than one year, certain real estate held for less than four years and property disposed of in a prohibited transaction.

It also modifies the treatment of long-term capital gains income received by a REIT. The REIT can elect to retain the gains and pay the income tax. The REIT shareholders would then include their portion of the gain in income, but they would also receive a credit for their share of the tax paid by the REIT.

The spending side of the budget package includes few changes related to real estate. It does make permanent two restrictions on rent adjustments for Section 8 rent subsidy units that have been implemented on a year-to-year basis through appropriations bills.

Section 8 rents are generally increased each year through the application of annual adjustment factors (AAFs). One provision in the budget bill limits AAF rent increases for project-based Section 8 units whose rents already exceed the area fair market rents (FMRs). In such cases, rents can be increased only to the extent that the owner can show the adjusted rents won't exceed rents for comparable unassisted units. The other provision reduces by one percentage point the AAF adjustment for units which haven't had a change in tenants since the last adjustment. In no case, however, could rents be reduced.

IRS issues proposed rules on financing for at-risk projects The Internal Revenue Service (IRS) has issued proposed rules on qualified nonrecourse financing for at-risk investments that would allow partnerships and limited liability companies (LLCs) to guarantee such financings.

Under the at-risk provisions of the Internal Revenue Code, taxpayers' deductions for an investment are generally limited to the amount they have at risk in cash, property and debt for which they are personally liable. However, they can also take deductions against their share of nonrecourse financing for which no one is personally liable.

Under the proposed regulations, a partnership or LLC guarantee won't disqualify otherwise qualified nonrecourse financing if the only assets of the partnership or LLC are real property used in the activity of holding real property and any other incidental property and if no other person is liable for repayment of the financing.

Freddie Mac to finance tax-credit projects Freddie Mac has started a pilot program to provide construction and permanent financing for low-income housing tax-credit projects.

Under the program, Freddie Mac will make loans of $3 million to $15 million at a fixed interest rate which is locked in prior to construction. During the 12- to 24-month construction period, interest-only payments will be due. For the permanent loan phase, developers can choose terms of 18 to 30 years, with 25- or 30-year amortization.

The maximum loan-to-value ratio will generally be 85%, though it can go up to 90% for loans in HUD's risk-sharing program. The minimum debt service coverage ratio will be 1.15 to 1.

Subordinate financing will be permitted with Freddie Mac's consent. If the borrower has to make payments on the subordinate loan, the minimum combined debt service coverage ratio will be 1.10 to 1, and the maximum combined LTV ratio will be 90%. For a soft second, where no regular payments are due, the combined debt service coverage ratio can be as low as 1.05 to 1 and the combined LTV ratio can be as high as 100%.

* Real estate investors will get 20% capital gains rate for the portion of the gain representing appreciation in property value. * The gain attributable to depreciation recapture will be taxed at 25%. * For assets held at least five years beginning on Jan. 1, 2001, the gain attributable to appreciation will be taxed at 18%.

Barry G. Jacobs is NREI's Washington Correspondent and editor of Housing and Development Reporter.