farming or other closely held business purposes, all or a portion of the Federal estate tax
benefits obtained from the reduced valuation will be recaptured by means of a special
"additional estate tax” imposed on the qualified heir.

Deferred payment of estate tax

The estate tax is imposed on transfers at death and the tax generally is due 9
months after the date of death.” The Commissioner of Internal Revenue has the discretion
to grant an extension to pay estate tax upon a showing of reasonable cause for a period not
exceeding 10 years (sec. 6161(a)).

An executor generally may elect to pay the Federal estate tax attributable to an
interest in a closely held business in installments over, at most, a 14-year period (sec.
6166). To qualify for the election, the business must be an active trade or business and the
value of the decedent's interest in the closely held business must exceed 35 percent of the
decedent's adjusted gross estate. If an election is made, the estate pays only interest for the
first four years, followed by up to ten annual installments of principal and interest. Interest
is generally imposed at the rate applicable to underpayments of tax under section 6621
(i.e., the Federal short term rate plus three percentage points). Under section 6601(j),
however, a special four-percent interest rate applies to the amount of deferred estate tax
attributable to the first $1,000,000 in value of the closely-held business (i.e., the amount of
estate tax on the first $1,000,000 less the amount of any allowable unified credit).

?° The Commissioner of Internal Revenue may grant an extension for a period not to exceed
six months (sec. 6081).

-18-



F. Use of Tax-Exempt Bonds

In general

The Code exempts interest on certain debt obligations of States, territories, and
possessions of the United States from the regular individual and corporate income taxes
(sec. 103). Interest on debt of local governments generally receives identical treatment to
that provided for States.’? The State and local government bond interest exemption applies
to two principal types of bonds. First, interest is tax-exempt on bonds issued to finance
public activities conducted and paid for by States and local governments themselves
("governmental bonds"). Examples of activities financed with governmental bonds are
schools, courthouses, roads, public mass transit systems, and governmentally owned and
operated water, sewer, and electric facilities.

The second major category of State and local government bonds on which interest
is tax-exempt consists of bonds issued by these governmental units acting as a conduit to
provide financing for private persons ("private activity bonds"). Unlike governmental
bonds, tax-exempt private activity bonds generally may only be issued for purposes
specified in the Code. The specified purposes include several activities related to private
land use and real estate development.

Private activity bonds
Exempt-facility bonds

Exempt-facility bonds are private activity bonds issued to finance certain privately
operated transportation facilities (airports, ports, mass commuting facilities, and high-
speed intercity rail facilities), municipal service facilities (water, sewage, solid waste, local
furnishing of electricity or gas, environmental enhancement of hydroelectric dams, and
local district heating and cooling facilities); hazardous waste disposal facilities; and
multifamily rental housing.

Bonds for each of these private activities are subject to extensive Federal targeting
criteria. For example, developers of housing receiving tax-exempt financing must agree
that either (1) 20 percent of the rental housing units will be occupied by tenants having
incomes of 50 percent or less of the area median income where the project is located, or (2)
40 percent of the rental housing units will be occupied by tenants having incomes of 60
percent of less of the area median income where the project is located. This low-income
tenant occupancy requirement must be continuously satisfied for a minimum period of 15

” Interest on these "State and local government bonds" may, in certain cases, be
includible in calculating the individual and corporate alternative minimum taxes. Additionally,
State and local government bond interest is included in determining whether a portion of Social
Security benefits is taxable under the regular individual income tax.

-12-



Special withholding rules apply in the case of certain dispositions of U.S. real
property interests by partnerships, trusts, and estates; certain distributions by foreign or
domestic corporations, partnerships, trusts and estates; and certain dispositions of interests
in partnerships, trusts, and estates.

Reporting requi ni nalties fe 01
Section 6039C of the Code authorizes the IRS to require reporting by foreign
persons holding direct investments in U.S. real property interests, and imposes penalties

for failure to file any required reports. However, to date no such requirements have been
imposed.

-22-



include certain clearing and grading costs associated with land’ and golf course
improvements.®

The cost of minerals and other natural resources imbedded in land are recoverable
through depletion allowances (sec. 611).

* Rev. Rul. 65-256, 1965-2 C.B. 52, and Rev. Rul. 68-193, 1968-1 CB. 79.
© Rev. Rul. 55-290, 1955-1 C.B. 320.

3-


I. Foreign Investment in U.S. Real Property

In general

Nonresident alien individuals and foreign corporations (referred to herein
collectively as "foreign persons") are subject to U.S. tax at a flat rate of 30 percent (or a
lower rate pursuant to an applicable tax treaty) on certain types of passive income (but
generally not capital gains) derived from U.S. sources. Foreign persons are subject to U.S.
tax at the regular graduated rates applicable to U.S. persons on income derived from a U.S.
trade or business.

Special U.S. tax rules apply to gains of foreign persons attributable to dispositions
of interests in U.S. real property. The rules governing the imposition and collection of tax
on such dispositions are contained in a series of provisions that were enacted in 1980 and
that are collectively referred to as the Foreign Investment in Real Property Tax Act
("FIRPTA") (secs, 897, 1445, 6039C, and 6652(f)). Prior to the enactment of the FIRPTA
provisions, foreign persons could invest in U.S. real property without being subject to U.S.
tax upon the eventual disposition of such property.

