The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) provides certain tax relief to real property trades or businesses from provisions of the Tax Cuts and Jobs Act of 2017 (TCJA). The purpose of this alert is to provide background regarding these changes that may be of particular interest to real property trades or businesses.
Under the TCJA, the deduction of business interest expense (including interest of a real estate business) generally is subject to an annual limitation of 30% of “adjusted taxable income.” For years prior to 2022, adjusted taxable income is EBITDA (earnings as computed for tax purposes prior to interest, tax, depreciation, and amortization); after 2021, adjusted taxable income is EBIT (earnings as computed for tax purposes prior to interest and tax). Interest disallowed under this provision is carried forward to the next year and subject to the same limitation in the next year.
The TCJA also allowed immediate expensing of property with a recovery period of 20 years or less and placed in service prior to 2023 (80% in 2020, 60% in 2024, 40% in 2025, and 20% in 2026), but due to an unintentional glitch in the wording of the TCJA, the immediate expensing provision did not apply to “qualified improvement property,” defined as any improvement to an interior portion of a building that is nonresidential real property if such improvement was placed in service after the date the building was first placed in service. As a result of the glitch in law, qualified improvement property was subject to depreciation over a 39-year period.
The TCJA allowed real property trades or businesses to make an election to avoid the limitation on the deduction of interest expense, but in exchange for such election, electing real estate trades or businesses were required to depreciate nonresidential real property, residential rental property, and qualified improvement property under the alternative depreciation system (ADS) rather than under the modified accelerated cost recovery system (MACRS) and forgo any “immediate expensing,” such as furniture, fixtures, and equipment, on eligible property.
Many real estate trades or businesses made the election to avoid the limitation on interest deductions at the price of being subject to ADS depreciation and forgoing immediate expensing. The difference between ADS depreciation and MACRS depreciation was not significant: for residential real property, 30 years under ADS versus 27.5 years under MACRS; for non-residential real property, 40 years under ADS versus 39 years under MACRS; for qualified improvement property, 40 years under ADS versus 39 years under MACRS. Furthermore, the difference between the time value of money from immediate expensing of furniture, fixtures, and equipment versus depreciation under MACRS over 5 or 7 years was not significant.
The CARES Act made significant changes to the interest limitation provision in addition to retroactively fixing the unintended quirk in the language of the TCJA to allow qualified improvement property to be eligible for the immediate expensing provision retroactive to 2018.
With regard to the interest limitation provisions, the CARES Act increased the limitation percentage from 30% of EBITDA to 50% of EBITDA for 2019 and 2020 for corporations and 2020 for partnerships (but with partners allowed to treat 50% of any excess business interest from a partnership allocated to them in 2019 and carrying over to 2020 as not subject to the interest limitations rules in 2020). Additionally, the CARES Act affords the taxpayer subject to the interest limitation deduction to use 2019 EBITDA rather than 2020 EBITDA for purposes of the 2020 interest limitation computation.
As a result of these changes, many real estate trades or businesses may want to reconsider whether the election to avoid the limitation on the deduction of interest expense makes sense. On April 10, the IRS promulgated Revenue Procedure 2020-22 to afford real estate businesses a limited time to “undo” the prior election. Generally, the “election withdrawal statement” needs to be filed by October 15, 2021. However, if the original election was filed with the 2018 return, the election withdrawal statement could be required to be filed earlier (e.g., on the later of the 3-year anniversary of the filing date or the extended filing due date of such return).
In summary, a real property trade or business that files the election withdrawal statement has the opportunity to take full advantage of certain provisions in the CARES Act, including:
- The ability to claim bonus depreciation on qualified improvement property,
- The ability to increase the limit on interest deductibility from 30% of EBITDA to 50% of EBITDA (for 2019 and 2020 for corporate taxpayers and 2020 for partnerships), and
- The ability to use 2019 adjusted taxable income (i.e., 2019 EBITDA) for purposes of calculating a taxpayer’s 2020 interest limitation.
Whether it makes sense for a particular real property trade or business to file an election withdrawal statement will depend on the taxpayer’s particular facts and circumstances. Additionally, in making this analysis, the taxpayer should consider the impact of other related changes under the CARES Act, such as the following:
- The TCJA limitation of using net operating losses (NOLs) generated after 2017 to offset at most 80% of taxable income does not apply for 2018, 2019, and 2020. Taxable income in 2018, 2019, and 2020 can be fully offset by NOLs.
- NOLs generated in 2018, 2019, and 2020 can be carried back 5 years. The TCJA had eliminated the carryback of NOLs. Prior to the TCJA, NOLs could be carried back 2 years. Note that higher tax rates applied prior to the TCJA, so the ability to carryback NOLs prior to 2018 will result in increased tax benefit from utilization of NOLs.
- The TCJA imposed an additional limitation on non-corporate taxpayers from deducting “excess business losses” from trades or businesses against other non-business income. (Excess business losses were losses from all trades or businesses that exceeded $500,000 for married filing jointly and $250,000 for single.) Prior to the TCJA, individuals who “materially participated” generally could deduct such losses against other income. The CARES Act eliminated this limitation for 2018, 2019, and 2020.