April 3, 2020
CARES Act and other tax issues for the real estate industry
The Coronavirus Aid, Relief, and Economic Security Act (CARES Act), enacted on March 27, 2020, includes several tax measures affecting the real estate industry. In addition, the economic turmoil that has resulted can cause several tax issues for the real estate industry.
Part I of this Tax Alert summarizes those measures, which may impact income tax provisions for the interim period including March 27, 2020 and have state and local tax implications. Given COVID-19's far-reaching effects on the economy, Part II of this Tax Alert discusses broader issues from the resulting economic effects that taxpayers in the real estate industry may want to consider in the upcoming months.
PART I. CARES ACT PROVISIONS
Temporary changes to IRC Section 163(j) limitation (CARES Act Section 2306)
Taxpayers are expected to be able to claim deductions for more interest expense accrued during the 2019 and 2020 tax years because the annual limitation on interest expense deductions under IRC Section 163(j) — i.e., as provided under the Tax Cuts and Jobs Act (TCJA), an annual limit based on 30% of adjusted taxable income (ATI) — has been increased for those years. For the 2019 and 2020 tax years, the annual business interest expense limitation increases to 50% of a taxpayer's ATI, with a special rule for partnerships. In addition, taxpayers may also use their 2019 ATI in calculating their 2020 IRC Section 163(j) limitation.
The CARES Act generally allows taxpayers to increase the 30% of adjusted taxable income (ATI) limitation on business interest expense to 50% of ATI for any tax year beginning in 2019 or 2020. Taxpayers may elect not to apply the higher 50% limitation. Taxpayers may also elect to use their 2019 ATI (in lieu of 2020 ATI) in their 2020 tax year to calculate their 2020 IRC Section 163(j) limitation. If the additional deduction yields negative tax consequences for another tax provision, such as IRC Section 59A (BEAT), taxpayers may decide not to elect to apply the increased IRC Section 163(j) limitation.
For tax year 2019, partnerships must use the 30% of ATI limitation. The ATI limitation increases to 50% of ATI for partnerships in their 2020 tax years, unless the partnership elects not to apply the higher limitation. The partnership may elect to substitute tax year 2019 ATI for tax year 2020 ATI.
Partners may treat 50% of any excess business interest expense (EBIE) allocated to them from a partnership in tax year 2019 as automatically paid or accrued to them in the partner's 2020 tax year, without further IRC Section 163(j) limitations at the partner level (i.e., the partner can deduct that 50% portion regardless of the partner's ATI). The remaining 50% of 2019 EBIE is subject to the "normal" testing rules for EBIE at the partner level (i.e., the partner needs to receive an allocation of excess taxable income (ETI) from that same partnership in future tax years to potentially free up those amounts). The partner may elect not to apply this special rule.
This rule for partnerships can be illustrated with the following example: For the tax year ended December 31, 2019, a partnership (PRS) has $200 of ATI and $100 of business interest expense. PRS may deduct $60 of interest expense (i.e., 30% * $200 of ATI) and $40 is treated as EBIE, which PRS allocates to its partners. For the tax year ended December 31, 2020, PRS has $100 of ATI and $100 of business interest expense. If PRS elects to use 2019 ATI in computing its tax year 2020 limitation, PRS may deduct $100 of interest expense (i.e., 50% * $200).
PRS has no ETI or EBIE for tax year 2020. At the election of the PRS partners, $20 of the EBIE from tax year 2019 (i.e., 50% * $40) can be treated as paid or accrued by the partners in tax year 2020, despite PRS having no ETI in tax year 2020. The $20 treated as paid or accrued by the partners of PRS in tax year 2020 will not be subject to a further IRC Section 163(j) limitation at the partner level. The remaining $20 of EBIE cannot be treated as paid or accrued at the partner level until PRS has ETI in a subsequent year that is allocated by PRS to its partners. If PRS never has ETI in a subsequent year, then, upon a later disposition by the partners of their partnership interests in PRS, the partners increase their outside basis in their respective interests by $20 immediately before the disposition.