Impositi if tax

Section 897(a) provides that gain or loss of a foreign person from the disposition of
aU.S. real property interest is taken into account for U.S. tax purposes as if such gain or
loss were effectively connected with a trade or business within the United States during the
taxable year. Accordingly, foreign persons generally are subject to U.S. tax on any gain
from a disposition of a U.S. real property interest at the same rates that apply to similar
income received by U.S. persons.

In the case of nonresident alien individuals, the alternative minimum tax applies to
the lesser of the individual's alternative minimum taxable income or the individual's net
real property gains (sec. 897(a)(2)(A)). Losses of nonresident alien individuals are taken
into account under the FIRPTA provisions only to the extent that such losses would be
taken into account under Code section 165(c), which limits loss deductions to business
losses, losses on transactions entered into for profit, and certain casualty or theft losses

(sec. 897(b)).

In the case of foreign corporations, the gain from a disposition of a U.S. real
property interest may also be subject to the branch profits tax’at a 30-percent rate (or a
lower treaty rate). If a foreign corporation that holds a U.S. real property interest is
entitled to nondiscriminatory treatment with respect to such interest under an applicable
treaty, the foreign corporation may elect to be treated as a U.S. corporation for purposes of
the FIRPTA provisions (sec. 897(i)). This election may be made only if all shareholders of
the corporation consent to the election and specifically agree that any gain upon the
disposition of the interest that would be taken into account under the FIRPTA provisions
will be taxable even if such taxation would be contrary to a treaty. This election to be

-19-



As a general rule, nonrecognition provisions apply under the FIRPTA provisions
only in the case of an exchange of a U.S. real property interest for an interest the sale of
which would be taxable under the Code (sec. 897(e)). This rule is designed to prevent a
foreign person from escaping U.S. tax by exchanging a taxable asset for a nontaxable asset
in an exchange which would otherwise qualify for nonrecognition treatment under the
Code. Specific rules apply to require gain recognition in certain cases. In this regard,
foreign corporations are required in certain circumstances to recognize gain upon the
distribution (including a distribution in liquidation or redemption) to their shareholders of
appreciated U.S. real property interests (sec. 897(d)(1)). Moreover, gain generally is
recognized by a foreign person under the FIRPTA provisions on the transfer of a U.S. real
property interest to a foreign corporation if the transfer is made as paid-in surplus or as a
contribution to capital.

The Code generally imposes a withholding obligation when a U.S. real property
interest is acquired from a foreign person (sec. 1445). The withholding obligation
generally is imposed on the transferee; however, in certain limited circumstances, an agent
of the transferor or transferee is required to withhold. Any tax imposed on a foreign person
under the FIRPTA provisions in excess of the amount withheld remains the liability of the
foreign person. ~

The amount required to be withheld on the sale by a foreign person of a U.S. real
property interest generally is 10 percent of the amount realized on the transaction (i.e., the
gross sales price) (sec. 1445(a)). However, a certificate for reduced withholding may be
issued by the IRS such that the amount required to be withheld will not exceed the
transferor's maximum tax liability (sec. 1445(c)(1)).

There are several exemptions from the obligation to withhold on a disposition of a
U.S. real property interest. First, withholding by the transferee generally is not required if
the transferor furnishes to the transferee an affidavit stating, under penalty of perjury, that
the transferor is not a foreign person and providing the transferor's taxpayer identification
number (sec. 1445(b)(2)). Second, withholding is not required on the disposition of an
interest in a domestic corporation if the corporation furnishes an affidavit to the transferee
stating, under penalty of perjury, that the corporation is not a USRPHC and has not been a
USRPHC during the five-year period ending on the date of disposition (sec. 1445(b)(3)).
Third, withholding may be reduced or eliminated if the transferee receives a qualifying
statement issued by the IRS that the transferor is exempt from tax or either the transferor or
the transferee has provided adequate security or has made other arrangements for payment
of the tax (sec. 1445(b)(4)). Fourth, withholding is not required if the transferee intends to
use the transferred real property as a residence, and the amount realized by the transferor
on the disposition of the property is $300,000 or less (sec. 1445(b)(5)). Fifth, withholding
is not required on a disposition of stock of a class that is regularly traded on an established
securities market (sec. 1445(b)(6)).

-21-



G. Contributions of Qualified Conservation Interests
arit: contributions erall

Subject to certain limitations, a deduction is permitted for contributions of property
to charitable organizations, to the United States, or to a State or local government. The
amount of deduction generally equals the fair market value of the property on the date of
the contribution. Charitable deductions are provided for income, estate, and gift tax
purposes (secs. 170, 2055, and 2522, respectively).

Gifts of certain types of property interests are subject to special restrictions, either
as to the amount deductible or as to the types of property interests for which a deduction is
permitted. For example, a contribution of less than the donor's entire interest in property
generally does not give rise to a charitable deduction (for income, estate, or gift tax
purposes) unless the gift takes the form of an interest in a unitrust, annuity trust, or a
pooled income find. Exceptions to the partial interest rule are provided for gifts of
remainder interests in farms or personal residences, gifts of undivided portions of the
donor's entire interest in the property, and for gifts of qualified conservation interests.

