Pass-throughs and Capital Gains Inflation Indexing

There is growing interest in Washington in reducing the tax burden of capital investment by indexing capital gains for inflation.  This is not a new issue, but it is attracting new momentum, and could have enormous consequences for long-held assets, like real estate.

The Director of the National Economic Council, Larry Kudlow, is a strong advocate of indexing capital gains, as are many senior members of the congressional tax-writing committees.  A broad coalition of advocacy groups is campaigning for reform.  Debate has centered on whether the Treasury Department can and should act unilaterally to index the basis of assets for inflation.  In late June, Secretary Mnuchin told the Wall Street Journal he would like Congress to consider the issue as part of tax reform 2.0, “If we’re not able to complete Tax 2.0, then we’ll go back to the drawing board and decide whether we want to consider this on a non-legislative basis.”

Capital gains indexing is clearly part of the Tax Reform 2.0 discussions.  While 2.0 faces an uncertain future in the Senate, any tax provisions in the emerging House bill will likely remain key elements of the tax legislative agenda this year and going forward.

Senior Ways and Means Committee Republican Devin Nunes (R-CA) recently introduced the Capital Gains Inflation Relief Act.

  • The Nunes bill would replace adjusted basis with “indexed basis” for purposes of measuring the taxable gain or loss of an “indexed asset” held for more than 3 years.
  • Indexed assets include common stock in a C corporation, or tangible property, if it is a capital asset or property used in the trade or business. The bill would not apply to debt, intangible property, an interest in a real estate mortgage investment conduit (REMIC), and many other financial instruments.  In the past, some capital gains indexing proposals have excluded net lease property – see, g., Job Creation and Wage Enhancement Act of 1995 (H.R. 9), introduced by Ways and Means Chairman Bill Archer in 1995.  Net lease property is eligible for indexing under the Nunes bill.
  • Indexed basis is adjusted basis of the asset multiplied by the applicable inflation adjustment (the percentage by which the GDP deflator for the quarter before its disposition exceeds the GDP deflator for quarter before the asset was acquired).
  • By applying indexing to both the measurement of gain and loss, the proposal is more generous than some prior proposals, which only applied to the capital gain. For example, when the House passed the indexing of capital gains in 1995 (in conjunction with the Contract with America), the provision did not extend to losses.
  • Special rules apply to: (1) stock in foreign corporations regulatory traded on an established exchange; (2) American depository receipts; (3) periods when the asset is subject to diminished risk of loss; and (4) short sales.
  • In the case of partnerships, a partnership interest is not an indexed asset. This basic rule, developed when the House passed capital gains indexing in 1995, is marketed as a simplification measure necessary to avoid the complexity that would arise if indexing were to take into account the fluctuating basis of a partnership interest attributable to earnings and distributions or to the frequently changing mix of assets (e., indexed assets and non-indexed assets).  A partner would receive the benefit of the indexing adjustment when the partnership disposes of indexed assets.  Inflation adjustments at the entity level flow through to the holders and result in a corresponding increase in the basis of the holder’s interest in the entity.  In certain cases (754 election), if a partner transfers a partnership interest, the partner is entitled to any indexing adjustment that has accrued at the partnership level and the transferee is entitled to the benefits of indexing going forward.  The indexing adjustment is disregarded in determining any loss on the sale of an interest in a partnership.
  • Similar pass-through rules apply to S corporation stock or an interest in a common trust fund.
  • In the case of REITs, the indexing adjustments generally apply in computing both taxable income and earnings and profits (the indexing adjustments are not applicable in determining whether a corporation qualifies as a REIT). In the case of REIT shares, partial indexing is achieved by measuring the ratio of the FMV of indexed assets held by the entity to the FMV of all of its assets.  Full indexing of REIT shares is allowed if the ratio is greater than 80 percent.  If the ratio is between 20-80 percent, then the stock is treated as an indexed asset in the same ratio.  If the ratio is below 20 percent, the REIT shares would not be indexed at all.  Special rules would operate to deny the benefit of indexing to corporate shareholders of REITs.  Partnership interests held by a REIT are subject to a look-through rule.
  • Inflation indexing does not apply to any sale or disposition between related parties, unless the transferee receives a substituted basis, such as in the case of a gift.
  • In order to qualify for indexing, the taxpayer must acquire the asset after December 31, 2018.  In this respect, the Nunes bill is less generous than earlier proposals that would extend capital gains inflation indexing to existing investments, such as Treasury 1984.

How to apply inflation indexing of assets to pass-through business entities, without undue complexity and administrative challenges, is one of the principle technical challenges for policymakers, but has received little attention.  The Nunes bill largely reflects tax policy decisions that were made when the House last passed capital gains inflation indexing in 1995.  As the issues moves forward, those policy “calls” will be revisited and retested.

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