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Gulf Opportunity Zone Act of 2005

The recent natural disasters impacting the Gulf states has prompted the administration to provide incentives to encourage rebuilding in the afflicted areas. These incentives may provide an opportunity to your individual and business clients considering investing in the region. As such, we have prepared a detailed summary of the changes to the Internal Revenue Code that may benefit investors. Please take note that the sunset provisions for many of these benefits is rapidly approaching, therefore if you have clients considering investing in the Gulf region the time to act may be now.

On December 16, 2005 the Senate and the House passed the Gulf Opportunity Zone Act of 2005 by unanimous consent (Public Law 109-135) (the “Act”). The Act was signed into law by the resident on December 21, 2005. The Act appropriates $8.6 billion for regional reconstruction efforts. Many provisions are similar to tax incentives enacted after September 11, including bonus depreciation and enhanced small business expensing. However, in contrast to the earlier initiative, more tax relief is targeted to individuals. The Act also extends some tax incentives in the Katrina Emergency Tax Relief Act of 2005 (Public Law 109-73) enacted in September, 2005 to victims of hurricanes Rita and Wilma.

Geographic Scope

The Act applies to business activities in certain “Gulf Opportunity” or “GO” Zones. Generally, these appear to be declared ?disaster areas? as identified by the President on or before September 14, 2005 (in the case of Hurricane Katrina), on or before October 6, 2005 (in the case of Hurricane Rita), and on or before November 14, 2005 (in the case of Hurricane Wilma). Generally, such declarations are county specific. The “Gulf Opportunity Zone” refers exclusively to the portions of Alabama, Louisiana and Mississippi damaged by Hurricane Katrina.

PART I: TAX BENEFITS RELATED SOLELY TO HURRICANE KATRINA

Additional First Year Depreciation for Gulf Opportunity Zone Property: New Internal Revenue Code Section 1400N(d)

Background

Section 167 of the Internal Revenue Code of 1986, as amended (“Code”) allows taxpayers to recover through annual depreciation deductions (and in some cases, immediate expensing) the cost of property used in a trade or business or held for the production of income. Property is considered to be used in a trade or business if it is an integral part of ?considerable, regular, and continuous activities designed to generate a profit.? See e.g., Lewenhapt v. Commissioner, 20 T.C. 151, 162-63 (1953), aff’d per curiam, 221 F.2d 227 (9th Cir. 1954) De Amodio v. Commissioner, 34 T.C. 894, 905 (1960), Aff’d, 299 F.2d 623 (3d Cir.
1962). The activity must have a profit motive and must be regular, frequent, active, and substantial in order to constitute a trade or business. See West v. Commissioner, 51 T.C.M. 589, 591 (1986).

Property held for sale to customers (that is, inventory) is not used in a trade or business and is not depreciable. Treas. Regs. Sec. 1.167(a)-2. For example, the Internal Revenue Service has determined that a builder’s unsold homes used as models and sales offices are not property used in a trade or business because the essential purpose for which the houses were built — sale to customers — was not altered by their temporary use as models and sales offices, and thus they remain inventory in the hands of the builder. Rev. Rul. 89-25, 1989-1 C.B.79.

“The amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different types of property generally are assigned applicable recovery periods and depreciation methods. The recovery periods applicable to most tangible personal property (generally tangible property other than residential rental property and nonresidential real property) range from three to twenty-five years. The depreciation methods generally applicable to tangible personal property are the 200-percent and 150-percent declining balance methods, switching to the straight-line method for the taxable year in which the depreciation deduction would be maximized.” Joint Committee on Taxation Report (the “Committee Report”), page 41.

The Act creates an additional (“bonus”) depreciation deduction for the year depreciable property is placed in service.

Amount of Deduction

Fifty percent of the adjusted basis of “qualified Gulf Opportunity Zone Property.” The deduction applies for both regular and alternative minimum tax purposes.

Example 1

Assume an asset costs $100. The asset qualifies as Gulf Opportunity Zone Property and is therefore entitled to fifty percent (50%) bonus depreciation. The basis of the asset is reduced to $50 and the regular depreciation percentage for the first year is applied to the $50 adjusted basis.

Both the bonus depreciation and the regular depreciation are available to the taxpayer who owns the property to apply against gross income for the first year the property is placed in service. If the first year depreciation combined with certain other deductions recognized by the Act exceed the taxpayer’s gross income, the net operating loss thereby produced may be carried back by the taxpayer to the fifth year preceding the year in which the property was placed in service.

Definition of Qualified Gulf Opportunity Zone Property

Character of the property:

(1) Non-residential real property,

(2) residential rental property,

(3) off-the-shelf computer software,

(4) tangible personal property with a recovery period of twenty (20) years or less.

Location:

Substantially all use of the property must be in the Gulf Opportunity Zone (in connection with the active conduct of a trade or business).

Timing:

The original use must commence with the taxpayer on or after August 28, 2005.

Example 2:

Assume an investor constructs townhouse units in Biloxi, Mississippi in March, 2006, and sells them to LLCs with a maximum of twelve shares each. Each member would hold a minimum of 1/12 of the entity. The entity would place the unit for rental under the regulations. The units would be fully furnished and rented for not less than a thirty day period.

Residential rental property placed in service on or after August 28, 2005 by an active trade or business in areas affected by Hurricane Katrina constitutes qualified gulf opportunity zone property, therefore the fifty percent (50%) bonus depreciation provided by the Act is would apply.

Acquisition:

By purchase only on or after August 28, 2005 but only if no written binding contract for the acquisition was in effect before August 28, 2005.

The purchase requirement can also be satisfied in the case of property that is manufactured, constructed, or produced by the taxpayer if the property is used by the taxpayer, ?the taxpayer begins the manufacture, construction, or production of the property on or after August 28, 2005, and the property is placed in service on or before December 31, 2008 (in the case of qualified non-residential real property and residential rental property) or December 31, 2007 (in the case of all other qualifying Gulf Opportunity Zone property). “Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer.” Committee Report, pages 14-15.

Placed in Service Date:

On or before December 31, 2008 (in the case of non-residential real property and residential rental property) or on or before December 31, 2007 (in the case of all other qualified Gulf Opportunity Zone Property).

The term “placed in service” means that the asset has been acquired by a taxpayer engaged in the active conduct of a trade or business and commences when the property is in a condition or state of readiness and availability for a specifically defined function in that business.

The Committee Report indicates that the “original use” requirement may be satisfied by property as long “as it has not previously been used within the Gulf Opportunity Zone.” In addition, it is intended that additional capital expenditures incurred to recondition or rebuild property will satisfy the “original use” requirement if the original use of the property in the Gulf Opportunity Zone began with the taxpayer who is claiming the deduction. See Treas. Reg. Sec. 1.48-2 Example 5.

Increased Expensing for Gulf Opportunity Zone Property: New Internal Revenue Code Section 1400N(e)

Background:

In lieu of depreciation, Code Section 179 allows a taxpayer with a sufficiently small amount of annual investment to elect to deduct the entire cost of an asset in the year in which the asset is purchased and placed in use in the active conduct of a trade or business. (This is generally referred to as “expensing.”) Current law provides that the maximum amount a taxpayer may expense for taxable years beginning in 2003 through 2007 is $100,000 of the cost of qualifying property placed in service during the taxable year. In general, qualifying property is depreciable, tangible personal property purchased for use in the active
conduct of a trade or business. Off-the-shelf computer software placed in service in taxable years beginning before 2008 is also treated as qualifying property. The $100,000 limit on the maximum amount which can be expensed in any year is reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $400,000. The $100,000 and $400,000 amounts are indexed for inflation for taxable years beginning after 2003. As a result, in 2006, the basic $100,000 amount is inflation-indexed to $108,000, and the $400,000 investment limitation for phase-out of the Section 179 deduction is
inflation-indexed to $430,000.

The Act increases both the expensing limitation and the investment ceiling limitation for qualified Sec. 179 Gulf Opportunity Zone property.

Increased Tax Benefit:

The maximum amount a taxpayer may expense under Code Sec. 179 is increased by $100,000. Thus, the combination of indexing and increased expensing as a result of the Act will enable a taxpayer to deduct as much as $208,000 of the cost of Sec. 179 Gulf Opportunity Zone Property in 2006.

Increased Investment Ceiling Limitation:

If “excessive” amounts of qualified Sec. 179 Gulf Opportunity Zone property are purchased in one taxable year, the amount which is permitted to be expensed under Code Sec. 179 is reduced. The investment limitation is increased by $600,000. Thus, the combination of inflation-indexing and the increased investment ceiling now allows taxpayers to acquire as much as $1,030,000 in qualifying property before the $208,000 amount which can be expensed in 2006 will be reduced.
(Each dollar over $1,030,000 reduces the $208,000 amount by one dollar.)

Qualified Sec. 179 Gulf Opportunity Zone Property:

Property described in Code Sec. 179(d): generally, tangible personal property purchased for use in the active conduct of a trade or business and off-the-shelf computer software.

Location:

Substantially all of the use of the property must be in the Katrina Gulf Opportunity Zone in the active conduct of a trade or business conducted by a taxpayer in the Katrina Gulf Opportunity Zone.

Timing:

Use of the property must commence on or after August 28, 2005.