Qualified conservation interests

Qualified conservation interests are real property interests donated in perpetuity for
any of the following conservation purposes:

(1) The preservation of land areas for outdoor recreation by, or for the education of,
the general public;

(2) The protection of a natural habitat of fish, wildlife, plants, or a similar
ecosystem;

(3) The preservation of open space (including farmland and forest land) but only if
such preservation either (a) is for the scenic enjoyment of the general public, or is pursuant
to a clearly delineated Federal, State, or local governmental conservation policy, and (b)
will yield a significant public benefit; or

(4) The preservation of an historically important land area or a certified historic
structure (sec. 170(h)).

Deductible conservation interests may take any of three forms. First, the value of a
remainder interest is deductible. Second, the value of a restriction (e.g., an easement)
granted in perpetuity on the use of the property is deductible. Finally, the contribution of
the donee's entire interest in a property is deductible, except that the donor may retain his
or her interest in subsurface oil, gas, or other minerals and the right of access to such
minerals.

-16-



equipment because the asbestos removal eliminated human health risks, reduced the risk of
liability to employees resulting from the contamination, and made the property more
marketable. Similarly, in TAM 9411002 (November 19, 1993), the IRS required the
capitalization of expenditures to remove and replace asbestos in connection with the
conversion of a boiler room to garage and office space. However, the IRS permitted
deduction of costs of encapsulating exposed asbestos in an adjacent warehouse.

In 1994, the IRS issued Rev. Rul. 94-38, 1994-1 C.B. 35, holding that soil
remediation expenditures and ongoing water treatment expenditures incurred to clean up
land and water that a taxpayer contaminated with hazardous waste are deductible. In this
tuling, the IRS explicitly accepted the Plainfield Union valuation analysis. However, the
IRS also held that costs allocable to constructing a groundwater treatment facility are
capital expenditures.

More recently, the IRS issued TAM 9541005 (October 13, 1995) requiring a
taxpayer to capitalize certain environmental study costs, as well as associated consulting
and legal fees. The taxpayer acquired the land and conducted activities causing hazardous
waste contamination of the land. After the contamination, but before it was discovered,
the company donated the land to the county to be developed into a recreational park. After
the county discovered the contamination, it reconveyed the land to the company for $1.
The company incurred the costs in developing a remediation strategy. The IRS held that
the costs were not deductible under section 162 because the company acquired the land in
a contaminated state when it purchased the land from the county. In a TAM issued on
January 17, 1996, the IRS revoked and superseded TAM 9541005. Noting that the
company's contamination of the land and liability for remediation were unchanged during
the break in ownership by the county, the IRS concluded that the break in ownership
should not, in and of itself, operate to disallow a deduction under section 162.

® Rev. Rul. 94-38 generally rendered moot the holding in TAM 9315004 (December 17,
1992) requiring a taxpayer to capitalize certain costs associated with the remediation of soil
contaminated with polychlorinated biphenyls (PCBs).

-8-



C. Tax Credit for Rehabilitation Expenditures

In gen

An income tax credit is provided for a portion of certain expenditures incurred in
the rehabilitation of certified historic structures and certain other buildings first placed in
service before 1936. The amount of the credit is 20 percent of the qualified rehabilitation
expenditures for a certified historic structure and 10 percent of the qualified rehabilitation
expenditures for a qualified rehabilitated building other than a certified historic structure.

In order for a rehabilitation to qualify for the credit applicable to certified historic
structures, the rehabilitated building must be listed in the National Register of Historic
Places, or be located in a registered historic district and certified by the Secretary of the
Interior as being of historic significance to the district. In addition, the Secretary of the
Interior must certify that the rehabilitation is consistent with the historic character of the
building or the historic district in which the building is located.

In the case of other rehabilitations, a building (or its structural components) is a
qualified rehabilitated building if: (1) the building is substantially rehabilitated, (2) the
building was placed in service before the beginning of the rehabilitation, (3) the
rehabilitation meets a 75-percent retention test, (4) depreciation is allowable with respect
to the building, and (5) the building was first placed in service before 1936.”

A building is substantially rehabilitated if the qualified rehabilitation expenditures
incurred during the 24-month period selected by the taxpayer exceed the greater of: (1) the
adjusted basis of the building (and its structural components) as of the beginning of the
period (or as of the holding of the building, if later), or (2) $5,000.

Qualified rehabilitation expenditures generally include any amounts properly
chargeable to capital account in connection with the rehabilitation of a building, but do not
include the cost of: (1) acquiring the building or any interest in the building, (2) facilities
related to a building (e.g., a parking lot), (3) enlarging an existing building, or (4)
rehabilitations allocable to a portion of a building that is (or is reasonably expected to be)
tax-exempt use property.

The 75-percent retention test requires the retention, in place, of: (1) at least 75
percent of the building's existing external walls (including at least 50’ percent as external

7 The requirement that the building be placed in service before 1936 in order to be
eligible for the credit was added by the Tax Reform Act of 1986 ("1986 Act"). Prior to the 1986
Act, the rehabilitation tax credit was a three-tier credit. The credit was 15 percent for
nonresidential buildings at least 30 years old, 20 percent for nonresidential buildings at least 40
years old, and 25 percent for certified historic structures. The three-tier structure was added by
the Economic Recovery Tax Act of 1981.

5.



B. Income Tax Treatment of Disposition of Land

Capital gains treatment

In general, gain or loss reflected in the value of an asset is recognized for income
tax purposes at the time the taxpayer disposes of the property. On the sale or exchange of
capital assets held more than one year, gain generally is taxed to an individual taxpayer at
a maximum marginal rate of 28 percent. Losses from the sale or exchange of capital assets
are deductible only the extent of the gains from the sale or exchange of such assets, plus, in
the case of individuals, $3000.

Land is a capital asset unless held primarily for sale to customers in the ordinary
course of the taxpayer's trade or business, or is used in the taxpayer's trade or business. In
addition, if the gains from property, including land, used in a taxpayer's trade or business
exceeds the losses from such property, the gains and losses are treated as capital gains.

Deferral of gain or loss

Several provisions allow a taxpayer to defer gain when property, including land, is
disposed of. For example, if land held for investment or business use is exchanged for
property of a like kind (generally defined to include other real estate) gain or loss is
deferred (sec. 1031). Likewise if land is condemned and replaced with other property of a
like kind, gain or loss is deferred (sec. 1033).

Principal residence

If a principal residence, including the land on which it is located, is sold and
replaced with another principal residence within two years, gain is deferred (sec. 1034). If
a taxpayer age 55 or over sells property used as a principal residence for three of the prior
five years, up to $125,000 of the gain may be exempt from tax (sec. 121).


H. Estate Tax Preferences for Farms and Small Businesses

Special use valuation

A Federal estate tax is imposed on the value of property passing at death.
Generally, the value of property is its fair market value, i.e., the price at which the property
would change hands between a willing buyer and a willing seller, neither being under any
compulsion to buy or sell and both having reasonable knowledge of relevant facts.

If certain requirements are met, present law allows family farms and real property
used in a closely held business to be included in a decedent's gross estate at their current
use value, rather than full fair market value, provided that the gross estate may not be
reduced more than $750,000 (sec. 2032A).

An estate may qualify for current use valuation if: (1) the decedent was a citizen or
resident of the United States at his death; (2) the value of the farm or closely held business
assets in the decedent's estate, including both real and personal property (but reduced by
debts attributable to the real and personal property) is at least 50 percent of the decedent's
gross estate (reduced by mortgages and other secured debts); (3) at least 25 percent of the
adjusted value of the gross estate is qualified farm or closely held business real property;””
(4) the real property qualifying for current use valuation must pass to a qualified heir;’* (5)
such real property must have been owned by the decedent or a member of his family and
used or held for use as a farm or closely held business ("a qualified use") for 5 of the last 8
years prior to the decedent's death; and (6) there must have been material participation in
the operation of the farm or closely held business by the decedent or a member of his
family in 5 years out of the 8 years immediately preceding the decedent's death (sec.
2032A (a) and (b)).!

If, within 10 years after the death of the decedent (but before the death of the
qualified heir), the property is disposed of to nonfamily members or ceases to be used for

7 For purposes of the 50-percent and 25-percent tests, the value of property is determined
without regard to its current use value.

'* The term "qualified heir" means a member of the decedent's family, including his spouse,
lineal descendants, parents, and aunts or uncles of the decedent and their descendants.

° In the case of qualifying real property where the material participation requirement is
satisfied, the real property which qualifies for current use valuation includes the farmhouse, or
other residential buildings, and related improvements located on qualifying real property if such
buildings are occupied on a regular basis by the owner or lessee of the real property (or by
employees of the owner or lessee) for the purpose of operating or maintaining the real property
or the business conducted on the property. Qualified real property also includes roads, buildings,
and other structures and improvements functionally related to the qualified use.

-17-



D. Environmental Remediation Expenditures

Code section 162 allows a deduction for ordinary and necessary expenses paid or
incurred in carrying on any trade or business. Treasury regulations provide that the cost of
incidental repairs which neither materially add to the value of property nor appreciably
prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted
currently as a business expense. Section 263(a)(1) limits the scope of section 162 by
prohibiting a current deduction for certain capital expenditures. Treasury regulations
define "capital expenditures" as amounts paid or incurred to materially add to the value, or
substantially prolong the useful life, of property owned by the taxpayer, or to adapt
property to a new or different use. Amounts paid for repairs and maintenance do not
constitute capital expenditures. The determination of whether an expense is deductible or
capitalizable is based on the facts and circumstances of each case.

