Effort to Cut Deficit May Further Limit Some Tax Breaks

Just when you thought it was safe to exploit the Tax Reform Act of 1986, our friends in Congress may be changing the rules again.

Trying to raise tax revenue to cut the federal budget deficit, lawmakers have proposed a number of tax law revisions that would reduce the attractiveness of several popular investments and tax strategies, particularly home mortgage refinancings and home equity loans, real estate and bond swaps, and certain types of limited partnerships.

These proposals, contained in one or both of the tax-increase bills passed by the House and the Senate Finance Committee last month, will be considered along with other revenue-raising measures for inclusion in a final deficit reduction bill to be formulated by House and Senate tax-writing committees. The impetus for such a bill gained strength Friday, when President Reagan and congressional leaders endorsed a $9-billion tax increase as part of a plan to reduce the deficit by $30 billion this year.

If enacted, the changes could affect thousands of homeowners and investors--particularly in California, where real estate values are higher than in the nation as a whole. Already, the threat that these proposals may be enacted has prompted some taxpayers to postpone refinancings and asset swaps, experts say.

“It doesn’t pay to be a fool and rush in when they could change the ground rules,” said David A. Berenson, national director of tax policy for the accounting firm of Ernst & Whinney. “You have enough time before year-end to make your transactions. I wouldn’t rush now.”

Here’s how the proposals affecting home loans, swaps and limited partnerships will work:

Home Mortgage Refinancings

Tax reform has spawned a boom in home equity loans and mortgage refinancings. Taxpayers are using these loans to pay down credit card debts or other non-mortgage borrowing, on which deductibility is being phased out under tax reform.

A provision in the House bill approved Oct. 29 would limit the deductibility of interest on refinancings and home equity loans when they are used for purposes other than paying for the home or home improvements. That limit is $100,000 or the fair market value of the home, whichever is less.

Current law limits the amount of such borrowing eligible for full deductions to the purchase price of the home plus the value of home improvements, unless the excess is used for educational or medical expenses.

How will the proposed change work? Assume that you spent $300,000 to buy and improve your home and have a $175,000 mortgage balance on it. Under current law, you could take out a home equity loan or refinancing for the $125,000 difference and all its interest would be fully deductible, even if you used some of the money to buy such non-housing items as stocks or a new car.

But under the House provision, only $100,000 of the $125,000 will be eligible for full interest deductions. The deductibility of interest on the remaining $25,000 will depend on what the proceeds are used for. If it is used for home improvements, it may be fully deductible.

“This provision is very significant, particularly in California” because of the state’s expensive homes, Ernst & Whinney’s Berenson said. Homeowners with large equity in their homes will be limited in how much they can borrow on a fully deductible basis against that equity, experts say.

However, homeowners who bought their homes many years ago at less than $100,000 may be able to borrow more on a fully deductible basis. A homeowner who paid only $25,000 for his home--now worth more than $100,000--could borrow as much as $100,000 on it on a fully deductible basis. Under current law, he could only borrow up to $25,000, unless he used the loan for medical bills or tuition.

The House proposal also would curb other tax benefits related to mortgage borrowing. It would limit to $1 million the maximum amount of mortgage loans on which interest could be fully deducted. It would also drop the special exemption for education or medical expenditures. And it would eliminate boats and mobile homes from qualifying as second residences that are eligible for full interest deductions.

Loans in place on or before Oct. 13 would not be affected.

William G. Brennan, editor of Brennan Reports, a Valley Forge, Pa., tax-advisory newsletter, contends that there is a good chance these limits will be enacted. The boom in those loans makes them a convenient target, with the potential for raising millions in new tax revenue, he said. Also, the limits are likely to affect only the wealthiest homeowners, making the proposals politically palatable.

What if you just want to refinance the existing balance of your mortgage to get a lower interest rate? As long as you are not taking cash out to use for non-mortgage expenditures, interest would be still fully deductible under the House plan, Brennan said.

Real Estate Swaps

Another House proposal would curb the popularity of property swaps, a method to defer capital gains tax on homes, apartment buildings, shopping centers, raw land or other real estate. In these swaps, an investor exchanges a property for another like property, avoiding tax because none is due until properties are actually sold.

