July 31, 2020
IRC Section 163(j) guidance affects real estate industry
On July 28, 2020, the Treasury Department and IRS released long-awaited final regulations (TD 9005) (the Final Regulations) and proposed regulations (REG-107911-18) (the Proposed Regulations) on the IRC Section 163(j) business interest expense limitation (the Section 163(j) Limitation). The Section 163(j) Limitation was modified in December 2017 by the Tax Cuts and Jobs Act (TCJA), and in March 2020 by the Coronavirus Aid, Relief, and Economic Security Act (the CARES Act).
In addition to the regulations, the IRS issued Notice 2020-59, which creates a safe harbor allowing taxpayers that manage or operate qualified residential living facilities to be treated as a real property trade or business (RPTB) solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7). The IRS also released FAQs on the aggregation rules that apply for purposes of the gross receipts test and determining whether a taxpayer is a small business exempt from the Section 163(j) Limitation. The FAQs provide a brief summary of existing authorities but do not shed any new light on the aggregation rules.
The Final Regulations finalized proposed regulations issued on November 26, 2018 (the Old Proposed Regulations) (see Tax Alert 2018-2360). The Final Regulations apply to tax years ending after the date of publication in the Federal Register; taxpayers may, however, apply the Final Regulations to a tax year beginning after December 31, 2017, so long as they and their related parties consistently apply all of the rules of the Final Regulations to those tax years.
The Proposed Regulations apply to tax years ending after the date they are published as final regulations. Taxpayers may, however, apply the Proposed Regulations to a tax year beginning after December 31, 2017, so long as they and their related parties consistently apply the relevant section of the Proposed Regulations to those tax years.
This Alert covers the aspects in the Final and Proposed Regulations and Notice 2020-59 that are of interest to the real estate industry.
The Tax Cuts and Jobs Act substantially amended IRC Section 163(j). For tax years beginning after December 31, 2017, IRC Section 163(j) generally limits a taxpayer's business interest expense deduction to the sum of: (1) business interest income, (2) 30% of adjusted taxable income (ATI), and (3) 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 IRC Section 448(c) and certain trades or businesses listed in IRC Section 163(j)(7).
The CARES Act made several temporary changes to IRC Section 163(j), including increasing the 30% of ATI limitation on business interest expense to 50% of ATI for any tax year beginning in 2019 or 2020. (See Tax Alerts 2020-0806, 2020-0872, 2020-0979, 2020-1061).
Electing real property trade or business
IRC Section 163(j) does not apply to any "electing real property trade or business" (electing RPTB) (IRC Section 163(j)(7)(A)(ii)). An electing RPTB includes any trade or business that is described in IRC Section 469(c)(7)(C) and makes an election under IRC Section 163(j)(7)(B). A trade or business described in IRC Section 469(c)(7)(C) includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. An electing RPTB must depreciate its nonresidential real property, residential rental property and qualified improvement property (QIP) using the alternative depreciation system. Once the election is made, it is generally irrevocable.
Final Regulations clarify RPTB elections
The Final Regulations answered many of the questions practitioners had about making an IRC Section 163(j)(7)(B) election to be an electing RPTB.
Taxpayers can make an RPTB election regardless of whether they are otherwise subject to the small-business exemption, which exempts small businesses from the Section 163(j) Limitation if their average annual gross receipts for the preceding three years were $25 million or less. Under the Old Proposed Regulations, taxpayers exempt from IRC Section 163(j) by virtue of being a small business could not elect to be an electing RPTB.
An RPTB election may be made for a real property trade or business that does not otherwise meet the definition of a trade or business under IRC Section 162. A taxpayer engaged in activities described in IRC Section 469(c)(7)(C) and Treas. Reg. Section1.469-9(b)(2) may elect for those activities to be an RPTB, regardless of whether the activities qualify as an IRC Section 162 trade or business. Under the Old Proposed Regulations, there was uncertainty as to whether taxpayers owning and renting triple net lease property could make the election under IRC Section 163(j)(7).
