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How Was Real Estate Affected by the Tax Cuts and Jobs Act? Part II

This is the second of a two-part series. The first part was published in the March 2020 issue.

In my previous article, I discussed how The Tax Cuts and Jobs Act (TCJA) created the widely discussed Internal Revenue Code Section 199A, Qualified Business Income Deduction and safe harbor rules. This month, let’s examine how the act affects interest expense and depreciation.

Interest Expense

While there has been focus on many aspects of the TCJA, the interest expense limitation under IRC Section 163(j) may have the most effect on the real estate industry. In many ways, the leasing of real estate is simply off-balance sheet financing for many companies. The multifamily market is an off-balance sheet approach to an individual’s shelter, rather than having to use one’s own balance sheet to own a home. Leverage is very common to real estate companies, and this leverage was under attack by the TCJA. IRC Section 163(j) limited the interest expense deduction for business interest expense (BIE) to the extent of the sum of the following: + 30% of adjusted taxable income (ATI), + 100% of business interest income (BII) and +100% of the taxpayer’s floor plan interest.

There were two major exemptions to the disallowed BIE; one was for small businesses under $25 million, and the other was for Electing Real Property Trade or Business companies. At first glance, it would seem that most real estate entities would be covered by the $25 million exemption, and they could deduct all of their interest expenses. However, the $25 million exemption has two catches. First is the complex series of aggregation rules that require entities with common ownership to aggregate their receipts. This has created a significant practical issue — what happens if multiple accounting firms prepare tax returns for partnerships that are related? How does each firm determine if the $25 million threshold is crossed?

The next hurdle is that the $25 million gross receipts exemption does not apply to tax shelters. In general, the term “tax shelter” includes:

• Any enterprise, other than a C corporation, if at any time interest in such enterprise has been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale; and

• Any syndicate (within the meaning of certain Internal Revenue Code sections); a partnership or S corporation in which more than 35% of the losses of such entity during the taxable year are allocable to limited partners or limited entrepreneurs.

Any tax shelter is defined as any partnership or other entity, or any plan or arrangement, if a “significant purpose” of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax. This is also potentially problematic, but we would hope it does not apply merely because the taxpayers chose to organize an entity as a flow-through entity rather than a C corporation, assuming the business was formed to make a profit and not to create inflated tax losses.

Thus, if a real estate entity had losses allocated to its limited partners and was deemed to be a tax shelter, the entity had one final solution to having its BIE not limited. The entity can be an Electing Real Property Trade or Business. This is applicable to any taxpayer who is engaged in a “real property trade or business” (RPTB) who may file an irrevocable election to not be subject to the section 163(j) limitation.

An RPTB is defined as:

  1. Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.
  2. Proposed regulations define “real property operation” and “real property management” but do not provide a detailed definition for other “flavors” of RPTB. These proposed definitions are limited to rental real estate operations — real estate that is used by “customers.” The proposed regulations allow for “incidental personal services” to be provided to customers so long as they are insubstantial in relation to the customer’s use of the real property and are not a significant factor in the customer’s decision to use the property.

In the case of a partnership business, the election must be made on the partnership’s return, not on the partner’s return. If the election is made, the electing RPTB must depreciate its nonresidential real property, residential real property and qualified improvement property using the alternative depreciation system (ADS). The electing RPTB will not be able to claim bonus depreciation under section 168(k).

The change in use rules must be used to compute depreciation for assets placed in service in prior years. There is a safe harbor rule for REITs.

Depreciation

Businesses may take 100% bonus depreciation on qualified property both acquired and placed in service after September 27, 2017, and before January 1, 2023. Full bonus depreciation is phased down by 20% each year for property placed in service after December 31, 2022, and before January 1, 2027.

So what is qualified property? Under TCJA, qualified property is defined as tangible personal property with a recovery period of 20 years or less. TCJA eliminates the requirement that the original use of the qualified property begin with the taxpayer. This “new to you” rule for the inclusion of used property is a significant and favorable change for real estate owners from previous bonus depreciation rules.

TCJA increases the maximum amount of assets a taxpayer may expense under section 179 to $1 million. TCJA expands the definition of section 179 property to include any of the following improvements made to nonresidential real property: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems, as long as the improvements are placed in service after the date the building was first placed in service. This was not available to real estate entities in the past.

Guidance on Bonus Depreciation Elections

The IRS has issued guidance that allows taxpayers to make a late bonus depreciation election, or to revoke an election, for certain property acquired after September 27, 2017. Under TCJA, taxpayers can: elect out of 100% bonus depreciation; elect to take 50% bonus depreciation (instead of 100%) for qualified property acquired after September 27, 2017, and placed in service during the tax year that includes September 28, 2017; or elect to deduct bonus depreciation for any specified plant that is planted or grafted after September 27, 2017, and before 2027.

Taxpayers who failed to make these elections for the tax year that includes September 28, 2017, can make late elections by filing an amended return or a Form 3115 for a limited period of time. If elections were made, taxpayers can revoke the elections under the same terms.

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