As the 2021 tax filing season approaches it is important for business owners to identify tax savings and opportunities that exist as a result of the recent tax legislation and relief provisions enacted this past year. The IRS has also issued various guidance with respect to the CARES Act (March 2020) and the Economic Aid Act (December 2020), while signaling more guidance is expected to be released later this year. The scope of this article focuses on certain components of these tax laws changes that may be of interest to owners of real estate, including opportunities to amend tax returns that have previously been filed and make key decisions going forward. Please consult with your TBC advisor as there may be additional federal and state tax considerations not addressed below.
Increase to allowable business interest expense deductions:
Section 163(j) generally provides rules governing a taxpayer’s ability to deduct business interest expense. These rules changed in 2018 under the TCJA and now apply a limitation test at the business and individual filing levels. Taxpayers with high gross receipts are subject to these rules and must test whether their business interest expense is deductible each year on Form 8990. For qualified small taxpayers with average gross receipts below $26 million for the past three years, there is generally no restriction under these rules and business interest expense may be fully deductible (subject to other tax law rules). One exception here: if a qualified small business has losses flowing to passive investors then they are potentially subject to these rules irrespective of the gross receipts test. Note that complex aggregation and attribution rules apply to combine gross receipts across commonly owned businesses and individuals.
What were the business interest limitation rules?
If subject to these rules prior to the CARES Act, taxpayers could only deduct business interest expense up to the sum of (i) 30% of adjusted taxable income (ATI), (ii) business interest income, and (iii) floor plan financing interest.
Example 1 (Old Rule Pre-CARES Act): Taxpayer’s business interest expense was $40 and ATI was $100. Taxpayer should be able to deduct only $30 (30% of ATI) of interest expense on the tax return. The remaining $10 of interest expense is limited and should generally carryover to next year and be subject to retesting on next year’s tax return.
What are the business interest limitation rules today?
The CARES Act made favorable changes to the Section 163(j) limits. The allowable business interest expense limitation changed from 30% to 50% of ATI for tax years 2019 and 2020 for corporations and individuals (tax year 2020 only for partnerships), respectively. There are additional specific rules provided for partnerships. As a result, these law changes may provide taxpayers with an ability to increase deductible interest expense and decrease taxable income on 2019 and 2020 tax returns.
Example 2 (New Rule Post CARES Act): Taxpayer’s business interest expense was $40 and ATI was $100. The taxpayer should be able to deduct all $40 of interest expense since the business interest limit was $50 (50% of ATI). Note that the taxpayer was able to reduce taxable income by $10 compared to Example 1 under the CARES Act tax law change.
Other Section 163(j) Considerations
Partnerships subject to these rules are eligible to deduct up to 50% of the 2019 business interest expense that was limited by Section 163(j) on 2020 tax returns.
Taxpayers can elect to use ATI reported on 2019 returns on 2020 tax returns if it provides for a higher amount of deductible business interest expense.
Eligible real estate businesses that expect to have a limitation may escape the Section 163(j) limit regime if they make a RPTOB election (more on this below).
Consider making a Real Property Trade or Business Election:
Real estate businesses subject to these limits may have the ability to elect out of the rules under Section 163(j) by making a Real Property Trade or Business (RPTOB) Election under Section 163(j)(7)(B) and Treas. Reg. Sec. 1.163(j)-9. The result of making this election is that business interest expense for that tax year and all future tax years is fully deductible. However, the taxpayer must use slower depreciation on residential property, nonresidential property and qualified improvement property assets under Alternative Depreciation System (ADS). It is advisable for business owners to weigh the benefits and costs of making this election.
Who can make the RPTOB election?
Generally, any business in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage industry can make the RPTOB election. However, a taxpayer can’t make a RPTOB election if 80% or more of the taxpayer’s real property, by fair market value, is leased to a related party. Furthermore to achieve the most benefit a taxpayer must be considered a real estate professional. For more information, read here:
What is the impact on depreciation expense if a RPTOB election is made?
If a RPTOB election is made, then the business must switch to ADS for depreciating residential rental property, non-residential property and qualified improvement property assets. Normal depreciable lives under Modified Accelerated Cost Recovery System (MACRS) for these assets are 27.5, 39, and 15, respectively. ADS depreciable lives for these assets are 30, 40, and 20, respectively. A significant difference between MACRS and ADS is that bonus depreciation is not permitted on certain assets being depreciated under the ADS method. Accordingly, business owners should be aware that making a RPTOB election may in turn reduce depreciation expense claimed each year. Note, bonus depreciation may still be claimed on certain assets that are not affected by the ADS method, such as assets with 5 and 7 year recovery periods and certain land improvements. Therefore, a cost segregation study may be beneficial to identify a business’s assets that are not subject to ADS treatment upon making a RPTOB election.
How does the taxpayer make a RPTOB election?
An election statement must be attached to a timely filed tax return (including extensions) for the year the taxpayer intends to make the election. The statement must include the following information:
- The taxpayer’s name, address, and social security number or employer identification number;
- A description of the electing trade or business, including the principal business activity code; and
- A statement that the taxpayer is making an election as a real property trade or business (under section 163(j)(7)(B) or as a farming business (under section 163(j)(7)(C)), as applicable.
Is it possible to revoke a RPTOB election once made?
