On March 27, 2020, the President signed the Coronavirus, Aid, Relief, and Economic Security (CARES) Act to support the economy with loans, subsidies, and some much-needed tax relief. One highly-anticipated tax provision was a fix to the definition of Qualified Improvement Property (QIP) to allow for a 15-year life and bonus depreciation. There are also additional provisions related to interest expense limitations and Net Operating Losses (NOLs) that can greatly benefit real estate organizations – if you leverage them correctly.
QIP Technical Correction
First, let’s talk about the QIP technical correction. QIP is defined as any improvement to an interior portion of a building that is non-residential real property as long as that improvement is placed in service after the building was first placed in service by any taxpayer (Section 168(k)(3)). QIP specifically excludes expenditures for (1) the enlargement of a building, (2) elevators or escalators, or (3) the internal structural framework of a building.
Based on the provisions in the CARES Act, QIP is now eligible for a 15-year life (20-year ADS), and thus eligible for bonus depreciation. Because the provision is a technical correction of the Tax Cut and Jobs Act (TCJA), taxpayers have two options for taking advantage of the additional expense for the 2018 year. Taxpayers can choose to file an amended 2018 return or to push the 2018 adjustment through their 2019 tax return.
Increase to Interest Expense Limitations
The CARES Act increases the interest expense limits from 30% to 50% for tax years beginning in 2019, with an exception for partnerships (more on that later in this post). For taxpayers subject to these limitations, the calculation starts with Adjusted Taxable Income (ATI). ATI is essentially the tax version of Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). Also, for 2020, taxpayers can elect to use their 2019 ATI rather than 2020, if 2019 is higher.
For Partnerships, it’s a little different. Partnerships will not benefit from the increase in limitations in 2019. Instead, partners will get a partial benefit in 2020 for the 2019 Excess Business Interest Expense (EBI). EBI is generally the amount of interest expense that exceeds the 30% limitation.
For partnerships, the EBI passes out to each partner for each tax year. The partner’s share of EBI becomes a carryover for the partner until that particular partnership passes out Excess Taxable Income (ETI), which is the amount that the ATI was above what was needed to deduct the interest for that year. The CARES Act changes the game by providing that partners will have a 2020 deduction of 50% of the 2019 EBI that passed out to them in 2019, while the remaining 50% continues to be a carryover until the partnership has ETI.
Additional Interest Expense Limitation Guidance
For qualifying businesses, such as real estate and construction, the TCJA allows the option of electing to be a Real Property Trade or Business (RPTB). However, in exchange for not being subject to the interest limitations, the IRS requires RPTBs electing this option to slow depreciation through the use of the Alternative Depreciation System (ADS) method for real property such as buildings and QIPs.
In a move that will surprise and delight, the IRS issued guidance, which allows taxpayers to either revoke or make a late election for 2018 or 2019 for treatment as an RPTB. To take advantage of this IRS guidance, you’ll have to file an amended return for either 2018 or 2019.
The TCJA eliminated Net Operating Loss (NOL) carrybacks as well as putting an 80% limitation on the deductibility of the NOL. Under the CARES Act, not only will individuals and businesses not be subject to the 80% TCJA limitation on the amount of loss that they can deduct, but they will also be able to carry the loss back up to five years. So, if the deductions for QIP and the increase in interest limits generate an NOL, you may be able to carry that back to a year where you may have been subject to a higher tax rate, which is the ultimate icing on the cake.
Navigating the complexities of the CARES Act to ensure your real-estate organization is getting the maximum benefit may require professional expertise, and Barnes Dennig is here to help.
If you have any questions about these provisions and their impact, please contact any of our Barnes Dennig COVID-19 Advisory Team Leaders: