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On November 26, 2018, the Treasury and IRS released proposed regulations under Section 163(j) (the Proposed Regulations), which limits the amount of business interest that taxpayers may deduct. The Proposed Regulations generally apply to tax years ending after the date the Proposed Regulations are published as final regulations. Taxpayers may, however, apply the Proposed Regulations to a tax year beginning after December 31, 2017, so long as the taxpayers and their related parties consistently apply the rules of the Proposed Regulations to those tax years.

Background

The Tax Cuts and Jobs Act substantially amended Section 163(j). For tax years beginning after December 31, 2017, Section 163(j) generally limits a taxpayer's business interest expense deduction to the sum of: (i) business interest income, (ii) 30% of adjusted taxable income (ATI), and (iii) floor plan financing interest expense. Any business interest expense not deductible in a tax year is generally treated as business interest expense paid or accrued in the succeeding tax year. The Section 163(j) limitation applies to all taxpayers except for certain small businesses that meet the gross receipts test in Section 448(c) and certain trades or businesses listed in Section 163(J)(7).

The Proposed Regulations include several provisions of interest to the real estate industry.

Electing real property trade or business

Section 163(j) does not apply to any "electing real property trade or business" (RPTB), as provided in Section 163(j)(7)(A)(ii). An electing RPTB includes "any trade or business [that] is described in [Section] 469(c)(7)(C) and [that] makes an election under this subparagraph [Section 163(j)(7)(B]." Once the election is made, it is irrevocable. An electing RPTB must depreciate its nonresidential real property, residential rental property and qualified improvement property using the alternative depreciation system. A trade or business described in Section 469(c)(7)(C) includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

The Proposed Regulations would make clarifications about an electing RPTB.

