April 8, 2020
H.R. 748 CARES Act Tax Provisions Impacting Real Estate Industry
Posted by COVID-19 Rapid Response Team
On March 27, 2020, President Trump signed H.R. 748, the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) into law. The CARES Act contains a number of tax provisions that will likely impact the real estate industry and its owners, investors, and operators, including:
- Modification of Net Operating Loss (“NOL”) carryback and utilization rules under §172
- Modification of Excess Business Loss Limitations under §461(l)
- Modification of Business Interest Expense Limitations under §163(j)
- Technical correction to the treatment of Qualified Improvement Property under §168
As detailed below, taxpayers with the following circumstances could be impacted:
- NOLs – Taxable losses in 2018 and/or 2019 after prior taxable income in years 2013 through 2018
- Excess Business Loss Limitation – Taxpayer was subject to the §461(l) limitation in 2018 and/or 2019
- Qualified Improvement Property – Significant non-residential real property additions that would qualify as Qualified Improvement Property placed in service during 2018 and/or 2019
Net Operating Losses – §172
Prior to the enactment of the CARES Act, NOLs could be utilized as follows:
- For NOLs arising in taxable years beginning before January 1, 2018
- Carrybacks: None
- Carryforwards: 20 years
- Utilization: Could be used to offset 100% of taxable income
- For NOLs arising in taxable years beginning after December 31, 2017[i]
- Carrybacks: None
- Carryforwards: Indefinite
- Utilization: Could be used to offset 80% of taxable income
Section 2303 of the CARES Act modifies both the carryback and utilization of certain NOLs.
- Utilization – for NOLs arising in taxable years beginning before January 1, 2021, the 80% of taxable income limitation no longer applies and the NOL can be used to offset 100% of taxable income. As a result, the 80% of taxable income limitation, which was originally effective for taxable years beginning on or after January 1, 2018, has been postponed three years to taxable years beginning on or after January 1, 2021. Thus, for calendar year taxpayers, NOLs can now be used to fully offset taxable income for taxable years through 2020.
- NOL Carrybacks – special NOL carryback rules are created for NOLs arising in taxable years on or after January 1, 2018 and through December 31, 2020 (for calendar year taxpayers, this would be NOLs generated in 2018, 2019 and 2020). These changes allow such NOLs (2018 – 2020) to be a NOL carryback to each of the five prior taxable years.
- Other Considerations
- A NOL for a Real Estate Investment Trust (“REIT”) cannot be carried back to any taxable year preceding the loss year. Furthermore, if a loss is sustained in a non-REIT year, it cannot be carried to any preceding taxable year in which the taxpayer was a REIT. Thus, if either of (i) the year of NOL generation or (ii) the year in which an NOL would be carried back are a REIT year, the NOL cannot be carried from or to that taxable year.
- AMT Limitation – Under §56(d), NOLs are only allowed to offset 90% of Alternative Minimum Taxable Income. This limitation was not impacted by the CARES Act and taxpayers could thus remain subject to Alternative Minimum Tax in years in which 100% of regular taxable income is offset by regular NOLs.
As a result of these amendments, taxpayers with NOL utilization or generation in 2018 and 2019 should review the following:
- For taxpayers utilizing NOLs in 2018 and 2019 – confirm if limited by the 80% utilization limit of prior §172(a)(2). If limited, consider filing an amended return (or Form 1139/1045) to reflect the updated 100% NOL utilization.
- For taxpayers with NOL Carryforwards remaining (after the application of number 1 above) for taxable years beginning on or after January 1, 2018 to current, review the remaining NOLs to determine if there was taxable income in any of the prior five taxable years to which the NOL could be carried back and used to offset taxable income and generate a refund.
Excess Business Loss Limitation – §461(l)
TCJA created §461(l) and the concept of limiting the deductibility of Excess Business Losses (after the application of §704(d), §465 and §469), which was intended to apply to taxable years beginning on or after January 1, 2018 (and terminating for taxable years beginning before January 1, 2026). Section 2304 of the CARES Acts amends this, quite simply, by extending the effective date until taxable years beginning on or after January 1, 2021 (three-year deferral).
Section 2304 of the CARES Act also made several technical corrections to §461(l) as originally enacted by TCJA. While not of relevance now, these are worth noting below:
- §461(l)(3)(A)(i) – specifies that the term “Excess Business Loss” is determined without regard to any deduction allowable under §172 (NOL) or §199A (Qualified Business Income).
- §461(l)(3)(A)(i) Flush Language – this was updated to state “Such excess (Excess Business Loss) shall be determined without regard to any deductions, gross income, or gains attributable to any trade or business of performing services as an employee.” While beyond the scope of this alert, there previously existed a position that employment income (i.e. trade or business of being an employee) could enter into the calculation of Excess Business Loss. As a result, business losses could offset employment income, and §461(l) was relegated to preventing net losses from a trade or business from offsetting investment income. This new language is directly aimed at such a position and appears to clarify that §461(l) prevents business losses from offsetting both employee/wage and investment income.
- Finally, the treatment of capital gains is clarified/specified in §461(l)(3)(B)
- Capital Losses – are not taken into account as an ‘aggregate deduction’ under §461(l)(3)(A)(i), and
- Capital Gain – the amount of capital gain taken into account under §461(l)(3)(A)(ii) (gross income/gain attributable trade or business) cannot exceed net capital gain (apparently at the taxpayer level).