Technical amendments regarding qualified improvement property (CARES Act Section 2307): Options for taxpayers eligible to claim bonus depreciation for property subject to the general depreciation system or, alternatively, to change to a correct recovery period for property subject to the alternative depreciation system
Eligible taxpayers (i.e., those not using the alternative depreciation system) that make and have made certain facilities improvements that qualify as "qualified improvement property" (QIP) may be able to deduct those costs immediately (instead of depreciating those costs over time), provided the improvements are owned. This technical correction, made by the CARES Act, allows certain taxpayers to amend returns to claim refunds for costs that were being depreciated or, in appropriate cases, file Form 3115, Application for Change in Accounting Method, to implement an automatic method change. Which alternative(s) is appropriate is highly taxpayer-specific. The Treasury Department is presently expected to release procedural guidance for payers in the near future; this guidance also is anticipated to address the definition of QIP (which may not apply to used property previously placed in service and acquired by the taxpayer). In addition, special consideration should be given to partnerships as discussed herein. Taxpayers that are using the alternative depreciation system with a 40-year recovery period for QIP that desire to change to a 20-year recovery period also may consider the procedural alternatives below, including an accounting method change. If the depreciation at issue is subject to capitalization under IRC Section 263A and the taxpayer does not comply, an automatic change is not presently available unless a concurrent IRC Section 263A change is made.
As background, with the TCJA, Congress created a new category of assets called QIP. QIP generally includes any improvement to an interior portion of a building that is nonresidential real property if that improvement is placed in service after the building was first placed in service and, as added by the CARES Act, is "made by the taxpayer." Due to a technical error, the TCJA treated QIP as 39-year property, which was ineligible for bonus depreciation. As a result, QIP acquired after September 27, 2017, and placed in service after December 31, 2017, had to be recovered over 39 years and, accordingly, was not eligible for bonus depreciation. (However, QIP acquired after September 27, 2017, and placed in service on or before December 31, 2017, was eligible for bonus depreciation and, therefore, was not at issue in the CARES Act changes described here.)
The CARES Act amends IRC Section 168(e)(3)(E) to retroactively include the QIP inadvertently classified as 39-year property under the TCJA as property to which a 15-year recovery period applies and for which bonus depreciation may be claimed. Under the TCJA, taxpayers may claim 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. Because of the new technical amendments, taxpayers that make or have made improvements to their facilities may now take appropriate steps to claim the missed 2018 100% bonus depreciation. Potential options for properly depreciating QIP in light of the CARES Act are discussed in detail in Tax Alert 2020-0806 and summarized further later.
The technical amendment confirms Congress's intent to classify QIP as 15-year property, which is eligible for bonus depreciation. This amendment also confirms that QIP is currently eligible for full expensing if the taxpayer is not required to depreciate QIP using the alternative depreciation system (ADS), in which case a 20-year recovery period applies. Taxpayers that have made a real property trade or business (RPTOB) election under IRC Section 163(j) must use ADS for QIP and thus are not eligible for full expensing.
Many taxpayers that placed significant QIP in service after the effective date of the CARES Act provision for QIP made RPTOB elections, as in 2018, largely because the QIP was not eligible for bonus depreciation. Now that Congress has corrected the TCJA's statutory language, those taxpayers may want to forgo the benefits of unlimited interest expense deductions in exchange for full expensing. Under the TCJA, however, the RPTOB election, once made, is irrevocable. Proposed IRC Section 163(j) regulations interpret the term "irrevocable" to mean that a taxpayer may not change its election in a future year. If the final Treasury regulations are consistent with the proposed IRC Section 163(j) regulations, taxpayers may be unable to change their RPTOB elections. Absent a change in the IRS position in final regulations, it appears that such taxpayers are not presently eligible for bonus depreciation on ADS assets.