Acquisition:

The property must be acquired by purchase on or after August 28, 2005 but only if no written binding contract for the acquisition was in effect before August 28, 2005.

Use:

The original use of the property in the Gulf Opportunity Zone must commence with the taxpayer on or after August 28, 2005. Used property may qualify so long as it has not been previously used within the Gulf Opportunity Zone. In addition, capital expenditures incurred to recondition or rebuild property will also satisfy the “original use” requirement, if the original use in the Gulf Opportunity Zone began with the taxpayer. (For example, the taxpayer purchases a “damaged” asset, reconditions the asset, and places the asset in service in the active conduct of a trade or business conducted in the Katrina Gulf Opportunity
Zone.)

Timing:

The property must be placed in service by the taxpayer on or before December 31, 2007.

Expensing for Certain Demolition and Clean-up Costs: New Internal Revenue Code Section 1400N(f)

Background:

The cost of demolition of a structure is “captialized” into a taxpayer’s basis for the land on which the structure is located. (Land is not subject to allowances for depreciation or amortization.) Consequently, the cost of demolition is not recovered until the property is sold. Debris removal may be subject to similar limitations depending upon the distinction between repairs and replacement.

The Act permits taxpayers to deduct fifty percent of any qualified Gulf Opportunity Zone clean-up cost.

Qualifying Gulf Opportunity Clean-up Cost:

Any of the following costs incurred in connection with real property located in the Gulf Opportunity Zone which is held for use by a taxpayer in a trade or business or for the production of income, as well as inventory:

(1) removal of debris and

(2) demolition of structures.

Timing:

The clean-up cost must be incurred and paid on or after August 28, 2005 and before January 1, 2008.

This provision allows investors to purchase property, demolish damaged structures, remove storm debris, then flip the property (even if sale occurs after 2007 and even if the property constitutes inventory in the hands of the taxpayer) while deducting fifty percent of the demolition and clean-up costs in the year in which they are incurred.

Increase in Rehabilitation Tax Credit: New Internal Revenue Code Section 1400N(h)

Background:

Code Sec. 47 provides a two-tier tax credit for rehabilitation expenditures. A twenty percent credit is provided for qualified rehabilitation expenditures with respect to a certified historic structure. A “certified historic structure” means any building that is listed in the National Register or is located in a registered historic district and is certified by the Secretary of the Interior to the Secretary of the Treasury as being of historic significance to that
district. In addition, a ten percent credit is provided for qualified rehabilitation expenditures with respect to a qualified rehabilitated building.

A “qualified rehabilitated building” is defined by Code Sec. 47(c)(1)(A) as any building (and its structural components) which:

(1) has been substantially rehabilitated,

(2) placed in service before the beginning of the rehabilitation, and

(3) with respect to which

(a) at least fifty percent or more of the existing external walls are retained in place as external walls,

(b) at least seventy-five percent of the existing external walls are
retained in place as internal or external walls, and

(c) at least seventy-five percent of the existing internal structural framework is retained in place.

The term “substantially rehabilitated” is defined by Code Sec.47(c)(1)(C) to mean rehabilitation expenditures during a twenty-four (24) month period exceeding the greater of:

(1) the adjusted basis of the building or

(2) $5,000.

The Act increases from twenty percent to twenty-six percent and from ten percent to thirteen percent, respectively, the rehabilitation tax credit for certified historic structures and qualified rehabilitated buildings located in the Gulf Opportunity Zone.

Timing:

The qualified rehabilitation expenditures must be incurred between August 28, 2005 and December 31, 2008.

Five Year NOL Carryback for Certain Amounts Related to Hurricane Katrina or the Gulf Opportunity Zone: New Internal Revenue Code Section 1400N(k)

Background:

A net operating loss (“NOL”) is, generally, the amount by which a taxpayer’s deductions exceed gross income. When a NOL is incurred in a taxable year, the NOL may be carried back to two prior taxable years (thereby generating a refund for the taxpayer). If application of the NOL carried back to offset the taxpayer’s income in the prior two years does not completely exhaust the NOL, it may be carried forward to be applied against the taxpayer’s gross income in the following year. Remaining NOLs can continue to be carried forward for nineteen additional years (that is, a potential carry forward for as many as twenty years all together).

The Alternative Minimum Tax (“AMT”) rules under Code Sec. 56(d) provide that a taxpayer’s NOL deduction cannot reduce the taxpayer’s alternative minimum taxable income by more than ninety percent (an exception applies to NOL carrybacks arising in taxable years ending in 2001 and 2002).

The Act increases the carryback period for qualified Gulf Opportunity Zone losses from two years to five years. The Act suspends the ninety percent AMT limitation, thereby allowing an NOL carryback to completely eliminate a taxpayer’s alternative minimum taxable income for the carryback year.

Qualified Gulf Opportunity Zone Losses: Only certain losses and expenditures will qualify for the extended NOL carryback

(1) Deductions for qualified Gulf Opportunity Zone casualty losses:

Casualty losses with respect to property used in a trade or business and capital assets held for more than one year in connection with a trade or business or a transaction entered into for profit are included in computing the NOL carryback. The property which is the subject of the casualty loss must be located in the Gulf Opportunity Zone and the loss must be attributable to Hurricane Katrina. (Customary requirements of current law that a casualty loss does not include amounts compensated for by insurance continue to apply.)

(2) Employee Moving Expenses:

Reasonable expenses of moving household goods and personal effects from the former residence of an employee who lived in the Gulf Opportunity Zone before August 28, 2005 to the employee’s new residence, as well as travel (including lodging) from the employee’s former residence to the new place of residence when paid by an employer may be included in the employer’s NOL eligible for the extended five year carryback. The former residence and the new residence may either be the same residence (if the employee initially vacated the former residence as a result of Hurricane Katrina) or different residences. It is not necessary that the employee have been employed by the employer at the time the expenses were incurred. Thus, the Committee Report provides that “a taxpayer who pays the moving expenses of a prospective employee and subsequently employs the individual in the Gulf Opportunity Zone may include such expenses in the eligible NOL.”

(3) Temporary Housing Expenses:

Deductions for expenses of an employer to temporarily house employees who are employed in the Gulf Opportunity Zone may be included in the NOL eligible for the extended carryback. The Committee Report provides that it “is not necessary for the temporary housing to be located in the Gulf Opportunity Zone in order for such expenses to be included in the eligible NOL; however, the employee’s principal place of employment with the taxpayer must be in the Gulf Opportunity Zone.”

(4) Depreciation of Gulf Opportunity Zone Property:

NOLs attributable to the depreciation deduction discussed above with respect to qualified Gulf Opportunity Zone Property qualify for the extended carryback period. In addition, the extended carryback period also applies to the regular depreciation deduction for the qualified Gulf Opportunity Zone Property. (Consequently, an election out of the first year bonus depreciation for Gulf Opportunity Zone Property would not preclude the five year carryback of the regular depreciation with respect to the same Property).

(5) Repair Expenses:

The extended carryback period also applies to NOLs attributable to deductions for repair expenses (including the cost of removal of debris, mold, or other contaminants) from property located in the Gulf Opportunity Zone. In order to qualify, the amounts must be paid or incurred after August 27, 2005 and before January 1, 2008.

Housing Relief for Individuals Affected by Hurricane Katrina: New Internal Revenue Code Section 1400P

Background:

If an employer provides housing to an employee, the fair rental value of the housing is generally includible in the employee?s gross income as compensation and is treated as employer paid wages for purposes of social security, medicare taxes, and unemployment taxes.

The Act provides a temporary income exclusion for the value of in-kind lodging provided to a qualified employee (and the employee’s spouse or dependents) by or on behalf of a qualified employer. The Act also provides a tax credit to the employer for the value of the lodging excluded from the income of the employee.

Amount of Income Exclusion:

The entire fair rental value of the lodging is excluded from the qualified employee’s income up to $600 per month. The exclusion does not apply for purposes of social security, medicare taxes, or unemployment taxes.

Amount of Employer’s Tax Credit:

A qualified employer is entitled to a tax credit equal to thirty percent of the value of the lodging excluded from the income of the qualified employee (not to exceed $180 per month). The balance of the expense incurred by the employer to provide lodging will be fully deductible assuming other customary requirements are met.

Qualified Employee:

Is defined by the Act as someone who:

(1) on August 28, 2005 had a permanent residence in the Gulf Opportunity Zone, and

(2) performs substantially all of his or her employment services in the Gulf Opportunity Zone for the employer who furnishes the lodging.

Qualified Employer:

Is defined by the Act as an employer with a trade or business located in the Gulf Opportunity Zone.

Timing:

The exclusion from income for the employee and the employer’s tax credit is limited to the first six months of 2006.

Exclusion for Certain Types of Property from Tax Benefits Available under the Act: New Internal Revenue Code Section 1400N(p)

The provisions discussed above regarding first year bonus depreciation, increased expensing under Code Section 179, and the five year carryback, of net operating losses attributable to depreciation do not apply with respect to certain property. (In this regard, the Committee Report also applies this limitation to the five year carryback of NOLs attributable to casualty losses. A technical correction may be necessary if the statute is to be conformed to the Committee Report.) The tax benefit allowed by these provisions is not attributable to property used “in connection with any private or commercial golf course, country club, massage parlor, hot tub facility, sun tan facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises or…any gambling or animal racing property.” New Code Section 1400N(p)(3)(A). Businesses engaged in the foregoing activities may nonetheless claim the benefit of the provisions of the Act for property which is not used in the conduct of the prohibited activities. Thus, for example, a business operating a gambling casino could nonetheless claim the tax benefits provided by the Act for rental units purchased in order to provide lodging for persons employed to work
in the casinos.