Treasury regulations provide that capital expenditures include the costs of
acquiring or substantially improving buildings, machinery, equipment, furniture, fixtures
and similar property having a useful life substantially beyond the current year. In
INDOPCO, Inc. v. Commissioner, 112 S. Ct. 1039 (1992), the Supreme Court required the
capitalization of legal fees incurred by a taxpayer in connection with a friendly takeover by
one of its customers on the grounds that the merger would produce significant economic
benefits to the taxpayer extending beyond the current year; capitalization of the costs thus
would match the expenditures with the income produced. Similarly, the amount paid for
the construction of a filtration plant, with a life extending beyond the year of completion,
and as a permanent addition to the taxpayer's mill property, was a capital expenditure
rather than an ordinary and necessary current business expense. Woolrich Woolen Mills v.
United States, 289 F.2d 444 (3d Cir. 1961) .

Although Treasury regulations provide that expenditures that materially increase
the value of property must be capitalized, they do not set forth a method of determining
how and when value has been increased. In Plainfield-Uni ter_Co. v, issioner,
39 T.C. 333 (1962), nonacq., 1964-2 C_B. 8, the U.S. Tax Court held that increased value
was determined by comparing the value of an asset after the expenditure with its value
before the condition necessitating the expenditure. The Tax Court stated that "an
expenditure which returns property to the state it was in before the situation prompting the
expenditure arose, and which does not make the relevant property more valuable, more
useful, or longer-lived, is usually deemed a deductible repair."

In several Technical Advice Memoranda (TAM), the Internal Revenue Service
(IRS) declined to apply the Plainfield Union valuation analysis, indicating that the analysis
represents just one of several alternative methods of determining increases in the value of
an asset. In TAM 9240004 (June 29, 1992), the IRS required certain asbestos removal
Costs to be capitalized rather than expensed. In that instance, the taxpayer owned
equipment that was manufactured with insulation containing asbestos; the taxpayer
replaced the asbestos insulation with less thermally efficient, non-asbestos insulation. The
IRS concluded that the expenditures resulted in a material increase in the value of the

-7-



DESCRIPTION OF SELECTED FEDERAL TAX
PROVISIONS THAT IMPACT LAND USE

Scheduled for a Hearing
Before the
SUBCOMMITTEE ON OVERSIGHT
of the
HOUSE COMMITTEE ON WAYS AND MEANS

On July 16, 1996

Prepared by the Staff
of the

JOINT COMMITTEE ON TAXATION

July 11, 1996

JCX-37-96



Definition of "quali ne property"

Present-law section 1397C defines "qualified zone property" as depreciable
tangible property (including buildings), provided that: (1) the property is acquired by the
taxpayer (from an unrelated party) after the zone or community designation took effect; (2)
the original use of the property in the zone or community commences with the taxpayer;
and (3) substantially all of the use of the property is in the zone or community in the active
conduct of a trade or business by the taxpayer in the zone or community. In the case of
property which is substantially renovated by the taxpayer, however, the property need not
be acquired by the taxpayer after zone or community designation or originally used by the
taxpayer within the zone or community if, during any 24-month period after zone or
community designation, the additions to the taxpayer's basis in the property exceed 100
percent of the taxpayer's basis in the property at the beginning of the period, or $5,000
(whichever is greater).

Definition of "enterprise zone business"

Present-law section 1397B defines the term "enterprise zone business" as a
corporation or partnership (or proprietorship) if for the taxable year: (1) the sole trade or
business of the corporation or partnership is the active conduct of a qualified business
within an empowerment zone or enterprise community; (2) at least 80 percent of the total
gross income is derived from the active conduct of a "qualified business" within a zone or
community; (3) substantially all of the use of the business property occurs within a zone or
community; (4) substantially all of the business's intangible property is used in, and
exclusively related to, the active conduct of such business; (5) substantially all of the
services performed by employees are performed within a zone or community; (6) at least
35 percent of the employees are residents of the zone or community; and (7) no more than
five percent of the average of the aggregate unadjusted bases of the property owned by the
business is attributable to (a) certain financial property, or (b) collectibles not held
primarily for sale to customers in the ordinary course of an active trade or business.

A “qualified business" is defined as any trade or business other than a trade or
business that consists predominantly of the development or holding of intangibles for sale
or license.’® In addition, the leasing of real property that is located within the
empowerment zone or community to others is treated as a qualified business only if (1) the
leased property is not residential property, and (2) at least 50 percent of the gross rental
income from the real property is from enterprise zone businesses. The rental of tangible
personal property to others is not a qualified business unless substantially all of the rental
of such property is by enterprise zone businesses or by residents of an empowerment zone
or enterprise community.

® Also, a qualified business does not include certain facilities described in section
144(c)(6)(B)(e.g., massage parlor, hot tub facility, or liquor store) or certain large farms.

-10-


E. Empowerment Zone and Enterprise Community Tax Incentives

In general

Pursuant to the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993), the
Secretaries of the Department of Housing and Urban Development (HUD) and the
Department of Agriculture designated a total of nine empowerment zones and 95
enterprise communities on December 21, 1994. As required by law, six empowerment
zones are located in urban areas (with aggregate population for the six designated urban
empowerment zones limited to 750,000) and three empowerment zones are located in rural
areas.” Of the enterprise communities, 65 are located in urban areas and 30 are located in
tural areas (sec. 1391). Designated empowerment zones and enterprise communities were
required to satisfy certain eligibility criteria, including specified poverty rates and
population and geographic size limitations (sec. 1392). The designated areas were selected
from among over 500 areas nominated by State and local governments, which submitted
proposed strategic plans to promote economic development in these areas.