Additional options for properly depreciating QIP over a shorter recovery period (e.g., 20 years under the ADS years as required by the CARES Act):
Determining the best year to take the additional QIP deductions (e.g., 2018, 2019, 2020) depends on many factors and affected by the type of taxpayer involved (e.g., partnership, corporation, other). Factors can include, but are not limited to, actual and/or projected taxable income, the need for cash, other cash tax-planning, interaction with carryback provisions and/or NOL rules (as applicable), and other provisions as applicable to a taxpayer. Modeling of this and other CARES Act changes will be valuable.
Alternatively, and as previously noted, eligible taxpayers may be able to amend their income tax returns to change the depreciation recovery period for QIP (based on ADS recovery periods) from 40 years to 20 years, even if they have made an RPTOB election. If the taxpayer is a partnership, the amendment is made as an administrative adjustment request and results in a change to the partners' taxable income in the year in which the request is submitted. As the Treasury Department is contemplating procedural guidance, taxpayers should be aware that additional and/or simplified procedural options may be available upon issuance (possibly prospectively only).
Alternatively, and as previously noted, eligible taxpayers may be able to amend their income tax returns to change the depreciation recovery period of QIP (based on ADS recovery periods) from 40 years to 20 years, even if they have made an RPTOB election. If the taxpayer is a partnership subject to the centralized partnership audit regime (enacted as part of the Bipartisan Budget Act of 2015) for the relevant tax year, it cannot file an amended return with amended K-1s and as a result cannot issue amended K-1s to its partners after the due date for the partnership return has passed (including extensions, if an extension was filed). Rather, the partnership would have to file an administrative adjustment request and the results of such request would be reflected in the partners' taxable income in the year in which the request is submitted. The IRS and Treasury Department are aware of the need to permit alternatives to the administrative adjustment request process and could issue guidance authorizing additional and/or simplified procedural options to the administrative adjustment request process in the near future.
Modifications for net operating losses (CARES Act Section 2303)
The use of net operating losses (NOLs) for corporate and noncorporate businesses is expanded by two amendments to IRC Section 172(a). Taxpayers may (1) use NOLs to offset 100% of taxable income, rather than 80% of taxable income as enacted under the TCJA, and (2) carry back NOLs to offset prior-year income for five years. These are temporary provisions that apply to NOLs incurred in the 2018, 2019 or 2020 tax years. For tax years after 2020, the 80% taxable income limitation is reinstated with modifications that increase taxable income by a taxpayer's deductions under IRC Sections 199A or 250. Taxpayers that carry back NOLs to a year in which the IRC Section 965 transition tax applies will be treated as making an election under IRC Section 965(n), which allows taxpayers to preserve their NOLs. Technical corrections were made to conform effective dates that were mismatched in the statutory language enacted by the TCJA.
If a corporate blocker in a real estate fund or a taxable REIT subsidiary (TRS) has tax losses in 2018 through 2020, it may carry such losses back up to five years to claim taxes paid in an earlier year. For this reason, companies may want to consider reviewing their tax accounting methodologies to determine whether there are any changes they could employ to reduce taxable revenues or increase deductible expenses. Real estate investment trusts (REITs), however, are not able to carry back net operating losses. These provisions also apply to individual taxpayers with NOLs.
The tax benefit of an NOL carryback may be limited for those companies that were subject to GILTI in a year to which the NOL would be carried back (see, generally, Tax Alert 2020-9011).
Modification of limitation on losses for taxpayers other than corporations (CARES Act Section 2304)
NOL relief extends to pass-throughs and sole proprietors by allowing excess business losses under IRC Section 461 for tax years before 2021. Those businesses may also carry losses into subsequent tax years.
Many real estate partnerships generate tax losses due to depreciation and interest expense. Those losses may have been limited under IRC Section 461 after it was amended by the TCJA. The CARES Act makes a technical amendment allowing taxpayers to deduct those losses against non-business income. The provision, however, applies only to tax years before 2021. Thus, real estate partnerships ought to review their tax accounting methodologies to determine whether it is possible to defer taxable income and accelerate deductible expenses into years prior to 2021. For example, a cost segregation study may be beneficial to generate more losses before 2021.