PART II: TAX BENEFITS RELATED TO HURRICANES RITA AND WILMA

Special Rules for Use of Retirement Funds: New Internal Revenue Code Section 1400Q

Background:

The Katrina Emergency Tax Relief Act of 2005 (Public Law 109-73) provides an exception to the ten percent early withdrawal penalty in the case of distributions from a 401(k) plan, IRA, or 403(b) annuity. In addition, the amounts withdrawn are permitted to be taken into income ratably over a three year period. Finally, the amounts distributed can be recontributed to an eligible retirement plan within three years of distribution. In order for a distribution from a retirement plan to qualify under the Katrina Emergency Tax Relief Act of 2005, the distribution was required to be made on or after August 25, 2005 and before January 1, 2007 to an individual whose principal place of abode on August 28, 2005 was located in the Hurricane Katrina disaster area and who sustained an economic loss by reason of the hurricane. The total amount of Hurricane Katrina distributions that an individual can receive from all plans without penalty is limited to $100,000.

Amounts recontributed are treated as rollover distributions and thus reduce the amount of the distribution taken into income. The Committee Report to the Act provides the following example:

“If an individual receives a qualified Hurricane Katrina distribution in 2005, that amount is included in income, generally ratably over the year of the distribution and the following two years, but is not subject to the ten percent early withdrawal tax. If, in 2007, the amount of the qualified Hurricane Katrina distribution is recontributed to an eligible retirement plan, the individual may file an amended return (or returns) to claim a refund of the tax attributable to the amount previously included in income. In addition, if, under the ratable inclusion provision, a portion of the distribution has not yet been included in income at the time of the recontribution, the remaining amount is not includible in income.”

A qualified Hurricane Katrina distribution is a permissible distribution from a 401(k) plan, 403(b) annuity, or governmental 457 plan.

The Act codifies and expands the relief provided under the Katrina Emergency Tax Relief Act of 2005 to include distributions relating to Hurricanes Rita and Wilma. Generally, the requirements for victims of Hurricanes Rita and Wilma are the same as for those individuals affected by Hurricane Katrina. However, with respect to Hurricane Rita, the relief applies to distributions from retirement plans made on or after September 23, 2005 and before January 1, 2007 to individuals whose principal place of abode on September 23, 2005 was located in the Hurricane Rita disaster area and who sustained an economic loss by reason of that hurricane. With respect to Hurricane Wilma, distributions must be made on or after October 23, 2005 and before January 1, 2007 to individuals whose principal place of abode on October 23, 2005 was located in the Hurricane Wilma disaster area and who sustained an economic loss by reason of that hurricane.

Recontribution of Withdrawals for Home Purchases Cancelled due to Hurricanes Rita and Wilma

Background:

The Katrina Emergency Tax Relief Act of 2005 generally provides that a distribution received from a 401(k) plan, 403(b) annuity, or IRA in order to purchase a home in the Hurricane Katrina disaster area may be recontributed to the plan, annuity, or IRA from which it was withdrawn in certain circumstances. Only “qualified distributions” may be recontributed. A qualified distribution may be either a hardship distribution from a 401(k) plan or 403(b) annuity or a qualified first-time home buyer distribution from an IRA that was (1) received after February 28, 2005 and before August 29, 2005 and (2) was used to purchase or construct a principal residence in the Hurricane Katrina disaster area, but the residence was not purchased or constructed on account of Hurricane Katrina. Qualified distributions must be recontributed before February 28, 2006. Amounts recontributed are treated as a rollover. As a result, the portion of the qualified distribution that is recontributed is not includible in income and is also not subject to the ten percent early withdrawal penalty.

The Act codifies and extends the relief provided by the Katrina Emergency Tax Relief Act of 2005 to qualified Hurricane Rita distributions and qualified Hurricane Wilma distributions. Generally, the requirements imposed on Hurricane Rita distributions and Hurricane Wilma distributions in order to qualify are the same as those imposed on Hurricane Katrina distributions. However, in the case of Hurricane Rita distributions, the distribution could have been received as late as September 24, 2005 and in the case of Hurricane Wilma distributions, the distribution could have been received as late as October 24, 2005. The ending date for recontribution (February 28, 2006) is not extended.

Loans from Qualified Plans to Individuals Sustaining an Economic Loss Due to Hurricane Rita or Wilma

Many employer provided retirement plans permit participants to borrow limited amounts from the plan. Generally, loans are limited to the lesser of (1) $50,000 or (2) the greater of $10,000 or one-half of the participant’s accrued benefit under the plan. Generally, the loan most be repaid within five years. However, an extended repayment period is permitted for the purchase of a principal residence. Repayment of plan loans (principal as well as interest) must be amortized in level payments and made not less frequently than quarterly over the term of the loan.

The Katrina Emergency Tax Relief Act of 2005 provides special rules in the case of loans from a qualified employer plan to a qualified individual made after September 23, 2005 and before January 1, 2007. Qualifying individuals are those persons whose principal place of abode on August 28, 2005 is located in the Hurricane Katrina disaster area and who have sustained an economic loss by reason of the hurricane. The Katrina Emergency Tax Relief Act of 2005 increases the amount permitted to be borrowed from $50,000 to $100,000. Further, in the case of loans outstanding on our after August 25, 2005, the due date for repayment is
extended for one (1) year in the case of any loan otherwise required to be repaid between August 25, 2005 and December 31, 2006.

The Act codifies and expands the special rules for loans from qualified employer plans provided under the Katrina Emergency Tax Relief Act of 2005 to loans from qualified employer plans to plan participants affected by Hurricane Rita or Hurricane Wilma. The loans must be made on or after the date of enactment of the Act and before January 1, 2007. Otherwise, the rules applicable to plan participants affected by Hurricane Rita and Hurricane Wilma are generally the same as those impacted by Hurricane Katrina: an increase in the limitation on plan loans from $50,000 to $100,000 and a one (1) year extension of repayments otherwise due between August 25, 2005 and December 31, 2006.

On December 16, 2005 the Senate and the House passed the Gulf Opportunity Zone Act of 2005 by unanimous consent (Public Law 109-135) (the “Act”). The Act was signed into law by the resident on December 21, 2005. The Act appropriates $8.6 billion for regional reconstruction efforts. Many provisions are similar to tax incentives enacted after September 11, including bonus depreciation and enhanced small business expensing. However, in contrast to the earlier initiative, more tax relief is targeted to individuals. The Act also extends some tax incentives in the Katrina Emergency Tax Relief Act of 2005 (Public Law 109-73) enacted in September, 2005 to victims of hurricanes Rita and Wilma.

Geographic Scope:

The Act applies to business activities in certain “Gulf Opportunity” or “GO” Zones. Generally, these appear to be declared disaster areas as identified by the President on or before September 14, 2005 (in the case of Hurricane Katrina), on or before October 6, 2005 (in the case of Hurricane Rita), and on or before November 14, 2005 (in the case of Hurricane Wilma). Generally, such declarations are county specific. The “Gulf Opportunity Zone” refers exclusively to the portions of Alabama, Louisiana and Mississippi damaged by Hurricane Katrina.

PART I: TAX BENEFITS RELATED SOLELY TO HURRICANE KATRINA

Additional First Year Depreciation for Gulf Opportunity Zone Property: New Internal Revenue Code Section 1400N(d)

Background:

Section 167 of the Internal Revenue Code of 1986, as amended (“Code”) allows taxpayers to recover through annual depreciation deductions (and in some cases, immediate expensing) the cost of property used in a trade or business or held for the production of income. Property is considered to be used in a trade or business if it is an integral part of ?considerable, regular, and continuous activities designed to generate a profit.? See e.g., Lewenhapt v. Commissioner, 20 T.C. 151, 162-63 (1953), aff’d per curiam, 221 F.2d 227 (9th Cir. 1954) De Amodio v. Commissioner, 34 T.C. 894, 905 (1960), Aff’d, 299 F.2d 623 (3d Cir. 1962). The activity must have a profit motive and must be regular, frequent, active, and substantial in order to constitute a trade or business. See West v. Commissioner, 51 T.C.M. 589, 591 (1986).

Property held for sale to customers (that is, inventory) is not used in a trade or business and is not depreciable. Treas. Regs. Sec. 1.167(a)-2. For example, the Internal Revenue Service has determined that a builder’s unsold homes used as models and sales offices are not property used in a trade or business because the essential purpose for which the houses were built — sale to customers — was not altered by their temporary use as models and sales offices, and thus they remain inventory in the hands of the builder. Rev. Rul. 89-25, 1989-1 C.B.79.