Yes. As stated above, the IRS has ruled that the election, once made, is generally irrevocable and binding on the trade or business for all succeeding years. However, as a result of the pandemic and recent tax law changes, the IRS is now granting taxpayers the option to revoke a RPTOB election that was previously made for 2018 and 2019 tax returns. This makes sense from a tax policy perspective given that (i) the Section 163(j) rules have changed and (ii) the qualified improvement property recovery period was corrected (discussed below) pursuant to the CARES Act. Taxpayers who previously filed a RPTOB election may have otherwise chosen not to do so given these changes. To revoke the RPTOB election, taxpayers must file an amended return or administrative adjustment request (AAR), if applicable, by October 15, 2021. For more information see IRS Rev. Proc. 2020-22.
Is it possible to file a late RPTOB election if the tax return was already filed?
Yes. The IRS is now allowing taxpayers to make a late RPTOB election with respect to 2018 and 2019 tax returns. The taxpayer must file an amended return or an AAR, if applicable, by October 15, 2021. For more information see IRS Rev. Proc. 2020-22.
Increase depreciation expense attributable to Qualified Improvement Property:
The CARES Act also included a long anticipated technical correction fixing the depreciation periods for qualified improvement property (QIP). Generally, QIP consists of interior improvements to an existing nonresidential real property, including but not limited to, plumbing, electrical equipment, fixtures, roofs, HVAC, fire protection, alarm and security systems. In addition to Section 179 expensing, QIP is now eligible for 100% bonus depreciation under MACRS.
What was the QIP technical correction made under the CARES Act?
The TCJA replaced the three categories of property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property) included in qualified real property with QIP. Under the TCJA, Congress intended to assign a 15 year recovery period to QIP placed in service after 2017 in order to make it eligible for bonus depreciation. However, due to a drafting error in the TCJA, QIP was instead assigned a 39 year recovery period, thereby making these assets ineligible for bonus depreciation under MACRS. The CARES Act corrected this error and clarified that QIP is depreciable over 15 years under MACRS and 20 years under ADS, thereby making it eligible for bonus depreciation under MACRS. As stated above, business owners should keep in mind that bonus depreciation is still not permitted under ADS for QIP.
How does a taxpayer report this QIP recovery period change on a tax return?
The IRS has issued guidance to taxpayers regarding the QIP technical correction. Taxpayers changing the depreciation of QIP will be treated as though they were changing from an impermissible to a permissible method of accounting. The guidance provides taxpayers that placed QIP in service in their 2018, 2019, or 2020 tax year with the option to file a Form 3115, Application for Change in Accounting Method, with their current-year return to claim the missed depreciation, or to file an amended return or AAR for the year the QIP was placed in service and any affected succeeding tax years. For additional information see IRS Rev. Proc. 2020-25.
NYS Nonconformity to CARES Act Regarding QIP Correction
NYS did not confirm to the CARES Act with respect to individuals and partnerships. Therefore, the QIP recovery period remains 39 years for these taxpayers for NYS tax law purposes. For 2020 tax returns, there will be an addback to NYS income reported on a new form, the IT-558, to account for the depreciation difference resulting from the federal QIP recovery period of 15 years compared to the NYS QIP recovery period of 39 years. Importantly, NYS also does not conform to the federal tax treatment of bonus depreciation. Therefore, business owners will be able to depreciate QIP faster for federal tax purposes compared to NYS tax purposes.
Other QIP Considerations
The QIP drafting error made it difficult for business owners in 2018 and 2019 to decide whether a RPTOB election should be made. The ability to claim 100% bonus depreciation on QIP, which is now permitted under MACRS, may have had a significant impact on whether to elect out of the Section 163(j) interest rules. This is another reason taxpayers may want to consider revoking a Section 163(j) election. In most situations, the costs of making the RPTOB will now be higher.
Increased depreciation expense allowed for Residential Rental Property:
The Economic Aid Act changed the ADS recovery period for residential real property placed in service before 2018 from 40 years to 30 years. This change could have a significant impact on the amount of depreciation expense claimed on a prior year tax return. Residential real estate owners should consider the impact on previously filed returns and on the cost benefit analysis of making a RPTOB election.
Who may benefit from this tax law change?
Residential rental property owners who made a RPTOB election to avoid the Section 163(j) interest limits in 2018 or 2019 may be able to claim additional depreciation expense for residential property placed in service prior to 2018.
Example 3 (Old Rule Pre-Economic Aid Act): Taxpayer has residential property worth $5,000,000 placed in service January 1, 2017. Taxpayer made the RPTOB election in 2018 to be able to fully deduct business interest expense. As a result of making the election, the taxpayer had to change the depreciable life on residential rental property from 27.5 years under MACRS to 40 years under ADS. One year depreciation expense for this asset under ADS is $125,000 (5,000,000 / 40 years).
Example 4 (New Rule Post-Economic Aid Act): Assume the same facts as Example 3, however, upon making the election the taxpayer now has to change its depreciable life on its residential rental property from 27.5 years MACRS to 30 years under ADS. One year depreciation expense for this asset is now $166,666 (5,000,000 / 30 years).
In this circumstance, the taxpayer was entitled to additional depreciation of $41,666 (166,666 – 125,000) for that tax year.
Given the tax law changes and relief provided under the recently passed legislation and IRS guidance, taxpayers should analyze whether tax savings and planning opportunities exist both retroactively on previously filed tax returns and prospectively. Should you have any questions please consult with your TBC advisor.