Major COVID-19 relief legislation provides some much-needed breathing room for hard-hit real estate entities. The Coronavirus, Aid, Relief and Economic Security (CARES) Act and The Consolidated Appropriations Act 2021 (CAA) are designed to help businesses recover and thrive – and one highly anticipated tax provision is 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 significantly benefit real estate organizations – if you leverage them correctly.
QIP Technical Correction
First, let’s talk about the QIP technical correction. QIP includes 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 expressly 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 CARES Act provisions, QIP is now eligible for a 15-year life (20-year ADS) and 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 and 2019 year. You can choose to file an amended return for the 2018 and 2019 years – or push the adjustment through your 2020 tax return.
Increase to Interest Expense Limitations
The CARES Act increases the interest expense limits from 30% to 50% for the 2019 and 2020 tax years, except partnerships (more on that later). 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, the Excess Business Interest (EBIE) passes out to partners each tax year. The partner’s share of EBIE 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 that allows taxpayers to either revoke or make a late election for 2018, 2019, or 2020 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 delight continued with the CAA – it provided a 30-year ADS life (down from a 40-year life) for residential rental property purchased before 2018. For those residential rental property owners that elected RPTB status in 2018 or 2019, we expect that the IRS will permit either a catch-up of depreciation on the 2020 return or on amended returns. We are still waiting for guidance on how to implement this change.
Finally, this change to a 30-year life may lead many residential property owners to think electing RPTB status on their 2020 returns is a great idea. However, we have found that the increase in the limit from 30% to 50% for 2020 may allow for little to no limit on your interest expense. Depending on how long you’ve had the property, the limited interest could be minor compared to the lost depreciation from the 2.5-year increase in the depreciable life. The bottom line is: you’ve got to do the math before making an irrevocable RPTB election. (Talking to a real estate tax professional would be a great idea.)
NOL Relief – for up to 5 Years
The TCJA eliminated Net Operating Loss (NOL) carrybacks and put 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.
Find Your Best Path Forward
The real estate tax professionals at Barnes Dennig can answer your questions and help you chart the best path forward. Contact us, and let’s have a conversation. We’re here to help.