“The amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different types of property generally are assigned applicable recovery periods and depreciation methods. The recovery periods applicable to most tangible personal property (generally tangible property other than residential rental property and nonresidential real property) range from three to twenty-five years. The depreciation methods generally applicable to tangible personal property are the 200-percent and 150-percent declining balance methods, switching to the straight-line method for the taxable year in which the depreciation deduction would be maximized.” Joint Committee on Taxation Report (the “Committee Report”), page 41.

The Act creates an additional (“bonus”) depreciation deduction for the year depreciable property is placed in service.

Amount of Deduction:

Fifty percent of the adjusted basis of “qualified Gulf Opportunity Zone Property.” The deduction applies for both regular and alternative
minimum tax purposes.

Example 1:

Assume an asset costs $100. The asset qualifies as Gulf Opportunity Zone Property and is therefore entitled to fifty percent (50%) bonus depreciation. The basis of the asset is reduced to $50 and the regular depreciation percentage for the first year is applied to the $50 adjusted basis.

Both the bonus depreciation and the regular depreciation are available to the taxpayer who owns the property to apply against gross income for the first year the property is placed in service. If the first year depreciation combined with certain other deductions recognized by the Act exceed the taxpayer’s gross income, the net operating loss thereby produced may be carried back by the taxpayer to the fifth year preceding the year in which the property was placed in service.

Definition of Qualified Gulf Opportunity Zone Property:

Character of the property:

(1) Non-residential real property,

(2) residential rental property,

(3) off-the-shelf computer software,

(4) tangible personal property with a recovery period of twenty (20) years or less.

Location:

Substantially all use of the property must be in the Gulf Opportunity Zone (in connection with the active conduct of a trade or business).

Timing:

The original use must commence with the taxpayer on or after August 28, 2005.

Example 2:

Assume an investor constructs townhouse units in Biloxi, Mississippi in March, 2006, and sells them to LLCs with a maximum of twelve shares each. Each member would hold a minimum of 1/12 of the entity. The entity would place the unit for rental under the regulations. The units would be fully furnished and rented for not less than a thirty day period.

Residential rental property placed in service on or after August 28, 2005 by an active trade or business in areas affected by Hurricane Katrina constitutes qualified gulf opportunity zone property, therefore the fifty percent (50%) bonus depreciation provided by the Act is would apply.

Acquisition:

By purchase only on or after August 28, 2005 but only if no written binding contract for the acquisition was in effect before August 28, 2005.

The purchase requirement can also be satisfied in the case of property that is manufactured, constructed, or produced by the taxpayer if the property is used by the taxpayer, ?the taxpayer begins the manufacture, construction, or production of the property on or after August 28, 2005,? and the property is placed in service on or before December 31, 2008 (in the case of qualified non-residential real property and residential rental property) or December 31, 2007 (in the case of all other qualifying Gulf Opportunity Zone property). “Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer.” Committee Report, pages 14-15.

Placed in Service Date:

On or before December 31, 2008 (in the case of non-residential real property and residential rental property) or on or before December 31, 2007 (in the case of all other qualified Gulf Opportunity Zone Property).

The term “placed in service” means that the asset has been acquired by a taxpayer engaged in the active conduct of a trade or business and commences when the property is in a condition or state of readiness and availability for a specifically defined function in that business.

The Committee Report indicates that the “original use” requirement may be satisfied by property as long “as it has not previously been used within the Gulf Opportunity Zone.” In addition, it is intended that additional capital expenditures incurred to recondition or rebuild property will satisfy the “original use” requirement if the original use of the property in the Gulf Opportunity Zone began with the taxpayer who is claiming the deduction. See Treas. Reg. Sec. 1.48-2 Example 5.

Increased Expensing for Gulf Opportunity Zone Property: New Internal Revenue Code Section 1400N(e)

Background:

In lieu of depreciation, Code Section 179 allows a taxpayer with a sufficiently small amount of annual investment to elect to deduct the entire cost of an asset in the year in which the asset is purchased and placed in use in the active conduct of a trade or business. (This is generally referred to as “expensing.”) Current law provides that the maximum amount a taxpayer may expense for taxable years beginning in 2003 through 2007 is $100,000 of the cost of qualifying property placed in service during the taxable year. In general, qualifying property is depreciable, tangible personal property purchased for use in the active
conduct of a trade or business. Off-the-shelf computer software placed in service in taxable years beginning before 2008 is also treated as qualifying property. The $100,000 limit on the maximum amount which can be expensed in any year is reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $400,000. The $100,000 and $400,000 amounts are indexed for inflation for taxable years beginning after 2003. As a result, in 2006, the basic $100,000 amount is inflation-indexed to $108,000, and the $400,000 investment limitation for phase-out of the Section 179 deduction is inflation-indexed to $430,000.

The Act increases both the expensing limitation and the investment ceiling limitation for qualified Sec. 179 Gulf Opportunity Zone property.

Increased Tax Benefit:

The maximum amount a taxpayer may expense under Code Sec. 179 is increased by $100,000. Thus, the combination of indexing and increased expensing as a result of the Act will enable a taxpayer to deduct as much as $208,000 of the cost of Sec. 179 Gulf Opportunity Zone Property in 2006.

Increased Investment Ceiling Limitation:

If “excessive” amounts of qualified Sec. 179 Gulf Opportunity Zone property are purchased in one taxable year, the amount which is permitted to be expensed under Code Sec. 179 is reduced. The investment limitation is increased by $600,000. Thus, the combination of inflation-indexing and the increased investment ceiling now allows taxpayers to acquire as much as $1,030,000 in qualifying property before the $208,000 amount which can be expensed in 2006 will be reduced.
(Each dollar over $1,030,000 reduces the $208,000 amount by one dollar.)

Qualified Sec. 179 Gulf Opportunity Zone Property:

Property described in Code Sec. 179(d): generally, tangible personal property purchased for use in the active conduct of a trade or business
and off-the-shelf computer software.

Location:

Substantially all of the use of the property must be in the Katrina Gulf Opportunity Zone in the active conduct of a trade or business conducted by a taxpayer in the Katrina Gulf Opportunity Zone.

Timing:

Use of the property must commence on or after August 28, 2005.

Acquisition:

The property must be acquired by purchase on or after August 28, 2005 but only if no written binding contract for the acquisition was in effect before August 28, 2005.

Use:

The original use of the property in the Gulf Opportunity Zone must commence with the taxpayer on or after August 28, 2005. Used property may qualify so long as it has not been previously used within the Gulf Opportunity Zone. In addition, capital expenditures incurred to recondition or rebuild property will also satisfy the “original use” requirement, if the original use in the Gulf Opportunity Zone began with the taxpayer. (For example, the taxpayer purchases a “damaged” asset, reconditions the asset, and places the asset in service in the active conduct of a trade or business conducted in the Katrina Gulf Opportunity
Zone.)

Timing:

The property must be placed in service by the taxpayer on or before December 31, 2007.

Expensing for Certain Demolition and Clean-up Costs: New Internal Revenue Code Section 1400N(f)

Background:

The cost of demolition of a structure is “captialized” into a taxpayer’s basis for the land on which the structure is located. (Land is not subject to allowances for depreciation or amortization.) Consequently, the cost of demolition is not recovered until the property is sold. Debris removal may be subject to similar limitations depending upon the distinction between repairs and replacement.

The Act permits taxpayers to deduct fifty percent of any qualified Gulf Opportunity Zone clean-up cost.

Qualifying Gulf Opportunity Clean-up Cost:

Any of the following costs incurred in connection with real property located in the Gulf Opportunity Zone which is held for use by a taxpayer in a trade or business or for the production of income, as well as inventory:

(1) removal of debris and

(2) demolition of structures.

Timing:

The clean-up cost must be incurred and paid on or after August 28, 2005 and before January 1, 2008.

This provision allows investors to purchase property, demolish damaged structures, remove storm debris, then flip the property (even if sale occurs after 2007 and even if the property constitutes inventory in the hands of the taxpayer) while deducting fifty percent of the demolition and clean-up costs in the year in which they are incurred.

Increase in Rehabilitation Tax Credit: New Internal Revenue Code Section 1400N(h)

Background:

Code Sec. 47 provides a two-tier tax credit for rehabilitation expenditures. A twenty percent credit is provided for qualified rehabilitation expenditures with respect to a certified historic structure. A “certified historic structure” means any building that is listed in the National Register or is located in a registered historic district and is certified by the Secretary of the Interior to the Secretary of the Treasury as being of historic significance to that district. In addition, a ten percent credit is provided for qualified rehabilitation expenditures with respect to a qualified rehabilitated building.

A “qualified rehabilitated building” is defined by Code Sec.47(c)(1)(A) as any building (and its structural components) which:

(1) has been substantially rehabilitated,

(2) placed in service before the beginning of the r ehabilitation, and

(3) with respect to which

(a) at least fifty percent or more of the existing external walls are retained in place as external walls,

(b) at least seventy-five percent of the existing external walls are retained in place as internal or external walls, and

(c) at least seventy-five percent of the existing internal structural framework is retained in place.

The term “substantially rehabilitated” is defined by Code Sec.47(c)(1)(C) to mean rehabilitation expenditures during a twenty-four
(24) month period exceeding the greater of:

(1) the adjusted basis of the building or

(2) $5,000.

The Act increases from twenty percent to twenty-six percent and from ten percent to thirteen percent, respectively, the rehabilitation tax credit for certified historic structures and qualified rehabilitated buildings located in the Gulf Opportunity Zone.