The House measure would allow investors to defer no more than $100,000 in gains from swaps in any year. That would apply retroactively to exchanges after Oct. 13, 1987, unless a binding contract for the exchange existed before then.

Let’s say you bought a shopping mall for $350,000 and it’s now worth $1 million. You then swap it for another piece of real estate, also worth $1 million. Under current law, as long as no cash changes hands and the exchange is completed within six months, the $650,000 capital gain is not taxed.

But under the House measure, the amount you could defer would be limited to $100,000. Thus, $550,000 of your gain would be taxable.

“That would kill a lot of deals,” said William B. Kelliher, partner in the national tax office of Peat Marwick Main, noting that investors may not have the cash to pay such taxes.

“You’d have to dig into your own pockets to pay the tax. It’s not worthwhile then,” said a San Clemente property owner who has done two swaps this year and is completing a third.

Bond Swaps

Another House provision would reduce the attractiveness of bond swaps, a popular method to write off losses on discounted bonds while still keeping bonds in their portfolios. (Bonds fall in price when the general level of interest rates rise.)

Under a swap, an investor sells a discounted bond to claim a capital loss, which he can then use to write off against income. The investor then buys another bond of similar value, yield and maturity.

But the House proposal would tax each year a portion of the difference between the discount and the bond’s face value, even if the investor has yet to receive that difference in profit.

Here’s how the change would work: Let’s assume you have a bond with a $1,000 face value that had declined to a discounted value of $800. You sell it and then buy a similar bond for $800. Under current law, the $200 profit you would make when you redeem the newly purchased bond at maturity would only be taxed at maturity. Or it would be taxed when you sell it; in that case, the profit may be greater or less than $200.

However, under the House proposal, a portion of that $200 would be taxed every year on a pro-rated basis. Thus, by swapping, the investor is exposing himself to an immediate tax liability.

The measure would apply retroactively to bonds purchased after Oct. 13.

This provision will not only discourage swaps; it also will depress prices of all bonds selling at discounts because investors will be more reluctant to buy them, Ernst & Whinney’s Berenson said.

Master Limited Partnerships

Provisions in both House and Senate Finance Committee bills would reduce the tax advantages of certain so-called master limited partnerships and other partnerships whose shares are traded on stock exchanges or other secondary markets. (Shares in ordinary limited partnerships that are not publicly traded would be unaffected.)

Currently, investors in master limited partnerships enjoy tax advantages over investors owning conventional corporate stock, even though both are traded on stock exchanges. That is because limited partnerships can pass profits to shareholders without having to pay corporate income tax. Thus, partnership profits are taxed only once, while corporate profits are taxed twice. This benefit has led to a surge in formation of master limited partnerships since passage of tax reform.

Both House and Senate proposals would tax certain master limited partnerships as corporations. That, in effect, would reduce profits available to shareholders.

The change would be applied to master limited partnerships involved in “active businesses” such as macadamia nut farming or the Boston Celtics professional basketball team, adviser Brennan said. Certain types of master limited partnerships involved in “passive investments,” such as mortgages, that produce dividend or interest income would be exempt from corporate tax treatment, Brennan said. Certain MLPs involved in natural resources and rental real estate, such as oil drilling partnerships, also would be exempt, he said.

The new rule would apply retroactively to partnerships formed and publicly traded after Oct. 13, 1987, although partnerships traded before then and deemed as active businesses also would be taxed as corporations beginning in 1995, Brennan said.

If passed, the provision is likely to kill the market for master limited partnerships that are considered active businesses, Brennan said.

To be sure, it is far from certain that the above provisions will find their way into the final deficit-reduction bill and be signed into law by President Reagan. Real estate lobbyists are applying intense pressure to see that the provisions affecting their industry are killed.

But even if these changes are killed, don’t assume that similar proposals won’t come up again, given the pressure to reduce the budget deficit, Ernst & Whinney’s Berenson said.

“Get while the getting is good,” Berenson said, advising taxpayers to go ahead with home equity loans if the House provision to limit their deductibility dies.