It must be understood that the following discussion is based on information available as of June, 1985. At this date nothing has passed, and the discussion herein deals with proposals. However, it may be indicative of what could pass.
Since the President’s speech, various public opinion polls have indicated a high degree of acceptance toward the new proposal. Also, it is becoming increasingly apparent that a great deal of bipartisan support can be expected for the proposed reform. While it is still too early to predict with certainty, it would appear the tax reform as proposed by the President is beginning to “firm up” and gather momentum.
The primary purpose of this article is to evaluate the impact of the new proposal compared with the tax provisions and case study presented in the May, 1985, issue of SAM.
Those who are not familiar with the President’s proposal may benefit from a review of its key points.
President’s Key Points
Tax Rates—Individuals would be taxed under a three bracket system of 15, 25 and 35 percent. The top rate would apply to taxable income over $70,000 on joint returns and $42,000 on single returns. Corporations, which now pay rates up to 46 percent, would pay graduated rates of 15, 18, 25, and 33 percent.
Personal Exemption—The President’s proposal would raise to $2,000 the personal exemption available for the taxpayer and each dependent. This is an increase from the current $1,040 exemption amount. The zero bracket amount, the amount of earnings which may be earned without paying tax, would also be increased. This would increase to $4,000 for joint returns and $3,000 for single returns. The increase is up from the current $3,450 and $2,390 respectively under current law.
Interest Expense—Mortgage interest would remain deductible for principal residences. Deductions for other personal interest would be limited to $5,000 plus net investment income.
Charitable Contributions—Contributions would continue to be deductible.
State and Local Taxes—The itemized deduction for taxes would be repealed. Property, sales, income and other taxes would not be deductible unless incurred in a trade or business activity.
Fringes—Company-paid health benefits would be taxed as income up to $10 per month for individuals and $25 for joint filers.
Business Deductions—Entertainment expenses such as tickets to theaters, sporting events, etc., including ski passes, would be non-deductible business expenses. Deductions would be denied for 50 percent of the cost of meals above a statutory dollar amount and travel expenses would be restricted.
Capital Gains—Non-depreciable capital assets would receive a 50 percent capital gain exclusion yielding a top rate of 17.5 percent. Capital gains from depreciable property would be taxed at ordinary income tax rates without the benefit of any exclusion.
Following are some of the proposals that would have a profound impact on ski areas and real estate.
Proposals Affecting Ski Areas
Investment Credit—The tax credit of up to 10 percent on the purchase of new business equipment would be repealed. This includes ski lifts.
Depreciation—Rapid depreciation write-offs against taxes, to recover the cost of business investments, would be extended dramatically.
Indexing—The original cost of business assets would be adjusted for inflation for purposes of determining depreciation and the gain from the sale of property.
“Windfall” Recapture—Taxpayers who claimed high amounts of depreciation deductions from 1980 to 1985 would be required to add back into income, over the next three years, 40 percent of a portion of their depreciation deductions. The provision is complex and will be discussed later in this article.
Real Estate—In addition to the changes in interest expense and depreciation deductions as outlined above, real estate would now be subject to the general “at-risk” rules. This would prevent investors from claiming deductions on real estate in excess of the amounts actually contributed to an activity plus any debt on which they are personally liable.
How these points will impact on the ski industry and real estate in general, deserves further explanation. In addition, the similarities and differences in the President’s proposal compared to the Treasury proposal introduced in November, 1984, and addressed in the article in Ski Area Management, May, 1985 need to be explained.
Interest on Indebtedness
The President’s proposal did not change the Treasury proposal on this point. In general, the proposal limits the interest that may be deducted in an individual income tax return. Exceptions to the general rule are interest costs incurred to purchase a personal residence or to carry on a trade or business.
Interest not incurred in a trade or business or incurred to purchase a principal residence would be deductible only to the extent of $5,000 plus net investment income. Net investment income would be generally defined as income earned from passive income sources, such as, dividends, interest, etc., reduced by the expenses incurred to earn the passive income.
The enactment of this provision could limit the deduction of interest expense on second homes when the second home is used principally for personal purposes. The provision does not hinder the deductibility of interest when the rental home or condo is used in a trade or business.
Depreciable Assets
The Treasury proposal introduced the Real Cost Recovery System. Under this system, a standard depreciation rate was applied to the inflation-adjusted cost of an asset for each year. Under this proposal the potential depreciation period for real property was 64 years.
The President’s proposal takes some of the Treasury’s concepts of depreciation. As under the Treasury proposal, the President’s proposal adjusts the cost of a depreciable asset by an inflation index. However, rather than adjusting the original cost of an asset, the President’s proposal adjusts the adjusted basis of an asset. To this adjusted basis a new depreciation schedule is applied to the asset. The depreciation schedule would be based upon a more economic depreciation rate and would include six different classes of property, depreciating the assets over a four to 28-year life, with the 28 year life applying to real property.
The President’s proposal is a little more generous than the Treasury proposal in the depreciation lives. However, as observed in the prior article on the Treasury proposal, this new provision is not a tax simplification measure. The application of the concept is complex and should increase the need to consult with tax professionals.
Capital Gain Exclusion
The Treasury proposal repealed the capital gain exclusion. The President’s proposal does not go to the extreme of the Treasury proposal, but does modify the current law.
Under the President’s proposal, capital assets are separated into two separate categories: depreciable and non-depreciable assets. For depreciable assets, there would be no capital gains exclusion. Instead, all gains on depreciable assets would be taxed at the new ordinary income tax rates. The asset would, however, be adjusted for inflation by an inflation index factor.