Timing:

The qualified rehabilitation expenditures must be incurred between August 28, 2005 and December 31, 2008.

Five Year NOL Carryback for Certain Amounts Related to Hurricane Katrina or the Gulf Opportunity Zone: New Internal Revenue Code Section 1400N(k)

Background:

A net operating loss (“NOL”) is, generally, the amount by which a taxpayer’s deductions exceed gross income. When a NOL is incurred in a taxable year, the NOL may be carried back to two prior taxable years (thereby generating a refund for the taxpayer). If application of the NOL carried back to offset the taxpayer’s income in the prior two years does not completely exhaust the NOL, it may be carried forward to be applied against the taxpayer’s gross income in the following year. Remaining NOLs can continue to be carried forward for nineteen additional years (that is, a potential carry forward for as many as twenty years all together).

The Alternative Minimum Tax (“AMT”) rules under Code Sec. 56(d) provide that a taxpayer’s NOL deduction cannot reduce the taxpayer’s alternative minimum taxable income by more than ninety percent (an exception applies to NOL carrybacks arising in taxable years ending in 2001 and 2002).

The Act increases the carryback period for qualified Gulf Opportunity Zone losses from two years to five years. The Act suspends the ninety percent AMT limitation, thereby allowing an NOL carryback to completely eliminate a taxpayer’s alternative minimum taxable income for the carryback year.

Qualified Gulf Opportunity Zone Losses:

Only certain losses and expenditures will qualify for the extended NOL carryback:

(1) Deductions for qualified Gulf Opportunity Zone casualty losses:

Casualty losses with respect to property used in a trade or business and capital assets held for more than one year in connection with a trade or business or a transaction entered into for profit are included in computing the NOL carryback. The property which is the subject of the casualty loss must be located in the Gulf Opportunity Zone and the loss must be attributable to Hurricane Katrina. (Customary requirements of current law that a casualty loss does not include amounts compensated for by insurance continue to apply.)

(2) Employee Moving Expenses:

Reasonable expenses of moving household goods and personal effects from the former residence of an employee who lived in the Gulf Opportunity Zone before August 28, 2005 to the employee’s new residence, as well as travel (including lodging) from the employee’s former residence to the new place of residence when paid by an employer may be included in the employer’s NOL eligible for the extended five year carryback. The former residence and the new residence may either be the same residence (if the employee initially vacated the former residence as a result of Hurricane Katrina) or different residences. It is not necessary that the employee have been employed by the employer at the time the expenses were incurred. Thus, the Committee Report provides that “a taxpayer who pays the moving expenses of a prospective employee and subsequently employs the individual in the Gulf Opportunity Zone may include such expenses in the eligible NOL.”

(3) Temporary Housing Expenses:

Deductions for expenses of an employer to temporarily house employees who are employed in the Gulf Opportunity Zone may be included in the NOL eligible for the extended carryback. The Committee Report provides that it “is not necessary for the temporary housing to be located in the Gulf Opportunity Zone in order for such expenses to be included in the eligible NOL; however, the employee’s principal place of employment with the taxpayer must be in the Gulf Opportunity Zone.”

(4) Depreciation of Gulf Opportunity Zone Property:

NOLs attributable to the depreciation deduction discussed above with respect to qualified Gulf Opportunity Zone Property qualify for the extended carryback period. In addition, the extended carryback period also applies to the regular depreciation deduction for the qualified Gulf Opportunity Zone Property. (Consequently, an election out of the first year bonus depreciation for Gulf Opportunity Zone Property would not preclude the five year carryback of the regular depreciation with respect to the same Property).

(5) Repair Expenses:

The extended carryback period also applies to NOLs attributable to deductions for repair expenses (including the cost of removal of debris, mold, or other contaminants) from property located in the Gulf Opportunity Zone. In order to qualify, the amounts must be paid or incurred after August 27, 2005 and before January 1, 2008.

Housing Relief for Individuals Affected by Hurricane Katrina: New Internal Revenue Code Section 1400P

Background:

If an employer provides housing to an employee, the fair rental value of the housing is generally includible in the employee?s gross income as compensation and is treated as employer paid wages for purposes of social security, medicare taxes, and unemployment taxes.

The Act provides a temporary income exclusion for the value of in-kind lodging provided to a qualified employee (and the employee’s spouse or dependents) by or on behalf of a qualified employer. The Act also provides a tax credit to the employer for the value of the lodging excluded from the income of the employee.

Amount of Income Exclusion:

The entire fair rental value of the lodging is excluded from the qualified employee’s income up to $600 per month. The exclusion does not apply for purposes of social security, medicare taxes, or unemployment taxes.

Amount of Employer’s Tax Credit:

A qualified employer is entitled to a tax credit equal to thirty percent of the value of the lodging excluded from the income of the qualified employee (not to exceed $180 per month). The balance of the expense incurred by the employer to provide lodging will be fully deductible assuming other customary requirements are met.

Qualified Employee:

Is defined by the Act as someone who:

(1) on August 28, 2005 had a permanent residence in the Gulf Opportunity Zone, and

(2) performs substantially all of his or her employment services in the Gulf Opportunity Zone for the employer who furnishes the lodging.

Qualified Employer:

Is defined by the Act as an employer with a trade or business located in the Gulf Opportunity Zone.

Timing:

The exclusion from income for the employee and the employer’s tax credit is limited to the first six months of 2006.

Exclusion for Certain Types of Property from Tax Benefits Available under the Act: New Internal Revenue Code Section 1400N(p)

The provisions discussed above regarding first year bonus depreciation, increased expensing under Code Section 179, and the five year carryback of net operating losses attributable to depreciation do not apply with respect to certain property. (In this regard, the Committee Report also applies this limitation to the five year carryback of NOLs attributable to casualty losses. A technical correction may be necessary if the statute is to be conformed to the Committee Report.) The tax benefit allowed by these provisions is not attributable to property used “in connection with any private or commercial golf course, country club, massage parlor, hot tub facility, sun tan facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises or…any gambling or animal racing property.” New Code Section 1400N(p)(3)(A). Businesses engaged in the foregoing activities may nonetheless claim the benefit of the provisions of the Act for property which is not used in the conduct of the prohibited activities. Thus, for example, a business operating a gambling casino could nonetheless claim the tax benefits provided by the Act for rental units purchased in order to provide lodging for persons employed to work
in the casinos.

PART II: TAX BENEFITS RELATED TO HURRICANES RITA AND WILMA

Special Rules for Use of Retirement Funds: New Internal Revenue Code Section 1400Q

Background:

The Katrina Emergency Tax Relief Act of 2005 (Public Law 109-73) provides an exception to the ten percent early withdrawal penalty in the case of distributions from a 401(k) plan, IRA, or 403(b) annuity. In addition, the amounts withdrawn are permitted to be taken into income ratably over a three year period. Finally, the amounts distributed can be recontributed to an eligible retirement plan within three years of distribution. In order for a distribution from a retirement plan to qualify under the Katrina Emergency Tax Relief Act of 2005, the distribution was required to be made on or after August 25, 2005 and
before January 1, 2007 to an individual whose principal place of abode on August 28, 2005 was located in the Hurricane Katrina disaster area and who sustained an economic loss by reason of the hurricane. The total amount of Hurricane Katrina distributions that an individual can receive from all plans without penalty is limited to $100,000.

Amounts recontributed are treated as rollover distributions and thus reduce the amount of the distribution taken into income. The Committee Report to the Act provides the following example:

“If an individual receives a qualified Hurricane Katrina distribution in 2005, that amount is included in income, generally ratably over the year of the distribution and the following two years, but is not subject to the ten percent early withdrawal tax. If, in 2007, the amount of the qualified Hurricane Katrina distribution is recontributed to an eligible retirement plan, the individual may file an amended return (or returns) to claim a refund of the tax attributable to the amount previously included in income. In addition, if, under the ratable inclusion provision, a portion of the distribution has not yet been
included in income at the time of the recontribution, the remaining amount is not includible in income.”

A qualified Hurricane Katrina distribution is a permissible distribution from a 401(k) plan, 403(b) annuity, or governmental 457 plan.

The Act codifies and expands the relief provided under the Katrina Emergency Tax Relief Act of 2005 to include distributions relating to Hurricanes Rita and Wilma. Generally, the requirements for victims of Hurricanes Rita and Wilma are the same as for those individuals affected by Hurricane Katrina. However, with respect to Hurricane Rita, the relief applies to distributions from retirement plans made on or after September 23, 2005 and before January 1, 2007 to individuals whose principal place of abode on September 23, 2005 was located in the Hurricane Rita disaster area and who sustained an economic loss by
reason of that hurricane. With respect to Hurricane Wilma, distributions must be made on or after October 23, 2005 and before January 1, 2007 to individuals whose principal place of abode on October 23, 2005 was located in the Hurricane Wilma disaster area and who sustained an economic loss by reason of that hurricane.

