January 5, 2021
IRS establishes safe harbor for IRC Section 163(j) deductions for qualified residential living facilities
In Revenue Procedure 2021-9, the IRS created a safe harbor allowing taxpayers that manage or operate qualified residential living facilities to be treated as engaging in a real property trade or business (RPTB) solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7).
The Revenue Procedure applies to tax years beginning in 2018.
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 IRC 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 Coronavirus, Aid, Relief and Economic Security 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 Alerts2020-0806, 2020-0872, 2020-0979, 2020-1061).
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.
The IRS released final IRC Section 163(j) regulations in July 2020 (see Tax Alert 2020-1960). In conjunction with the final regulations, the IRS published Notice 2020-59 outlining 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).
Revenue Procedure 2021-9
In response to comments, the IRS made two changes to the proposals in Notice 2020-59 by (1) reducing the average period that customers or patients must use the rental dwelling units within the facility and adjusting the method of calculating the average period and (2) including an alternative test to meet the requirements of a qualified residential living facility.
Revenue Procedure 2021-9 includes a safe harbor that treats a trade or business managing or operating certain residential living facilities as an RPTB for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7)(B). To be eligible for that safe harbor, the trade or business must consist of operating or managing one or more residential living facilities that:
A property that qualifies as residential rental property under IRC Section 168(e)(2)(A) is also eligible as an RPTB and can satisfy the safe harbor. The Revenue Procedure clarifies that eligibility for the safe harbor must be determined annually.
Operators of residential living facilities will find Revenue Procedure 2021-9 helpful in addressing certain concerns raised in response to the proposed revenue procedure in Notice 2020-59 and confirming the availability of the RPTB election.