PART II. OTHER ITEMS TO CONSIDER REGARDING THE ECONOMIC EFFECTS of COVID-19
Possible changes in ownership for loss corporations
The income tax attributes of a loss corporation may be limited if the corporation, including a REIT, experiences an "ownership change." IRC Section 382 imposes limitations on the use of tax attributes (e.g. NOL carryforwards and built-in losses) for corporations whose ownership shifts by more than 50% over a rolling three-year period.
The unintended consequences of debt acquisition by the debtor or a party related to the debtor
When debt instruments begin to trade at a significant discount to their face amounts, the distressed debt markets create buying opportunities for third parties, for debtors themselves, and for the shareholders of debtors. If an existing debt instrument held by unrelated parties is acquired at a discount by certain related parties to the borrower, the acquisition will be treated the same as an acquisition by the borrower for purposes of determining whether the borrower realizes cancellation of debt (COD) income.1 For example, when private equity funds acquire the outstanding debt of their portfolio companies, the funds often qualify as a "related party" for purposes of the related-party acquisition rules that may result in taxable COD income.
The unintended tax consequences to borrowers and lenders of modifying a debt instrument
If the terms of an existing debt instrument are modified and the modification is determined to constitute a "significant modification" under certain tax rules, then the existing debt instrument is treated as being retired in exchange for the modified debt instrument (i.e., a deemed debt-for-debt exchange). A significant modification is a taxable exchange for tax purposes and may result from, among other modifications, certain changes to stated interest rates or to the timing of scheduled payments (including extending the maturity date), adding or removing a borrower on a debt or changing the collateral securing the debt. If a significant modification occurs, there are several tax issues to consider, including whether the deemed taxable exchange of the existing debt for the modified debt gives rise to COD income for the borrower and whether the lender has taxable gain.
The possibility of ordinary income and a capital loss resulting from the transfer of property by a debtor to a creditor in satisfaction of a debt
Often property is encumbered by debt that is "recourse" to the debtor. The transfer of the property to a lender in satisfaction of this "recourse" debt may be treated as two separate transactions. First, the debtor is treated as selling the property for its fair market value. The sale of the property is typically treated as capital or IRC Section 1231 gain (the tax treatment of IRC Section 1231 gain is beyond the scope of this discussion). Second, the debtor is then treated as repaying the creditor with the deemed proceeds from the sale. If the fair market value of the property is less than the outstanding debt, which is generally the case in these transactions, the debtor will have COD income equal to the difference. Because of the potential whipsaw in the character of the income, taxpayers may wish to consult with their advisors to consider possible alternatives.
The possibility for potential timing differences impacting tax provisions
Economic conditions may increase the possibility for receivables to be unrecovered or at higher risk. Tax rules may not allow for bad debt deductions for partnerships when they would otherwise be allowable for corporations. Other issues such as rent waivers, interest waivers, etc., may cause additional differences in timing of accruals for financial statement purposes and taxable income. Careful consideration should be given to potential timing differences impacting tax provisions.
REIT taxable stock dividends
Publicly-traded REITs may find themselves in a position in which they have taxable income that they must distribute to maintain their REIT status but would prefer to retain the cash to run their business. One solution may be for the REIT to pay the dividend in part cash and part stock. The IRS has issued rulings confirming that dividends consisting of 80% stock and 20% cash qualify for the dividends paid deduction.
On March 18, 2020, NAREIT submitted a comment letter to Treasury in which it recommended that Treasury issue guidance allowing REITs to reduce the cash component of the dividend to 10%. Regardless of whether additional guidance is forthcoming, REITs may consider the use of taxable stock dividends in order to retain cash.
1 See Treas. Reg. 1.108-2.