An RPTB election must be made for each of the taxpayer's eligible trades or businesses. A taxpayer may make elections for multiple trades or businesses on a single election statement.
How to make an RPTB election
Taxpayers may make the RPTB election by attaching an election statement (containing specific information set forth in the Final Regulations) to their timely filed original federal income tax return, including extensions (this process is unchanged from the Old Proposed Regulations). The Final Regulations clarify that the election statement must sufficiently describe the taxpayer's RPTB to demonstrate qualification for an election.
Once made, the election under IRC Section 163(j)(7)(B) is generally irrevocable. The CARES Act, however, permits the withdrawal of elections for tax years 2018 and 2019. See Tax Alert 2020-0979.
The taxpayer making the RPTB election must use the alternative depreciation system for certain types of property under IRC Section 163(j)(11) and cannot claim the additional first-year depreciation deduction under IRC Section 168(k) for those types of property.
The Final Regulations clarified how to treat disallowed IRC Section 163(j) interest carryforwards. IRC Section 163(j) carryforwards that arose before January 1, 2018, are carried forward as disallowed qualified interest to the taxpayer's first tax year beginning after December 31, 2017. These carryforwards are then subject to disallowance as a disallowed-business-interest-expense carryforward to the extent the interest is properly allocable to a non-excepted trade or business. Disallowed disqualified interest that is properly allocable to an excepted trade or business is not subject to the Section 163(j) Limitation.
In determining whether these disallowed amounts are properly allocable to an excepted or non-excepted trade or business, the Final Regulations permit taxpayers to apply a historical approach by either (1) looking to the tax year(s) in which the disallowed disqualified interest was paid or accrued or (2) applying an effective date approach treating all of the taxpayer's disallowed disqualified interest as if it were paid or accrued in the taxpayer's first tax year beginning after December 31, 2017. This would permit taxpayers who are electing RPTB for the 2018 tax year to treat these amounts as allocable to an excepted trade or business and claim a deduction.
IRC Section 163(j) disallowed business interest expense carryforwards that arose after December 31, 2017, retain their character as business interest. When a taxpayer ceases to be subject to IRC Section 163(j) as an electing RPTB, the carryforward amount is not re-allocated between non-excepted and excepted trades or businesses in a succeeding tax year. Instead, the carryforwards continue to be treated as allocable to a non-excepted trade or business.
When disallowed business interest expense is carried forward to a tax year in which the small-business exemption applies to the taxpayer, the interest expense is no longer subject to limitation.
Allocating between excepted and non-excepted trades and businesses
The Final Regulations clarified how to allocate tax items between excepted and non-excepted trades or businesses.
The Final Regulations contain special rules addressing 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. Under the Old Proposed Regulations, all of the assets of a real estate investment trust (REIT) would be treated as the electing RPTB's assets if the REIT made the RPTB election and had "real property financing assets" (which includes, for example, mortgage loan receivables) valued at 10% or less of its total assets; as such, an allocation of tax items between excepted trades or businesses and non-excepted trades or businesses would not be required. In contrast, if the value of the REIT's "real property financing assets" exceeded 10% of the REIT's total assets, then the REIT would need to apply the look-through rules in determining how to allocate its business interest expense and business interest income between excepted and non-excepted trades or businesses. The Final Regulations retained this approach with further clarification about how the allocation would be made for REITs that need to apply the look-through rules.
The Final Regulations allocate expenses (other than business interest expense), losses and other items that are "definitely related" to a trade or business 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 on the relative adjusted tax basis of the trades or businesses for this purpose. The Final Regulations made several clarifying changes intended to assist in allocating items, specifically addressing how investment items are determined and removed from the allocation computation.
