Although the economic stimulus provisions such as the small business loans and payroll tax deferrals of the Coronavirus Aid, Relief, and Economic Security Act have received much of the publicity, there are significant tax provisions that could have an almost immediate cash flow impact on commercial real estate entities. As is the case with any tax law that comes together in a matter of days (or even hours), there are often questions, and further guidance is needed. Despite the Internal Revenue Service’s recent guidance , questions remain. Owners and investors, as well as REITs, are well advised to quickly take appropriate steps to obtain refunds, as many of the CARES Act provisions directly impact their businesses.
Interest Limitation and Bonus Depreciation
The 2017 Tax Cuts and Jobs Act created significant limitations on how much interest a business could deduct on money it borrows. For taxable years starting on January 1, 2018, and later, the limitation on deduction of interest expense for business entities is 30% of adjusted taxable income. ATI, a term defined in the Internal Revenue Code, is similar to EBITDA, which is used in financial reporting. One major exception to the interest limitation is provided for real property trades or businesses that were allowed to elect out of the limitation.
The one downside to electing out is that a RPTOB is required to depreciate real estate assets over a longer period under the alternative depreciation system. However, this “penalty” isn’t so onerous because real estate assets would have to be depreciated over 40 years instead of the 39 years mandated under the general depreciation rules.
But there was a drafting glitch in the TCJA which caused nonresidential building improvements to be depreciated over 39 years instead of the 15 years under prior law. This also resulted in QIP no longer being eligible for bonus depreciation, which would normally result in a complete write-off of QIP acquired in a year. Note that QIP property is defined as any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property. Such improvements do not include the enlargement of a building, any elevator or escalator work, or the internal structural framework of the building.
As a result, a RPTOB subject to the interest limitation had little downside to electing out of the rules. By opting out of the election, a RPTOB would be eligible to fully deduct interest on its borrowings, and the only cost would be to depreciate QIP over 40 years instead of 39 years.
For 2019 and 2020 tax years, the CARES Act increases the interest limitation to 50% of ATI for corporations and individuals. Although this change is not retroactive to 2018, if a taxpayer were no longer subject to the interest limitation when using 50% of ATI as the cap for 2019 and 2020, perhaps the taxpayer would not have made the RPTOB election in 2018.
In addition, the CARES Act redesignated QIP property to 15-year property, which makes it eligible for 100% bonus depreciation. This change is retroactive to January 1, 2018, and herein lies the rub: Property owners and investors that made the “irrevocable” RPTOB election in 2018 may have been better off not making the election, instead, taking 100% bonus depreciation on QIP and being limited on the interest expense deduction, because the additional bonus depreciation expense is greater than the limitation on the interest expense.
Last week the IRS issued Revenue Procedure 2020-22, which provides taxpayers leeway to revoke the RPTOB election by filing an amended 2018 tax return. In filing the amended return, the taxpayer could take advantage of 100% bonus depreciation on the QIP and revoke the election at the same time; the taxpayer thereby will be treated as never having made the election.
This still doesn’t answer questions that came out when the TCJA was implemented. For example, would taxpayers be able to revoke the election for 2018 (to get the benefit of additional bonus depreciation) and then make the election in 2019, allowing all previous disallowed interest expense to be deductible? Or would the disallowed amount still need to go through the interest limitation calculation?
At the very least, taxpayers and their advisers will certainly have to put pen to paper to decide on the best course of action regarding the RPTOB election and QIP. And for partnerships, the change made by the CARES Act to the interest limitation complicates matters even more: For tax year 2019, the interest limitation percentage for partnerships is not increased.
Carrying Back NOLs
The CARES Act also provides corporations with the opportunity to carry back net operating losses from 2018, 2019 and 2020 for five years. One of the first ideas that comes to mind is that perhaps taxpayers could “supercharge” their 2018 NOLs (or create a 2018 NOL) by amending 2018 tax returns to take advantage of bonus depreciation on QIP. Alternatively, it may make sense for certain taxpayers to take advantage of bonus depreciation for the 2018 tax year by filing a change of accounting Form 3115, thereby taking the deduction in 2019. However, note that the corporate tax rate in 2019 is 21% versus the carryback years of 2013-2017 at 35%.
Thus, amending the 2018 tax return and carrying back the NOL will provide more bang for your buck.
In addition, the IRS issued Notice 2020-26, which allows corporations to use Form 1139 to carry back 2018 NOLs. Form 1139 provides for a “quick refund” with limited IRS review. The notice extends the due date for such forms to June 30, 2020. After that time, 2018 losses can still be carried back, but must be done so on an amended 1120X. The benefits of using Form 1139 include the ease of filing such forms and presumably getting money into the taxpayer’s hands as quickly as possible. However, there may be delays in refunds, given the volume of anticipated claims.
Some intriguing questions also remain regarding NOL carrybacks. Prior to 2018, there was still a corporate-level alternative minimum tax (“AMT”), but it was repealed with the enactment of the TCJA. It is difficult to conclude that there is no AMT NOL to carry back; surely that would not be the law’s intent, as it would negate much of the benefit of the NOL carryback. However, even assuming there is an AMT NOL to carry back, under the rules provided for carryback years 2013-2017, the AMT NOLs would be limited to 90% of alternative minimum taxable income, resulting in an AMT due in those years.
This brings us to another change made by the CARES Act, which was to make minimum tax credits that are carried forward fully refundable in 2019. Additionally, taxpayers could, in fact, refund the entire credit on a 2018 amended return. Does this then require taxpayers to go through all the mechanics of filing different forms just to get the full refund?
The CARES Act made a second change to NOLs, which was to eliminate the limitation on NOL use for 2019 and 2020; under the TCJA, there was an 80% limitation on use of NOLs. Of course, this should be considered along with all the other changes mentioned above as taxpayers and their advisors work through their analysis.
Amended Partnership Returns
Finally, the IRS issued Revenue Procedure 2020-23, which allows an eligible partnership to file an amended Form 1065 and furnish a Schedule K-1 to each of its partners. The alternative to this would be for each partner to file their own administrative adjustment request (“AAR”). There are a couple of reasons to consider both options. First, if partners file their own AAR, such partners would take the adjustment in income during 2019 rather than 2018. Additionally, to the extent that a partnership is able to take advantage of bonus depreciation on QIP, for example, then it must consider that each of its partners will have to amend their Form 1065. A likely scenario may involve a corporate partner requesting that all partners invest to amend their 2018 K-1 so that the corporation can take advantage of the new carryback rules.