Recontribution of Withdrawals for Home Purchases Cancelled due to Hurricanes Rita and Wilma

Background:

The Katrina Emergency Tax Relief Act of 2005 generally provides that a distribution received from a 401(k) plan, 403(b) annuity, or IRA in order to purchase a home in the Hurricane Katrina disaster area may be recontributed to the plan, annuity, or IRA from which it was withdrawn in certain circumstances. Only “qualified distributions” may be recontributed. A qualified distribution may be either a hardship distribution from a 401(k) plan or 403(b) annuity or a qualified first-time home buyer distribution from an IRA that was (1) received after February 28, 2005 and before August 29, 2005 and (2) was used to purchase or construct a principal residence in the Hurricane Katrina disaster area, but the residence was not purchased or constructed on account of Hurricane Katrina. Qualified distributions must be recontributed before February 28, 2006. Amounts recontributed are treated as a rollover. As a result, the portion of the qualified distribution that is recontributed is not includible in income and is also not subject to the ten percent early withdrawal penalty.

The Act codifies and extends the relief provided by the Katrina Emergency Tax Relief Act of 2005 to qualified Hurricane Rita distributions and qualified Hurricane Wilma distributions. Generally, the requirements imposed on Hurricane Rita distributions and Hurricane Wilma distributions in order to qualify are the same as those imposed on Hurricane Katrina distributions. However, in the case of Hurricane Rita distributions, the distribution could have been received as late as September 24, 2005 and in the case of Hurricane Wilma distributions, the distribution could have been received as late as October 24, 2005. The ending date for recontribution (February 28, 2006) is not extended.

Loans from Qualified Plans to Individuals Sustaining an Economic Loss Due to Hurricane Rita or Wilma

Many employer provided retirement plans permit participants to borrow limited amounts from the plan. Generally, loans are limited to the lesser of (1) $50,000 or (2) the greater of $10,000 or one-half of the participant’s accrued benefit under the plan. Generally, the loan most be repaid within five years. However, an extended repayment period is permitted for the purchase of a principal residence. Repayment of plan loans (principal as well as interest) must be amortized in level payments and made not less frequently than quarterly over the term of the loan.

The Katrina Emergency Tax Relief Act of 2005 provides special rules in the case of loans from a qualified employer plan to a qualified individual made after September 23, 2005 and before January 1, 2007. Qualifying individuals are those persons whose principal place of abode on August 28, 2005 is located in the Hurricane Katrina disaster area and who have sustained an economic loss by reason of the hurricane. The Katrina Emergency Tax Relief Act of 2005 increases the amount permitted to be borrowed from $50,000 to $100,000. Further, in the case of loans outstanding on our after August 25, 2005, the due date for repayment is
extended for one (1) year in the case of any loan otherwise required to be repaid between August 25, 2005 and December 31, 2006.

The Act codifies and expands the special rules for loans from qualified employer plans provided under the Katrina Emergency Tax Relief Act of
2005 to loans from qualified employer plans to plan participants affected by Hurricane Rita or Hurricane Wilma. The loans must be made on or after the date of enactment of the Act and before January 1, 2007. Otherwise, the rules applicable to plan participants affected by Hurricane Rita and Hurricane Wilma are generally the same as those impacted by Hurricane Katrina: an increase in the limitation on plan loans from $50,000 to $100,000 and a one (1) year extension of
repayments otherwise due between August 25, 2005 and December 31, 2006.

On December 16, 2005 the Senate and the House passed the Gulf Opportunity Zone Act of 2005 by unanimous consent (Public Law 109-135) (the “Act”). The Act was signed into law by the resident on December 21, 2005. The Act appropriates $8.6 billion for regional reconstruction efforts. Many provisions are similar to tax incentives enacted after September 11, including bonus depreciation and enhanced small business expensing. However, in contrast to the earlier initiative, more tax relief is targeted to individuals. The Act also extends some tax incentives in the Katrina Emergency Tax Relief Act of 2005 (Public Law 109-73) enacted in September, 2005 to victims of hurricanes Rita and Wilma.

Geographic Scope:

The Act applies to business activities in certain “Gulf Opportunity” or “GO” Zones. Generally, these appear to be declared disaster areas as identified by the President on or before September 14, 2005 (in the case of Hurricane Katrina), on or before October 6, 2005 (in the case of Hurricane Rita), and on or before November 14, 2005 (in the case of Hurricane Wilma). Generally, such declarations are county specific. The “Gulf Opportunity Zone” refers exclusively to the portions of Alabama, Louisiana and Mississippi damaged by Hurricane Katrina.

PART I: TAX BENEFITS RELATED SOLELY TO HURRICANE KATRINA

Additional First Year Depreciation for Gulf Opportunity Zone Property: New Internal Revenue Code Section 1400N(d)

Background:

Section 167 of the Internal Revenue Code of 1986, as amended (“Code”) allows taxpayers to recover through annual depreciation deductions (and in some cases, immediate expensing) the cost of property used in a trade or business or held for the production of income. Property is considered to be used in a trade or business if it is an integral part of considerable, regular, and continuous activities designed to generate a profit.? See e.g., Lewenhapt v. Commissioner, 20 T.C. 151, 162-63 (1953), aff’d per curiam, 221 F.2d 227 (9th Cir. 1954) De Amodio v. Commissioner, 34 T.C. 894, 905 (1960), Aff’d, 299 F.2d 623 (3d Cir. 1962). The activity must have a profit motive and must be regular, frequent, active, and substantial in order to constitute a trade or business. See West v. Commissioner, 51 T.C.M. 589, 591 (1986).

Property held for sale to customers (that is, inventory) is not used in a trade or business and is not depreciable. Treas. Regs. Sec. 1.167(a)-2. For example, the Internal Revenue Service has determined that a builder’s unsold homes used as models and sales offices are not property used in a trade or business because the essential purpose for which the houses were built — sale to customers — was not altered by their temporary use as models and sales offices, and thus they remain inventory in the hands of the builder. Rev. Rul. 89-25, 1989-1 C.B.79.

“The amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different types of property generally are assigned applicable recovery periods and depreciation methods. The recovery periods applicable to most tangible personal property (generally tangible property other than residential rental property and nonresidential real property) range from three to twenty-five years. The depreciation methods generally applicable to tangible personal property are the 200-percent and 150-percent declining balance methods, switching to the straight-line method for the taxable year in which the depreciation deduction would be maximized.” Joint Committee on Taxation Report (the “Committee Report”), page 41.

The Act creates an additional (“bonus”) depreciation deduction for the year depreciable property is placed in service.

Amount of Deduction:

Fifty percent of the adjusted basis of “qualified Gulf Opportunity Zone Property.” The deduction applies for both regular and alternative
minimum tax purposes.

Example 1:

Assume an asset costs $100. The asset qualifies as Gulf Opportunity Zone Property and is therefore entitled to fifty percent (50%) bonus depreciation. The basis of the asset is reduced to $50 and the regular depreciation percentage for the first year is applied to the $50 adjusted basis.

Both the bonus depreciation and the regular depreciation are available to the taxpayer who owns the property to apply against gross income for the first year the property is placed in service. If the first year depreciation combined with certain other deductions recognized by the Act exceed the taxpayer’s gross income, the net operating loss thereby produced may be carried back by the taxpayer to the fifth year preceding the year in which the property was placed in service.

Definition of Qualified Gulf Opportunity Zone Property:

Character of the property:

(1) Non-residential real property,

(2) residential rental property,

(3) off-the-shelf computer software,

(4) tangible personal property with a recovery period of twenty (20) years or less.

Location:

Substantially all use of the property must be in the Gulf Opportunity Zone (in connection with the active conduct of a trade or business).

Timing:

The original use must commence with the taxpayer on or after August 28, 2005.

Example 2:

Assume an investor constructs townhouse units in Biloxi, Mississippi in March, 2006, and sells them to LLCs with a maximum of twelve shares each. Each member would hold a minimum of 1/12 of the entity. The entity would place the unit for rental under the regulations. The units would be fully furnished and rented for not less than a thirty day period.

Residential rental property placed in service on or after August 28, 2005 by an active trade or business in areas affected by Hurricane Katrina
constitutes qualified gulf opportunity zone property, therefore the fifty percent (50%) bonus depreciation provided by the Act is would apply.

Acquisition:

By purchase only on or after August 28, 2005 but only if no written binding contract for the acquisition was in effect before August 28, 2005.

The purchase requirement can also be satisfied in the case of property that is manufactured, constructed, or produced by the taxpayer if the property is used by the taxpayer, ?the taxpayer begins the manufacture, construction, or production of the property on or after August 28, 2005, and the property is placed in service on or before December 31, 2008 (in the case of qualified non-residential real property and residential rental property) or December 31, 2007 (in the case of all other qualifying Gulf Opportunity Zone property). “Property that is manufactured, constructed, or produced for the taxpayer by another person under a contract that is entered into prior to the manufacture, construction, or production of the property is considered to be manufactured, constructed, or produced by the taxpayer.” Committee Report, pages 14-15.

Placed in Service Date:

On or before December 31, 2008 (in the case of non-residential real property and residential rental property) or on or before December 31, 2007 (in the case of all other qualified Gulf Opportunity Zone Property).

The term “placed in service” means that the asset has been acquired by a taxpayer engaged in the active conduct of a trade or business and commences when the property is in a condition or state of readiness and availability for a specifically defined function in that business.