An exception to the allocation rule applies when a taxpayer with qualified nonrecourse indebtedness under Treas. Reg. Section 1.861-10T(b) must directly allocate interest expense from the debt to the trade or business incurring that debt. The Final Regulations helpfully change the treatment of directly allocated items by reducing basis only by the amount of qualified nonrecourse indebtedness, rather than the entire basis of the property securing the indebtedness for purposes of allocating items.
For depreciable property, the adjusted tax basis used for purposes of allocating items between excepted and non-excepted trades or businesses would be determined by using the alternative depreciation system before applying additional first-year depreciation deductions (e.g., under IRC Section 168(k)). Consequently, taxpayers that may have otherwise elected bonus depreciation on certain assets must recompute basis on those assets solely for purposes of this allocation.
The Final Regulations retain the rules allowing partners in partnerships to electively look through to the partnership's adjusted tax basis in its assets 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 is mandatory. When looking through, the partner allocates the basis of its partnership interest between excepted and non-excepted trades or businesses based on the ratio in which the partner's share of the partnership's adjusted tax basis in its trade or business assets is allocated between excepted and non-excepted trade or business assets.
Additionally, the Final Regulations retain the three permissible methodologies described in the Old Proposed Regulations for bifurcating the tax basis of assets, which taxpayers with multiple trades or businesses use. These methodologies are based on:
The Final Regulations do not require a taxpayer to use the same allocation methodology for each type of asset used in a trade a business. Instead, a taxpayer may use different allocation methodologies for different types of assets used in a trade or business.
Changes to the definition of real property
The Final Regulations generally adopt the Old Proposed Regulations in defining the term "real property" for purposes of IRC Section 469(c)(7)(C) and the types of trades or businesses that qualify as "real property trades or businesses." The Final 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 Final Regulations generally retain the definitions in the Old Proposed Regulations of the terms "real property operation" and "real property management" but still reserve definitions for real property development, redevelopment, construction, reconstruction, acquisition, conversion and rental. In addition, the Final Regulations retain the example clarifying that a taxpayer's ownership and operation of a luxury hotel may constitute a "real property operation" and thus be an eligible RPTB.
The Proposed Regulations, however, define the terms "development" and "redevelopment" to include business activities that involve the preservation, maintenance and improvement of forest-covered areas (timberland).
In the Preamble to the Final Regulations, the Treasury Department and the IRS indicate that businesses involving real property construction, reconstruction, development, redevelopment, conversion, acquisition or brokerage should not necessarily be required to have direct nexus with, or a relationship to, rental real estate to be treated as an RPTB under IRC Section 469(c)(7)(C). The end products or final objectives of these businesses, however, should at least have the potential to be used as rental real estate or as integral components in rental real estate activities.
Revenue Procedure 2018-59, which was published in conjunction with the Old Proposed Regulations and provides a safe harbor allowing taxpayers to treat certain infrastructure trades or businesses (that would not otherwise qualify as RPTBs) as electing RPTBs, was not modified.
The Final Regulations make several changes concerning REITs.
The Final Regulations clarify that the REIT safe harbor RPTB election is available if a REIT holds real property directly or indirectly through tiers of partnerships or other REITs. Specifically, the Final Regulations consider a REIT eligible to make to an RPTB election if the REIT holds:
For this purpose, the definition of "real property" is consistent with the definition of real property under the REIT rules of IRC Section 856, rather than the more restrictive definition in the final regulations under IRC Section 469.
The Final Regulations include a new rule permitting certain partnerships controlled by REITs to make the REIT safe harbor RPTB election at the partnership level. A partnership may make the election if one or more REITs own, directly or indirectly, at least 50% of the partnership's capital and profits, the partnership satisfies the REIT asset and the 95% and 75% income tests (tested as if the partnership were a REIT), and the partnership directly or indirectly owns real property through interests in other partnerships or shares in REITs.
Anti-abuse rule regarding RPTB elections
Under the Final Regulations, an RPTB election may not be made for an RPTB if 80% or more of the RPTB's real property is leased to a related party.