• The election under Section 163(j)(7)(B) to be an electing RPTB would have to be made for each eligible trade or business of the taxpayer. A taxpayer would make the election by attaching an election statement (containing specific information set forth in the Proposed Regulations) to the taxpayer's timely filed original Federal income tax return, including extensions.
• A special "safe harbor" provides that, if a REIT holds real property, interests in partnerships holding real property, or shares in other REITs holding real property, the REIT is eligible to make the election under Section 163(j)(7)(B) to be an electing RPTB "for all or part of its assets." For this purpose, the term "real property" is defined consistent with the definition of real property under the REIT rules of Section 856, rather than the more restrictive definition set forth under the proposed Section 469 regulations.
• Special rules are provided to address which tax items, including business interest expense and business interest income, are "properly allocable to" excepted trades or businesses (e.g., an electing RPTB) and non-excepted trades or businesses. If a REIT made the RPTB election and the value of the REIT's "real property financing assets" (which includes, for example, mortgage loan receivables) were 10% or less of the value of the REIT's total assets, then all of the REIT's assets would be treated as assets of the electing RPTB; as such, an allocation of tax items between excepted trades or businesses and non-excepted trades or businesses would not be required.
• The Proposed Regulations provide that expenses (other than business interest expense), losses, and other items that are "definitely related" to a trade or business are allocable to the trade or business to which they relate. An item is definitely related to a trade or business if the item giving rise to the deduction is incurred as a result of, or incident to, an activity of the trade or business or in connection with property used in the trade or business.
• Business interest expense and business interest income, and any other items of expense or loss that are not definitely related to a trade or business, would generally be allocated between excepted and non-excepted trades or businesses based upon the relative adjusted tax basis of the trades or businesses for this purpose. An exception to this allocation rule would apply when a taxpayer with qualified nonrecourse indebtedness under Reg. Section 1.861-10T(b) must directly allocate interest expense from the debt to the trade or business incurring that debt in the manner and to the extent provided in Reg. Section 1.861-10T(b). The adjusted tax basis used for purposes of allocating items between excepted and non-excepted trades or businesses would, in the case of depreciable property, be determined by using the alternative depreciation system before any application of additional first-year depreciation deductions (e.g., under Section 168(k)), thus requiring taxpayers that may have otherwise elected bonus depreciation on certain assets to recompute basis on such assets solely for purposes of this allocation.
• The Proposed Regulations would allow partners in partnerships to electively look-through to the partnership's adjusted tax basis in its assets in order to determine the amount of the partner's outside basis that is allocable to an excepted or non-excepted trade or business. If a partner elects not to look-through, the partnership interest would be treated as a non-excepted trade or business asset. For partners owning more than 80% of the capital or profits of the partnership, the look-through rule would be mandatory.
• Additionally, the Proposed Regulations provide three permissible methodologies for bifurcating the tax basis of assets that are used in multiple trades or businesses of the taxpayer based on: (1) the relative amount of gross income the asset generates with respect to the trades or businesses; (2) the relative amount of the asset's physical space used by the trades or businesses (for land or inherently permanent structures); or (3) the relative amount of output generated by trades or businesses that generate the same unit of output.
• An anti-abuse rule provides that an RPTB is not eligible to be an electing RPTB if 80% or more of the business's real property is leased to a trade or business under common control with the RPTB. However, the anti-abuse rule would not apply to a REIT's lease of qualified lodging facilities and qualified health care properties to a taxable REIT subsidiary. The Preamble indicates that the anti-abuse rule was necessary to discourage taxpayers from entering into non-economic structures in which the real estate components of non-real estate businesses are separated from the rest of the businesses in order to artificially reduce the application of Section 163(j) by leasing the real property to the taxpayer or a related party of the taxpayer and electing for this "business" to be an electing RPTB.
• Proposed Regulation Section 1.469-9(b), which was also published on November 26 in conjunction with the Proposed Regulations, provide rules defining the term "real property" for purposes of Section 469(c)(7)(C) and the types of trades or businesses that qualify as "real property trades or businesses."
• The regulations generally define "real property" to mean land, buildings, and other inherently permanent structures that are permanently affixed to land, but not assets that serve an "active function," such as an item of machinery or equipment (e.g., HVAC system, elevator or escalator).
• The regulations provide definitions of the terms "real property operation" and "real property management," but reserve definitions for real property "development," "redevelopment," "construction," "reconstruction," "acquisition," "conversion," and "rental." An example clarifies that a taxpayer's ownership and operation of a luxury hotel may constitute a "real property operation" and thus be an eligible RPTB.
• Revenue Procedure 2018-59, which was published on November 26 in conjunction with the Proposed Regulations, provides a safe harbor that allows taxpayers to treat certain infrastructure trades or businesses (that would not otherwise qualify as RPTBs under the Proposed Regulations) as electing RPTBs. This safe harbor is narrow, however, applying generally to public private partnership (PPP or P3) availability payment transactions and limited PPP property rights transactions for which the government retains certain pricing controls.
• The regulations contain an example in which a partner in a partnership that engages in a real property trade or business is treated as engaging in the partnership's activities, further suggesting that the partner may elect to treat its partnership interest as an electing RPTB.

REITs

The Proposed Regulations would make several clarifications about REITs.

• The ATI for a REIT would be computed without regard to the dividends paid deduction, thus eliminating concerns by some REIT practitioners that a REIT (that is otherwise subject to Section 469(c)(7)) would have little or no ATI (especially for years beginning on or after January 1, 2022 when depreciation deductions are taken into account in computing ATI) since REITs generally obtain a dividends paid deduction to completely offset their taxable income (computed before the dividends paid deduction).
• A REIT's earnings and profits would be reduced in the tax year or years in which the business interest expense was deductible, as contrasted with the year in which the interest expense is incurred.
• As noted, the Proposed Regulations provide special rules for REITs regarding electing RPTBs. For REITs that own shares in other REITs (lower-tier REITs), the Proposed Regulations provide that the partnership look-through rule previously described shall be applied to the REIT's adjusted basis in its lower-tier REIT shares as though the lower-tier REIT were a partnership.

Implications

The Proposed Regulations provide much-needed clarification to the application of Section 163(j) to the real estate industry. In particular, the rules provide helpful detail as to what constitutes a real property trade or business and provide useful clarification to many of the issues that arise for taxpayers determining whether to make the election. The allocation rules for business interest expense and business interest income, as well as other tax items, provide greater clarity for what will be treated as "properly allocable to" excepted and non-excepted businesses for purposes of Section 163(j).

The special rules applicable to REITs provide helpful clarifications for items that were not addressed by the statutory language of Section 163(j) affecting REITs. Additionally, the de-minimis rule for REITs with small amounts of non-excepted trade or business assets is a welcome addition that may help alleviate the burden of applying Section 163(j) for certain REITs that intend to make the RPTB election.

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