The House this week overwhelmingly passed a compromise bill that would protect most sellers of property from a tax trap arising from last year's Deficit Reduction Act.
The compromise, approved 425 to 0 Tuesday, eases the rules covering the tax treatment of below-market mortgages held by sellers.
The rules became an issue when Congress, at the request of the Treasury Department, voted to allow the Internal Revenue Service to "impute" a higher interest rate to below-market loans and to tax the sellers as if they were receiving the higher rate.
Last year's bill provoked a major outcry from the real estate industry and individuals who feared they might be caught up in the rules. The Treasury, while willing to agree to some relaxation, has been urging that some restrictions be retained to prevent traders in expensive properties from abusing the system.
Rep. Robert T. Matsui (D-Calif.), a leader of the compromise effort, said, "I think we've solved most of the major problems," and expressed optimism about quick Senate action and final passage in view of the big House vote.
The Treasury's goal has been to prevent buyers and sellers from distorting the tax consequences of a transaction by allocating more of the dollars involved to the price and fewer to interest on the note. Such an allocation allows the seller to treat more of the proceeds from the sale as lower-taxed capital gains, while allowing the buyer, in the case of a business or income property, to boost the amount he can take off his taxes in the form of depreciation.
But the new law would have had the effect of scooping up many sellers of homes who took back a mortgage at a below-market interest rate. It set forth a formula related to the Treasury's borrowing costs to define market rate, and allowed the IRS to impose a penalty on sellers who did not meet the test. The rules did grant an exception for principal to residences priced below $250,000 and farms valued at $1 million or less.
The result would have been that many sellers holding low-rate loans would have had to pay tax on "imputed" interest income that they did not actually receive or were treating as payments of principal.
The Treasury argued that the law would have no effect on the amount of money changing hands, but would merely force the structuring of deals to reflect economic reality.
But below-market seller loans are a major prop to real estate prices, especially in periods of high interest rates. Sellers, Realtors and other industry representatives complained loudly of the damaging effect the measure would have on the sale of homes, farms and other property.
Congress hastily passed a stop-gap measure exempting the first $2 million of seller financing, but this expires June 30.
The House bill requires that seller financing of $2 million or less carry an interest rate of either 9 percent or a rate equal to what the government pays on debt of similar term, whichever is less. Financing of $4 million or more would have to carry a rate at least equal to the federal rate.
On financing over $2 million but less than $4 million, a blended rate would be required, in which the lower rate is phased out dollar for dollar. This provision eliminates fears of a "tax cliff" -- an abrupt change in applicable rules so that a small increase in the amount financed could have a dramatic effect on the tax treatment.
The phase-out works this way: For each dollar above the $2 million threshold financed by the seller, a dollar of the amount below the threshold ceases to be eligible for the 9 percent minimum. Thus, if a seller holds a $3 million note, $1 million would be eligible for the 9 percent minimum -- $2 million minus the amount over $2 million. The rest would have to carry at least the applicable federal rate.
Of course, if interest rates fall so that the applicable federal rate is 9 percent or less, the issue is moot.
The House bill also contains a provision indexing its thresholds to inflation beginning in 1988.
The measure also requires parties to transactions qualifying for the exemption to use the same accounting method -- both must be operating on a cash basis or both on accrual. This provision is designed to prevent the parties from manipulating accounting practices to create large deductions on one side and little income on the other.
The bill is expected to cost the Treasury about $800,000 in lost revenue. To make up for this loss, it increases the write-off period under the accelerated cost recovery system to 19 years from 18, thus slowing down depreciation benefits.
Matsui noted that a hangup could arise if the Senate takes a different approach to the revenue recovery issue, thus complicating an otherwise fairly simple conference to resolve differences.
Elements of the industry that are not completely satisfied with the House approach also are working in the Senate to shape the measure more to their liking.
The National Association of Realtors is seeking to soften the treatment of seller financing in the $2 million to $8 million range, and to ease the accounting requirements somewhat. However, the NAR is not opposing the House bill, because neither it nor any other industry group wants to run the risk of derailing the whole thing. If Congress fails to act, the law reverts to the form in which it passed last year.