The Committee Report indicates that the “original use” requirement may be satisfied by property as long “as it has not previously been used within the Gulf Opportunity Zone.” In addition, it is intended that additional capital expenditures incurred to recondition or rebuild property will satisfy the “original use” requirement if the original use of the property in the Gulf Opportunity Zone began with the taxpayer who is claiming the deduction. See Treas. Reg. Sec. 1.48-2 Example 5.

Increased Expensing for Gulf Opportunity Zone Property: New Internal Revenue Code Section 1400N(e)

Background:

In lieu of depreciation, Code Section 179 allows a taxpayer with a sufficiently small amount of annual investment to elect to deduct the entire cost of an asset in the year in which the asset is purchased and placed in use in the active conduct of a trade or business. (This is generally referred to as “expensing.”) Current law provides that the maximum amount a taxpayer may expense for taxable years beginning in 2003 through 2007 is $100,000 of the cost of qualifying property placed in service during the taxable year. In general, qualifying property is depreciable, tangible personal property purchased for use in the active
conduct of a trade or business. Off-the-shelf computer software placed in service in taxable years beginning before 2008 is also treated as qualifying property. The $100,000 limit on the maximum amount which can be expensed in any year is reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $400,000. The $100,000 and $400,000 amounts are indexed for inflation for taxable years beginning after 2003. As a result, in 2006, the basic $100,000 amount is inflation-indexed to $108,000, and the $400,000 investment limitation for phase-out of the Section 179 deduction is
inflation-indexed to $430,000.

The Act increases both the expensing limitation and the investment ceiling limitation for qualified Sec. 179 Gulf Opportunity Zone
property.

Increased Tax Benefit:

The maximum amount a taxpayer may expense under Code Sec. 179 is increased by $100,000. Thus, the combination of indexing and increased expensing as a result of the Act will enable a taxpayer to deduct as much as $208,000 of the cost of Sec. 179 Gulf Opportunity Zone Property in 2006.

Increased Investment Ceiling Limitation:

If “excessive” amounts of qualified Sec. 179 Gulf Opportunity Zone property are purchased in one taxable year, the amount which is permitted to be expensed under Code Sec. 179 is reduced. The investment limitation is increased by $600,000. Thus, the combination of inflation-indexing and the increased investment ceiling now allows taxpayers to acquire as much as $1,030,000 in qualifying property before the $208,000 amount which can be expensed in 2006 will be reduced.
(Each dollar over $1,030,000 reduces the $208,000 amount by one dollar.)

Qualified Sec. 179 Gulf Opportunity Zone Property:

Property described in Code Sec. 179(d): generally, tangible personal property purchased for use in the active conduct of a trade or business and off-the-shelf computer software.

Location:

Substantially all of the use of the property must be in the Katrina Gulf Opportunity Zone in the active conduct of a trade or business conducted by a taxpayer in the Katrina Gulf Opportunity Zone.

Timing:

Use of the property must commence on or after August 28, 2005.

Acquisition:

The property must be acquired by purchase on or after August 28, 2005 but only if no written binding contract for the acquisition was in effect before August 28, 2005.

Use:

The original use of the property in the Gulf Opportunity Zone must commence with the taxpayer on or after August 28, 2005. Used property may qualify so long as it has not been previously used within the Gulf Opportunity Zone. In addition, capital expenditures incurred to recondition or rebuild property will also satisfy the “original use” requirement, if the original use in the Gulf Opportunity Zone began with the taxpayer. (For example, the taxpayer purchases a “damaged” asset, reconditions the asset, and places the asset in service in the active conduct of a trade or business conducted in the Katrina Gulf Opportunity
Zone.)

Timing:

The property must be placed in service by the taxpayer on or before December 31, 2007.

Expensing for Certain Demolition and Clean-up Costs: New Internal Revenue Code Section 1400N(f)

Background:

The cost of demolition of a structure is “captialized” into a taxpayer’s basis for the land on which the structure is located. (Land is not subject to allowances for depreciation or amortization.) Consequently, the cost of demolition is not recovered until the property is sold. Debris removal may be subject to similar limitations depending upon the distinction between repairs and replacement.

The Act permits taxpayers to deduct fifty percent of any qualified Gulf Opportunity Zone clean-up cost.

Qualifying Gulf Opportunity Clean-up Cost:

Any of the following costs incurred in connection with real property located in the Gulf Opportunity Zone which is held for use by a taxpayer in a trade or business or for the production of income, as well as inventory:

(1) removal of debris and

(2) demolition of structures.

Timing:

The clean-up cost must be incurred and paid on or after August 28, 2005 and before January 1, 2008.

This provision allows investors to purchase property, demolish damaged structures, remove storm debris, then flip the property (even if sale occurs after 2007 and even if the property constitutes inventory in the hands of the taxpayer) while deducting fifty percent of the demolition and clean-up costs in the year in which they are incurred.

Increase in Rehabilitation Tax Credit: New Internal Revenue Code Section 1400N(h)

Background:

Code Sec. 47 provides a two-tier tax credit for rehabilitation expenditures. A twenty percent credit is provided for qualified rehabilitation expenditures with respect to a certified historic structure. A “certified historic structure” means any building that is listed in the National Register or is located in a registered historic district and is certified by the Secretary of the Interior to the Secretary of the Treasury as being of historic significance to that
district. In addition, a ten percent credit is provided for qualified rehabilitation expenditures with respect to a qualified rehabilitated
building.

A “qualified rehabilitated building” is defined by Code Sec.47(c)(1)(A) as any building (and its structural components) which:

(1) has been substantially rehabilitated,

(2) placed in service before the beginning of the r ehabilitation, and

(3) with respect to which

(a) at least fifty percent or more of the existing external walls are retained in place as external walls,

(b) at least seventy-five percent of the existing external walls are
retained in place as internal or external walls, and

(c) at least seventy-five percent of the existing internal structural framework is retained in place.

The term “substantially rehabilitated” is defined by Code Sec.47(c)(1)(C) to mean rehabilitation expenditures during a twenty-four (24) month period exceeding the greater of:

(1) the adjusted basis of the building or

(2) $5,000.

The Act increases from twenty percent to twenty-six percent and from ten percent to thirteen percent, respectively, the rehabilitation tax credit for certified historic structures and qualified rehabilitated buildings located in the Gulf Opportunity Zone.

Timing:

The qualified rehabilitation expenditures must be incurred between August 28, 2005 and December 31, 2008.

Five Year NOL Carryback for Certain Amounts Related to Hurricane Katrina or the Gulf Opportunity Zone: New Internal Revenue Code Section 1400N(k)

Background:

A net operating loss (“NOL”) is, generally, the amount by which a taxpayer’s deductions exceed gross income. When a NOL is incurred in a taxable year, the NOL may be carried back to two prior taxable years (thereby generating a refund for the taxpayer). If application of the NOL carried back to offset the taxpayer’s income in the prior two years does not completely exhaust the NOL, it may be carried forward to be applied against the taxpayer’s gross income in the following year. Remaining NOLs can continue to be carried forward for nineteen additional years (that is, a potential carry forward for as many as twenty years all together).

The Alternative Minimum Tax (“AMT”) rules under Code Sec. 56(d) provide that a taxpayer’s NOL deduction cannot reduce the taxpayer’s alternative minimum taxable income by more than ninety percent (an exception applies to NOL carrybacks arising in taxable years ending in 2001 and 2002).

The Act increases the carryback period for qualified Gulf Opportunity Zone losses from two years to five years. The Act suspends the ninety percent AMT limitation, thereby allowing an NOL carryback to completely eliminate a taxpayer’s alternative minimum taxable income for the carryback year.

Qualified Gulf Opportunity Zone Losses:

Only certain losses and expenditures will qualify for the extended NOL carryback:

(1) Deductions for qualified Gulf Opportunity Zone casualty losses:

Casualty losses with respect to property used in a trade or business and capital assets held for more than one year in connection with a trade or business or a transaction entered into for profit are included in computing the NOL carryback. The property which is the subject of the casualty loss must be located in the Gulf Opportunity Zone and the loss must be attributable to Hurricane Katrina. (Customary requirements of current law that a casualty loss does not include amounts compensated for by insurance continue to apply.)

(2) Employee Moving Expenses:

Reasonable expenses of moving household goods and personal effects from the former residence of an employee who lived in the Gulf Opportunity Zone before August 28, 2005 to the employee’s new residence, as well as travel (including lodging) from the employee’s former residence to the new place of residence when paid by an employer may be included in the employer’s NOL eligible for the extended five year carryback. The former residence and the new residence may either be the same residence (if the employee initially vacated the former residence as a result of Hurricane Katrina) or different residences. It is not necessary that the employee have been employed by the employer at the time the expenses were incurred. Thus, the Committee Report provides that “a taxpayer who pays the moving expenses of a prospective employee and subsequently employs the individual in the Gulf Opportunity Zone may include such expenses in the eligible NOL.”

(3) Temporary Housing Expenses:

Deductions for expenses of an employer to temporarily house employees who are employed in the Gulf Opportunity Zone may be included in the NOL eligible for the extended carryback. The Committee Report provides that it “is not necessary for the temporary housing to be located in the Gulf Opportunity Zone in order for such expenses to be included in the eligible NOL; however, the employee’s principal place of employment with the taxpayer must be in the Gulf Opportunity Zone.”