In recognition of the permitted exception in IRC 856(d)(9)(D) to the REIT related-party rent rules for qualified lodging facilities and qualified healthcare properties, the Old Proposed Regulations contained an exception to the general anti-abuse rule for REITs leasing qualified lodging facilities and qualified healthcare properties. The Final Regulations revised the exceptions to the anti-abuse rule in several ways. First, a new exception (the de minimis exception) allows a lessor to make the RPTB election if at least 90% of the lessor's real property is leased to a related party that uses the real property in an excepted RPTB and/or to unrelated parties.
Second, a new exception allows a lessor to make the RPTB election to the extent that (1) the lessor leases real property to a related party that subleases the property to an unrelated party or another related party, and (2) each related-party sublessee makes an RPTB election. This "look-through" exception permits a taxpayer to treat that portion of its trade or business as an excepted RPTB that is ultimately leased to a third party or to a related party that uses the real property in an excepted RPTB.
Third, the REIT exception for leases of qualified lodging facilities and qualified health care properties now excludes partnerships making the REIT safe harbor RPTB election from application of the anti-abuse rule.
Additional anti-abuse rule
The Final Regulations add a new anti-abuse provision to prevent the formation and use of tiered entities to manipulate the Section 163(j) Limitation. Under the Final Regulations, the IRS can disregard or recharacterize arrangements that are entered with a principal purpose of avoiding the IRC Section 163(j) regulations, including the use of multiple entities to avoid the gross receipts test of IRC Section 448(c).
Notice 2020-59, released concurrently with the Final Regulations, outlines a proposed revenue procedure that would allow operators and managers of certain residential living facilities to elect to treat those trades or businesses as an RPTB, solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7)(B).
To be eligible, the trade or business must: (1) operate or manage one or more residential living facilities with multiple rental dwelling units that serve as a primary residence for customers on a permanent or semi-permanent basis; (2) provide supplemental assistive, nursing or other routine medical services; and (3) have an average customer use of the dwelling units of 90 days or more. A residential living facility is defined as a nursing home, continuing care retirement community, independent living facility, assisted living facility, memory care facility or skilled nursing facility.
The Final Regulations give taxpayers much-needed clarification about the application of IRC Section 163(j) to the real estate industry. The Final Regulations also allow taxpayers that may be exempt under the small-business exemption to make the RPTB election, providing certainty for taxpayers that may otherwise have had to determine their exemption status annually and potentially fall in and out of the Section 163(j) Limitation each year.
In addition, the Final Regulations make rental real property that is subject to triple net leases eligible for the RPTB election, again providing taxpayers with certainty regarding the permissibility of their RPTB elections, particularly when questions arose as to whether the activity qualified as an IRC Section 162 trade or business.
The allocation rules for business interest expense and business interest income, as well as other tax items, were changed in a manner that clarifies what will be treated as "properly allocable to" excepted and non-excepted businesses for purposes of IRC Section 163(j). The changes in methodology seek to more accurately distinguish between investment and business items and also recognize that the allocations ought to account for leveraged assets properly.
REITs will generally find the changes in the Final Regulations helpful. The new provision permitting partnerships controlled by REITs to make the safe harbor RPTB election is especially helpful, as many REITs (e.g., Up-REITs) hold assets and related indebtedness through lower-tier partnerships. Similarly, operators of residential living facilities will find Notice 2020-59 helpful in providing clarity as to the availability of the RPTB election.
The expansion of the exceptions to the anti-abuse rule recognizes that certain taxpayers may divide property ownership and property operations for valid business reasons, and that certain arrangements with intervening related parties should not be viewed as subject to the anti-abuse rule. The combination of the Notice and the expanded anti-abuse provisions provide certainty for taxpayers owning and/or operating residential living facilities in a "propco-opco" structure that both property-owning and property-operating entities are eligible for the RPTB election.