Non-depreciable capital assets would still be afforded a capital gains exclusion. Rather than the current law 60 percent exclusion, the President’s proposal offers a 50 percent capital gains exclusion. As with depreciable assets, non-depreciable assets will be adjusted for inflation by an inflation index factor. Under the President’s proposal, non-depreciable capital asset gains will be taxed at a maximum 17.5 percent.
| Item | Amount |
|---|---|
| Total depreciation taken between 1/1/80 – 6/30/86 | $2,500,000 |
| Straight line depreciation based on earnings and profit | ($1,200,000) |
| Subtotal | 1,300,000 |
| Proposed exclusion | (300,000) |
| Taxable difference | $1,000,000 |
| Item | 1986 | 1987 | 1988 |
|---|---|---|---|
| Excess depreciation as computed above | $1,000,000 | $1,000,000 | $1,000,000 |
| Excess depreciation tax rate per year | 12% | 12% | 16% |
| Addition to taxable income | 120,000 | 120,000 | 160,000 |
| Effective top corporate tax rate | 33% | 33% | 33% |
| Tax due | $39,600 | $39,600 | $52,800 |
| Total additional tax due to “windfall” recapture | $132,000 |
“At-Risk” Limitations
“At-risk” is generally measured by the amount that an investor has funded an activity including recourse debt. Under current law, the non-recourse debt associated with many real estate activities has provided tax basis. Both the Treasury proposal and the President’s proposal would not allow non-recourse debt to provide tax basis to real estate activities.
The tax features of real estate whereby the write-off exceeds the cash but is allowed to the extent of non-recourse debt, have long been a “sacred cow” of Congress. The President’s, as well as the Treasury’s proposal, are trying to insure that investments are not tax motivated.
Investment Tax Credit
The President’s proposal deals the same blow as did the Treasury proposal with respect to the investment tax credit. Both proposals repeal the tax credit which, in the past, has been a government subsidy on the purchase of fixed assets used in a trade or business. The credit in the past has provided up to a 10 percent credit on the cost of fixed assets placed in service during the taxable year. The credit is a direct reduction of a tax liability.
This provision will most definitely affect ski areas in a negative manner. Ski lifts, equipment and lodge furnishings would no longer receive the beneficial subsidy.
Limited Partnerships
The Treasury proposal had a provision to tax large limited partnerships—with more than 35 limited partners—as corporations. This provision was proposed as it was felt that large syndicated partnerships possessed more characteristics of a corporation than a partnership. This would have had a negative impact as no losses from these partnerships would pass through to the limited partners. This provision was not included in the President’s proposal. This is a victory for the small investor, with little cash, trying to invest in large limited partnerships.
“Big Whammy” for Ski Areas
The President’s proposal introduces a concept not even contemplated in the published Treasury proposal. This concept is becoming known as the “windfall” recapture provision. This provision has been designed to deny a windfall benefit derived from excess depreciation on capital assets taken between January 1, 1980 and July 1, 1986 due to the lower proposed tax rates under the President’s proposal. Excess depreciation is determined by computing the excess of cumulative depreciation deductions that would have been allowed during the same period using straight line methods for the extended “earnings and profits” depreciation lives (Section 312(K)).
Taxpayers whose total depreciation deductions taken between January 1, 1980 and December 31, 1985 are less than $400,000 would not be subject to the rate-reduction rule. Such taxpayers accordingly would not have to make the excess depreciation calculation described above. Moreover, for those taxpayers who are subject to the rule, the first $300,000 of excess depreciation would be exempt from the rate-reduction recapture rule.
For calendar-year taxpayers, 12 percent of the excess depreciation would be included in income for the 1986 taxable year, 12 percent in 1987 and 16 percent in 1988. Appropriate adjustments would be made to this schedule for fiscal-year taxpayers to put them on the same basis as calendar-year taxpayers.
To illustrate the above, an example is provided on page 29.
The provision as outlined by the President’s proposal applies at the individual or corporate level. For making the tests, an individual must aggregate all depreciation taken on all entities in which he or she has an interest in a pass-through capacity (i.e., partnerships, S-corporations and trusts). It is estimated by the drafters of the proposals that only about 10 percent of the corporations and 150,000 individuals would be subject to this provision. Mid to large ski areas would be well advised to give the potential excess depreciation provision some serious thought.
Case Study Review
In the article in SAM we presented a case study illustrating the Treasury proposal’s impact on a purchaser of a ski area condominium. That case study assumed that the purchaser would be able to support the fact that the condo was used in the trade or business of the taxpayer and that it was not used for personal purposes. Based on the assumptions in that case study, using a net present value analysis, the purchaser would have been worse off under the Treasury proposal than under current law by $7,407.
Applying the prior facts to the President’s proposal yields a similar result. Under the President’s proposal the purchaser would be worse off by $7,451. The minor difference is due solely to changes in the depreciation method between the two proposals.
Losses or Gains?
Some ski area operators are intrigued with the concept that the second home interest expense limitation may force more second home owners into rental pools, thereby increasing properties available for destination skiers. Other ski area operators see this provision as badly damaging ski area real estate developers’ capability to build and sell homes or condominiums. In any event, the proposed longer depreciation lives coupled with the loss of capital gains treatment and overall lower income tax brackets will, in all probability, increase the challenge of selling recreational property as demonstrated in the previous case study.
Ski area operators should consider the potential loss of the investment tax credit relative to planned equipment purchases. Mid to large ski area operators should also compute the potential cash flow burden stemming from the proposed “excess depreciation windfall tax” illustrated earlier.
Some destination ski areas operate on the premise that mountain operating losses are acceptable. They do so in the belief that these losses will be more than offset by real estate income. These areas would do well to reexamine that philosophy in view of potential changes wrought by “The President’s Tax Proposals to the Congress for Fairness, Growth and Simplicity.”
Gentlemen—start your CPA’s!