The following tax incentives are available for certain businesses located in
empowerment zones: (1) a 20-percent wage credit for the first $15,000 of wages paid to a
zone resident who works in the zone; (2) an additional $20,000 of section 179 expensing
for “qualified zone property" placed in service by an "enterprise zone business"
(accordingly, certain businesses operating in empowerment zones are allowed up to
$37,500 of expensing); and (3) special tax-exempt financing for certain zone facilities
(described in more detail below).

The 95 enterprise communities are eligible for the special tax-exempt financing
benefits but not the other tax incentives available in the nine empowerment zones. In
addition to these tax incentives, OBRA 1993 provided that Federal grants would be made
to designated empowerment zones and enterprise communities.

The tax incentives for empowerment zones and enterprise communities generally
will be available during the period that the designation remains in effect, i.e., a 10-year
period.

° The six designated urban empowerment zones are located in New York City, Chicago,
Atlanta, Detroit, Baltimore, and Philadelphia-Camden (N.J.).

The three designated rural empowerment zones are located in Kentucky Highlands
(Clinton, Jackson, Wayne counties, Kentucky), Mid-Delta Mississippi (Bolivar, Holmes,
Humphreys, Leflore counties, Mississippi), and Rio Grande Valley Texas (Cameron, Hidalgo,
Starr, Willacy counties, Texas).

-9-


walls) and (2) at least 75 percent of the building's internal structural framework. In
general, a building's internal structural framework includes all load-bearing internal walls
and any other structural supports, including the columns, girders, beams, trusses,
spandrels, and all other items that are essential to the stability of the building.

her r

The rehabilitation credit is part of the investment credit which, in turn, is part of the
general business credit. The general business credit may offset the first $25,000 of a
taxpayer's regular tax liability, plus 75 percent of the taxpayer's regular tax liability in
excess of $25,000. The general business credit is not allowed to offset a taxpayer's
minimum tax liability.

Taxpayers claiming the credit must reduce their adjusted basis in the building by
the amount of the credit. Capitalized rehabilitation expenditures must be depreciated using
a straight-line method.

The credit is subject to recapture if the rehabilitated building is disposed of or

otherwise ceases to be a qualified property within five years after the property is placed in
service.

-6-


treated as a domestic corporation is the exclusive remedy for any person claiming treaty
protection against discriminatory treatment as a result of the FIRPTA provisions.

Definition of. real property interest

Under the FIRPTA provisions, U.S. tax is imposed on gains from the disposition of
an interest in real property (including an interest in a mine, well, or other natural deposit)
located in the United States or the U.S. Virgin Islands. The term "interest in real property"
includes, with respect to both land and improvements thereon, fee ownership and
co-ownership, leaseholds, options to acquire, and options to acquire leaseholds (sec.
897(c)(6)(A)). Moreover, the term includes partial interests in real property, such as life
estates, remainders, and reversions. In addition, the term includes any direct or indirect
right to share in the appreciation in the value of, or in the gross or net proceeds or profits
generated by, U.S. real property.

Also included in the definition of a U.S. real property interest is any interest (other
than an interest solely as a creditor) in any domestic corporation, unless the taxpayer
establishes that the corporation was not a U.S. real property holding corporation
("USRPHC") at any time during the five-year period ending on the date of the disposition
of the interest (sec. 897(c)(1)(A)(ii)). This general rule does not apply to investments in a
publicly-traded USRPHC. Under a special rule, USRPHC stock of a class that is regularly
traded on an established securities market is treated as a U.S. real property interest only in
the case of a foreign person that, at some time during the five-year period described above,
held more than 5 percent of that class of stock (sec. 897(c)(3)). Rules similar to this
special rule apply to treat an interest in a publicly-traded partnership as a U.S. real property
interest.

A corporation is a USRPHC if the fair market value of such corporation's U.S. real
property interests equals or exceeds 50 percent of the sum of the fair market values of (i)
its U.S. real property interests, (ii) its interests in foreign real property, plus (iii) any other
of its assets which are used or held for use in a trade or business (sec. 897(c)(2)). For
purposes of this asset test, a corporation that is a partner in a partnership or a beneficiary of
an estate or trust generally takes into account its proportionate share of all assets of such
partnership, estate or trust (sec. 897(c)(4)(B)). Look-through rules also apply to a
controlling interest (50 percent or more of the fair market value of all classes of stock) held
by a corporation in another corporation, whether foreign or domestic (sec. 897(c)(5)).

Special rules applicable to certain transactions

Gain recognized by a foreign person on the disposition of an interest in a
partnership, trust, or estate generally is subject to tax under the FIRPTA provisions to the
extent that the gain is attributable to any appreciation in the value of any U.S. real property
interests of the entity (sec. 897(g)).