(4) Depreciation of Gulf Opportunity Zone Property:

NOLs attributable to the depreciation deduction discussed above with respect to qualified Gulf Opportunity Zone Property qualify for the extended carryback period. In addition, the extended carryback period also applies to the regular depreciation deduction for the qualified Gulf Opportunity Zone Property. (Consequently, an election out of the first year bonus depreciation for Gulf Opportunity Zone Property would not preclude the five year carryback of the regular depreciation with respect to the same Property).

(5) Repair Expenses:

The extended carryback period also applies to NOLs attributable to deductions for repair expenses (including the cost of removal of debris, mold, or other contaminants) from property located in the Gulf Opportunity Zone. In order to qualify, the amounts must be paid or incurred after August 27, 2005 and before January 1, 2008.

Housing Relief for Individuals Affected by Hurricane Katrina: New Internal Revenue Code Section 1400P

Background:

If an employer provides housing to an employee, the fair rental value of the housing is generally includible in the employee?s gross income as compensation and is treated as employer paid wages for purposes of social security, medicare taxes, and unemployment taxes.

The Act provides a temporary income exclusion for the value of in-kind lodging provided to a qualified employee (and the employee’s spouse or dependents) by or on behalf of a qualified employer. The Act also provides a tax credit to the employer for the value of the lodging excluded from the income of the employee.

Amount of Income Exclusion:

The entire fair rental value of the lodging is excluded from the qualified employee’s income up to $600 per month. The exclusion does not apply for purposes of social security, medicare taxes, or unemployment taxes.

Amount of Employer’s Tax Credit:

A qualified employer is entitled to a tax credit equal to thirty percent of the value of the lodging excluded from the income of the qualified employee (not to exceed $180 per month). The balance of the expense incurred by the employer to provide lodging will be fully deductible assuming other customary requirements are met.

Qualified Employee:

Is defined by the Act as someone who:

(1) on August 28, 2005 had a permanent residence in the Gulf Opportunity Zone, and

(2) performs substantially all of his or her employment services in the Gulf Opportunity Zone for the employer who furnishes the lodging.

Qualified Employer:

Is defined by the Act as an employer with a trade or business located in the Gulf Opportunity Zone.

Timing:

The exclusion from income for the employee and the employer’s tax credit is limited to the first six months of 2006.

Exclusion for Certain Types of Property from Tax Benefits Available under the Act: New Internal Revenue Code Section 1400N(p)

The provisions discussed above regarding first year bonus depreciation, increased expensing under Code Section 179, and the five year carryback of net operating losses attributable to depreciation do not apply with respect to certain property. (In this regard, the Committee Report also applies this limitation to the five year carryback of NOLs attributable to casualty losses. A technical correction may be necessary if the statute is to be conformed to the Committee Report.) The tax benefit allowed by these provisions is not attributable to property used “in connection with any private or commercial golf course, country club, massage parlor, hot tub facility, sun tan facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises or…any gambling or animal racing property.” New Code Section 1400N(p)(3)(A). Businesses engaged in the foregoing activities may nonetheless claim the benefit of the provisions of the Act for property which is not used in the conduct of the prohibited activities. Thus, for example, a business operating a gambling casino could nonetheless claim the tax benefits provided by the Act for rental units purchased in order to provide lodging for persons employed to work in the casinos.

PART II: TAX BENEFITS RELATED TO HURRICANES RITA AND WILMA

Special Rules for Use of Retirement Funds: New Internal Revenue Code Section 1400Q

Background:

The Katrina Emergency Tax Relief Act of 2005 (Public Law 109-73) provides an exception to the ten percent early withdrawal penalty in the case of distributions from a 401(k) plan, IRA, or 403(b) annuity. In addition, the amounts withdrawn are permitted to be taken into income ratably over a three year period. Finally, the amounts distributed can be recontributed to an eligible retirement plan within three years of distribution. In order for a distribution from a retirement plan to qualify under the Katrina Emergency Tax Relief Act of 2005, the distribution was required to be made on or after August 25, 2005 and before January 1, 2007 to an individual whose principal place of abode on August 28, 2005 was located in the Hurricane Katrina disaster area and who sustained an economic loss by reason of the hurricane. The total amount of Hurricane Katrina distributions that an individual can receive from all plans without penalty is limited to $100,000.

Amounts recontributed are treated as rollover distributions and thus reduce the amount of the distribution taken into income. The Committee
Report to the Act provides the following example:

“If an individual receives a qualified Hurricane Katrina distribution in 2005, that amount is included in income, generally ratably over the year of the distribution and the following two years, but is not subject to the ten percent early withdrawal tax. If, in 2007, the amount of the qualified Hurricane Katrina distribution is recontributed to an eligible retirement plan, the individual may file an amended return (or returns) to claim a refund of the tax attributable to the amount previously included in income. In addition, if, under the ratable inclusion provision, a portion of the distribution has not yet been included in income at the time of the recontribution, the remaining amount is not includible in income.”

A qualified Hurricane Katrina distribution is a permissible distribution from a 401(k) plan, 403(b) annuity, or governmental 457 plan.

The Act codifies and expands the relief provided under the Katrina Emergency Tax Relief Act of 2005 to include distributions relating to Hurricanes Rita and Wilma. Generally, the requirements for victims of Hurricanes Rita and Wilma are the same as for those individuals affected by Hurricane Katrina. However, with respect to Hurricane Rita, the relief applies to distributions from retirement plans made on or after September 23, 2005 and before January 1, 2007 to individuals whose principal place of abode on September 23, 2005 was located in the Hurricane Rita disaster area and who sustained an economic loss by reason of that hurricane. With respect to Hurricane Wilma, distributions must be made on or after October 23, 2005 and before January 1, 2007 to individuals whose principal place of abode on October 23, 2005 was located in the Hurricane Wilma disaster area and who sustained an economic loss by reason of that hurricane.

Recontribution of Withdrawals for Home Purchases Cancelled due to Hurricanes Rita and Wilma

Background

The Katrina Emergency Tax Relief Act of 2005 generally provides that a distribution received from a 401(k) plan, 403(b) annuity, or IRA in order to purchase a home in the Hurricane Katrina disaster area may be recontributed to the plan, annuity, or IRA from which it was withdrawn in certain circumstances. Only “qualified distributions” may be recontributed. A qualified distribution may be either a hardship distribution from a 401(k) plan or 403(b) annuity or a qualified first-time home buyer distribution from an IRA that was (1) received after February 28, 2005 and before August 29, 2005 and (2) was used to purchase or construct a principal residence in the Hurricane Katrina disaster area, but the residence was not purchased or constructed on account of Hurricane Katrina. Qualified distributions must be recontributed before February 28, 2006. Amounts recontributed are treated as a rollover. As a result, the portion of the qualified distribution that is recontributed is not includible in income and is also not subject to the ten percent early withdrawal penalty.

The Act codifies and extends the relief provided by the Katrina Emergency Tax Relief Act of 2005 to qualified Hurricane Rita distributions and qualified Hurricane Wilma distributions. Generally, the requirements imposed on Hurricane Rita distributions and Hurricane Wilma distributions in order to qualify are the same as those imposed on Hurricane Katrina distributions. However, in the case of Hurricane Rita distributions, the distribution could have been received as late as September 24, 2005 and in the case of Hurricane Wilma distributions, the distribution could have been received as late as October 24, 2005. The ending date for recontribution (February 28, 2006) is not extended.

Loans from Qualified Plans to Individuals Sustaining an Economic Loss Due to Hurricane Rita or Wilma

Many employer provided retirement plans permit participants to borrow limited amounts from the plan. Generally, loans are limited to the lesser of (1) $50,000 or (2) the greater of $10,000 or one-half of the participant’s accrued benefit under the plan. Generally, the loan most be repaid within five years. However, an extended repayment period is permitted for the purchase of a principal residence. Repayment of plan loans (principal as well as interest) must be amortized in level payments and made not less frequently than quarterly over the term of the loan.

The Katrina Emergency Tax Relief Act of 2005 provides special rules in the case of loans from a qualified employer plan to a qualified individual made after September 23, 2005 and before January 1, 2007. Qualifying individuals are those persons whose principal place of abode on August 28, 2005 is located in the Hurricane Katrina disaster area and who have sustained an economic loss by reason of the hurricane. The Katrina Emergency Tax Relief Act of 2005 increases the amount permitted to be borrowed from $50,000 to $100,000. Further, in the case of loans outstanding on our after August 25, 2005, the due date for repayment is
extended for one (1) year in the case of any loan otherwise required to be repaid between August 25, 2005 and December 31, 2006.

The Act codifies and expands the special rules for loans from qualified employer plans provided under the Katrina Emergency Tax Relief Act of 2005 to loans from qualified employer plans to plan participants affected by Hurricane Rita or Hurricane Wilma. The loans must be made on or after the date of enactment of the Act and before January 1, 2007. Otherwise, the rules applicable to plan participants affected by Hurricane Rita and Hurricane Wilma are generally the same as those impacted by Hurricane Katrina: an increase in the limitation on plan loans from $50,000 to $100,000 and a one (1) year extension of repayments otherwise due between August 25, 2005 and December 31, 2006.