Business Interest Expense Limitations – §163(j)
Significant changes were enacted by TCJA to business interest expense limitation rules of §163(j) and greatly expanded its reach and the population of taxpayers subject to its provisions. In broad terms, §163(j), as enacted by TCJA, limited the deductibility of business interest expense to the sum of (i) business interest income and (ii) 30% of Adjusted Taxable Income. Notably, taxpayers making an Electing Real Property Trade or Business Election (“ERPTB”) under §163(j)(7) were exempt from the §163(j) interest expense limitation regime.
Section 2306 of the CARES Act modifies §163(j) for 2019 and 2020 as follows:
- The Adjusted Taxable Income threshold becomes 50% (as opposed to 30%),
- New §163(j)(10)(B) provides an election allowing a taxpayer to use its 2019 Adjusted Taxable Income for taxable years beginning in 2020. For taxpayer’s with declining financial conditions in 2020, using their 2019 Adjusted Taxable Income could provide for a higher threshold against which to deduct interest expense. In the case of a partnership, this election is made at the partnership level.
- Application to Partnerships for 2019 – The general rule above (substituting 50% of Adjusted Taxable Income for 30% of Adjusted Taxable Income) does not apply for any partnership taxable year starting in 2019. Rather, 50% of any Excess Business Interest Expense allocable to a partner in 2019 is treated as “paid or accrued” by the partner in the partner’s taxable year beginning in 2020 and is not subject to limitation under §163(j)(1). The other/remaining 50% is treated in the same manner as any other Excess Business Interest Expense allocated from the partnership.
§163(j) continues to be inapplicable to taxpayers that have made an ERPTB election, and under §163(j)(7)(B) is irrevocable once made.
Because of these changes, taxpayers should:
- Review 2019 §163(j) calculations for taxpayers subject to §163(j) to ensure interest deductibility is based upon 50% of Adjusted Taxable Income.
- Be aware of the impact for partners in partnerships for 2020.
- Be aware of Adjusted Taxable Income elections and 50% threshold for 2020 return.
- Taxpayers should consider the change in depreciable lives/methods of Qualified Improvement Property (discussed below) when evaluating the cost/benefit analysis of an ERPTB Election.
Qualified Improvement Property – §168
Effective January 1, 2018, TCJA eliminated the prior asset categories of Qualified Leasehold Improvement property, Qualified Restaurant Property, and Qualified Retail Improvement Property and consolidated them into Qualified Improvement Property (“QIP”). While the conference agreement to TCJA clearly indicated congress intended QIP to be treated as 15-year MACRS and 20-year ADS property, drafting errors in the final text of TCJA failed to properly ‘link’ definitional sections within the Code. This resulted in QIP receiving no special treatment, with the default falling back to 39-year MACRS and 40-year ADS non-residential real property, with bonus depreciation not allowable under either system.
Section 2307 of the CARES Act included technical corrections to treat QIP as a 15-year MACRS asset and 20-year ADS asset, as originally intended by TCJA. Importantly, the bill treats this as a technical correction, and the amendment under CARES §2307 take effect as if originally included in the text of TCJA. As a result, QIP is treated as if it were a 15-year MACRS/20-year ADS asset from the effective date of the TCJA, or January 1, 2018.
QIP is defined as any improvement made by the taxpayer to an interior portion of a building which is non-residential real property if such improvement is placed in service after the date such building was first placed in service (specifically excludes the enlargement of a building, any elevator or escalator, or the internal structural framework).
Under §163(j)(7)(A), an eligible real property trade or business can elect out of the business interest expense limitations of §163(j) by making and Electing Real Property Trade or Business Election (“ERPTB”). The “pay-for” for being allowed to escape the §163(j) interest expense limitation is the taxpayer must use ADS depreciation (under §168(g)) for any non-residential real property, residential rental property, and Qualified Improvement Property held by an electing real property trade or business.
Below is a chart summarizing the CARES Act’s impact on QIP deprecation, which retroactively treats QIP as a 15-Year MACRS/20-Year ADS asset rather than non-residential real property (under §168(c)).
As a result of this technical correction, the following actions should be taken:
- Review 2018 – 2019 non-residential real property additions to determine if they would qualify as QIP.
- If QIP was placed in service in 2018, possible options include:
- Amend 2018 return to take bonus and/or shorten life from 39-year MACRS to 15-year MACRS (40-year ADS to 20-year ADS).
- Leave 2018 as is and make method change (3115) in 2019 (or 2020).
- If QIP was placed in service in 2019, possible options include:
- Leave as is and make accounting method change in 2020.
- Update 2019 calculations and re-distribute K-1s.
- If plan is to amend 2018 and claim bonus, may need to remove depreciation deduction for QIP from 2019 calculations.
- Analysis above applies to taxpayers who used ADS (REITs, taxpayers making ERPTB election, etc.) as ADS life was reduced from 40 years to 20.
- For taxpayers without an ERPTB election in place as of 2018, determine the impact of this change on the cost-benefit analysis of potentially making an ERPTB election in 2019 or subsequent tax years.
[i] §13302 of the Tax Cuts & Jobs Act (“TCJA”) originally contained drafting errors that the NOL utilization changes (80% of taxable income) applied to NOLs arising in taxable years beginning after December 31, 2017, while the carryback/carryover provisions applied to NOLs arising in taxable years ending after December 31, 2017. Section 2303 of the CARES Act contains a technical correction to align these two provisions to NOLs arising in taxable years after December 31, 2017.
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