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DESCRIPTION OF PRESENT-LAW TAX PROVISIONS

A. Cost Recovery for Land

In general

A taxpayer generally must capitalize the cost of property used in a trade or
business. The capitalized cost of business property that is subject to exhaustion, wear,
tear, or obsolescence may be recovered over time through allowances for depreciation (sec.
167). Depreciation allowances for tangible property placed in service after 1986 generally
are determined under the modified Accelerated Cost Recovery System ("MACRS") of
section 168, which provides that depreciation is computed by applying specific recovery
periods, placed-in-service conventions, and depreciation methods to the cost of various
types of depreciable property. Intangible property acquired after July 25, 1991, generally
is amortized under section 197, which provides a 15-year recovery period and applies the
straight-line method to the cost of applicable property.

Under MACRS, depreciable property is divided into nine classes (3-year property,
5-year property, 7-year property, 10-year property, 15-year property, 20-year property,
27.5-year residential rental property, 39-year nonresidential real property and 50-year
railroad grading or tunnel bores). An asset generally is sorted into a property class based
upon its class life. The 200-percent declining balance method of depreciation is used for
3-year, 5-year, 7-year, and 10-year property; the 150-percent declining balance method for
15-year and 20-year property and any property used in a farming business; and the
straight-line method for other property, including most depreciable real property.

Treatment of land

The cost of land generally may not be depreciated,” even if the taxpayer's use of the
land may result in its erosion or other type of wear or tear (e.g., in the case of certain
farming practices).* In addition, any interest in land may not be amortized under section
197 (sec. 197(e)(2)). Thus, when a taxpayer acquires both land and other property in a
single transaction (e.g. the purchase of an apartment building and the underlying land), the
acquisition cost must be allocated between the nondepreciable and depreciable assets.

Some improvements to land (such as sidewalks, roads, landscaping, etc.) may be
depreciated.* However, certain land improvements may be so "inextricably associated"
with the land as to be nondepreciable. Examples of nondepreciable land improvements

? Treas. reg. sec. 1.167(a)-2.
> Treas. reg. sec. 1.167(a)-6(b) and Duda & Sons, Inc., 560 F.2d 669 (5th Cir. 1977).
* Rev. Proc. 87-56, 1987-2 C.B. 674.

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years after the State and local government bonds are issued. The Code includes extensive
tules to ensure that developers comply with this requirement.

lif velopment b

Qualified redevelopment bonds are State and local government bonds issued for the
redevelopment of private property in governmentally designated "blighted areas." In
addition to any private revenues pledged to repayment of these bonds, the bonds must be
backed by a pledge of governmental tax revenues. The term "blighted area" is defined as
an area designated by a local government pursuant to a State statute as having excessive
vacant or abandoned land and structures, substandard structures, or real property tax
delinquencies. Designation of blighted areas is subject to limits on minimum size per area,
and aggregate designations may not exceed areas comprising 20 percent of the assessed
value of real property in the government's jurisdiction.

Qualified redevelopment bonds may be used for acquisition of property; clearing,
rehabilitation, and redevelopment activities; and expenses of relocating area residents.
This tax-exempt financing may not be used for new construction or enlargement of
existing buildings. Facilities such as golf courses, suntan parlors, racetracks, casinos and
other gambling facilities, and liquor stores may not be financed with loans financed with
these bonds.

Empowerment zone and enterprise community business bonds

State and local government bonds may be issued to finance capital expenditures of
certain businesses that are located in Federal empowerment zones and enterprise
communities and that are eligible for other tax incentives provided to empowerment zone
businesses. The following types of business are not eligiblé for this tax-exempt financing:
golf courses, country clubs, massage parlors, hot tub facilities, suntan parlors, gambling
facilities (including race tracks), and off-site alcoholic beverage stores.

The amount of these bonds is limited to $3 million per business in any one zone.
Businesses receiving this tax-exempt financing further are subject to a $20 million
aggregate limit on such bonds for property in all zones. Businesses receiving this tax-
exempt financing must continuously qualify as a "zone business" throughout the term of
the tax-exempt financing provided.

Qualified small-issue bonds

Qualified small-issue bonds are tax-exempt State and local government bonds used
to finance private business manufacturing facilities or the acquisition of land and
equipment by certain farmers. In both instances, these bonds are subject to limits on the
amount of financing that may be provided, both for an single borrowing and in the
aggregate. In general, no more than $1 million of small-issue bond financing may be
outstanding at any time for property of a business (including related parties) located in the

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greater of $50 per resident of the State or $150 million.* States may elect to carryover
their unused private activity bond volume authority for designated activities for a period of
up to three years. Bond authority that is not used within the carryforward period lapses.

The State volume limits do not apply to State and local government bonds for
section 501(c)(3) organizations, for airports and ports, for governmentally owned (but
privately operated) solid waste disposal facilities, for environmental enhancements of
hydro-electric generating facilities, for governmentally owned (but privately operated)
high-speed intercity rail facilities,'* and for qualified veterans’ mortgage loans.'*

Other restrictions on private activity bonds.--Among the other Federal restrictions

applicable to private activity, but not to governmental, State and local government bonds
are the following:

(1) A requirement that public notice be given and a hearing held before issuance of
the bonds;

(2) A restriction on the costs of issuance (e.g., bond attorney and underwriter fees)
that may be financed with bond proceeds to an amount not exceeding two
percent of the bond issue;

(3) A minimum rehabilitation requirement for existing property that is acquired
with State and local government bond proceeds;

(4) A limit on the amount of land that may be financed with any single bond issue;
and

(5) Loss of interest deductions for private borrowers receiving bond proceeds if the
bond-financed property ceases to be used in a qualifying use.

TM* A portion of the private business use financed with certain larger (i.e., over $150
million) governmental bond issues also is subject to these volume limitations.

*5 Bonds for privately owned high-speed intercity rail facilities must receive a State
volume limit allocation equal to 25 percent of the bond amount.

* As noted above, qualified veterans' mortgage bonds are subject to separate volume
limits based on historical State issuance as part of the 1984-enacted phase-out of that program.

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INTRODUCTION

The Subcommittee on Oversight of the House Committee on Ways and Means has
scheduled a public hearing on July 16, 1996, on issues relating to the impact of Federal tax law
on land use. This document, prepared by the staff of the Joint Committee on Taxation,
describes selected provisions of Federal income tax and estate and gift tax law that may have an

effect on the way land is used.

? This document may be cited as follows: Joint Committée on Taxation, Description of

Selected Federal Tax Provisions That Impact Land Use (JCX-37-96), July 11, 1996.

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CONTENTS

INTRODUCTION ...............--00 0000

DESCRIPTION OF PRESENT-LAW TAX PROVISIONS ................

A.

B
Cc
D.
E

TM

zo

i)

Cost Recovery forLand .............

Income Tax Treatment of Dispositions of Land .................

Tax Credit for Rehabilitation Expenditures .....................

Environmental Remediation Expenditures

Empowerment Zone and Enterprise Community Tax Incentives .....

Use of Tax-Exempt Bonds ...........

Contributions of Qualified Conservation Interests ................

Estate Tax Preferences for Farms and Small Businesses ...........

Foreign Investment in U.S. Real Property

ro
Ke) x wn es iS} is) a
io

12

16

17

19


Tax-exempt financing rules

Tax-exempt private activity bonds may be issued to finance certain facilities in
empowerment zones and enterprise communities. These bonds, along with most private
activity bonds, are subject to an annual private activity bond unified State volume cap
equal to $50 per resident of each State, or (if greater) $150 million per State.

Qualified enterprise zone facility bonds are bonds 95 percent or more of the net
proceeds of which are used to finance (1) "qualified zone property" (as defined above) the
principal user of which is an "enterprise zone business" (also defined above"), or (2)
functionally related and subordinate land located in the empowerment zone or enterprise
community. These bonds may only be issued while an empowerment zone or enterprise
community designation is in effect.

The aggregate face amount of all outstanding qualified enterprise zone bonds for
each qualified enterprise zone business may not exceed $3 million per zone or community.
In addition, total outstanding qualified enterprise zone bond financing for each principal
user of these bonds may not exceed $20 million for all zones and communities.

- "' For purposes of the tax-exempt financing rules, an “enterprise zone business" also
includes a business located in a zone or community which would qualify as an enterprise zone
business if it were separately incorporated.

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same municipality or county. This $1 million limit may be increased to $10 million if all
other capital expenditures of the business in the same municipality or county over a six-
year period are counted toward the limit. Outstanding aggregate borrowing under this

program is limited to $40 million per borrower (including related parties) regardless of
where the property is located.

Mortgage revenue bonds

Present law authorizes issuance of two types of tax-exempt bonds for owner-
occupied housing: qualified mortgage bonds and qualified veterans' mortgage bonds.
Qualified mortgage bonds are bonds issued to provide below-market financing to first-time
homebuyers having incomes below prescribed maximums and who purchase homes having
purchase prices below prescribed maximums. Only principal residences may be financed
with the proceeds of these bonds. If homebuyers sell the bond-financed homes within nine
years after the loan is made, a portion of the subsidy provided by the tax-exempt interest
rate is recaptured by the Federal Government. In addition to housing purchases, qualified
mortgage bonds may be used to finance limited amounts of home improvement and
rehabilitation loans.

Only five States are permitted to issue qualified veterans’ mortgage bonds.
Unlike qualified mortgage bonds, qualified veterans’ mortgage bond-financed loans are not
restricted to first-time home buyers satisfying income criteria, there is no limit on purchase
price of homes that are financed, and there is no recapture of the Federal tax subsidy if
property is sold early. Since 1984, issuance of these bonds is being gradually phased out.
The phase-out is accomplished by (1) limiting issuance to States that had issued the bonds
before 1985, (2) limiting each State's annual issuance to an amount not exceeding its
historical issuance of the bonds, and (3) limiting eligibility for bond-financed loans to
veterans who served on active duty before 1977 and who apply for a loan within 30 years
after leaving active military service (January 31, 1985, if later).

General restrictions on State and local government bond financing for private

Like many Federal direct spending programs, issuance of State and local
government private activity bonds is subject to general restrictions on amount and use.
The following discussion illustrates some of the major restrictions.

State volume limitations.--Issuance of most tax-exempt private activity bonds is
subject to annual per-State volume limitations. Each State (including local governments

within the State) is allowed to issue an annual amount of these bonds not exceeding the

© The States are Alaska, California, Oregon, Texas, and Wisconsin.
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