Long awaited guidance surrounding the business interest expense limitation under section 163(j) of the Tax Code arrived recently in the form of final regulations (the Final Regulations), new proposed regulations (the 2020 Proposed Regulations), and Notice 2020-59. The following article provides a summary of the implications to the real estate industry, which overall are favorable, particularly as compared to the proposed regulations issued in November 2018 (the 2018 Proposed Regulations).
Real Property Trade or Business election
Overview
The new guidance clarifies and expands the scope of an exception from the section 163(j) interest expense limitation that applies to taxpayers conducting an electing real property trade or business (RPTB). Section 163(j) limits business interest expense deductions for a taxable year that exceed the sum of 30% (50% in some years) of the taxpayers adjusted taxable income, their business interest income, and their floor plan financing interest. Congress provided an exception from the limitation for electing RPTBs in section 163(j)(7)(B) of the Tax Code. Taxpayers conducting an eligible RPTB may elect to except their RPTB from the section 163(j) interest deduction limitation; the election does not apply to any business the taxpayer conducts that is ineligible for the exception.
Making the RPTB election
To except interest expense of its RPTB from the section 163(j) interest expense deduction limitation, an eligible taxpayer generally must file an election statement with its timely filed income tax return.
The election generally is irrevocable. In some circumstances, however, Rev. Proc. 2020-22 allows RPTBs to either make this election late or withdraw the election if it was previously made. The general deadline for making or revoking an election under this Revenue Procedure is Oct. 15, 2021. This late election relief was provided in response to retroactive changes made in March 2020 by federal coronavirus relief legislation (the CARES Act) to certain depreciation rules and to the section 163(j) interest expense limitation rules. For further discussion of this late election relief, see our Alert IRS extends time to make 163(j) real property business elections.
Electing RPTBs must use ADS depreciation for certain assets
An electing RPTB is required to use the relatively slow alternative depreciation system (ADS) to depreciate its residential real property, non-residential real property and qualified improvement property. The electing RPTB is not allowed to use bonus depreciation or other accelerated depreciation methods. The IRS provided guidance on how electing RPTBs should implement the depreciation rules in Rev. Proc. 2019-8, which we discuss in our Alert New guidance clarifies depreciation and expensing of certain property.
Eligible taxpayers
An RPTB generally must carry on a trade or business described in section 469(c)(7)(C). That is, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. The 2020 final and proposed regulation package provides for definitions of real property operation, management, development and redevelopment. This guidance provides a clearer picture of what businesses qualify to make the RPTB election.
Some passthrough entities that do not directly benefit from an RPTB election may now make the election for their owners’ benefit. The preamble to the 2018 proposed section 163(j) regulations stated no RPTB election could be made by a taxpayer that either (1) is eligible for the small business exemption from section 163(j) or (2) conducts a real estate activity that does not rise to the level of a trade or business (typical triple net leasing activity, for example). The recent final regulations remove this statement and explicitly allow RPTB elections to be made for small business taxpayers and real estate activities that do not rise to the level of a trade or business.
These RPTB elections may benefit the entity’s owners. For example, if a partnership with a real property triple net lease activity that does not rise to the level of a trade or business has a corporate partner which is not an S corporation, the partnership would not treat its interest expense as the business interest potentially subject to section 163(j) but the corporate partner would treat its allocable share of that interest expense as business interest (due to the per se business interest rule applicable to corporations). The partner may also be able to allocate some of its own expense to real estate activity excepted from section 163(j). In this case, an RPTB election by the partnership could benefit the corporate partner.
However, taxpayers eligible to make the RPTB election that are not subject to section 163(j) should consider both the benefits and detriments associated with making the election. With no election in place these taxpayers generally are eligible to use bonus or modified accelerated depreciation methods rather than the slower ADS depreciation electing RPTBs are required to use for certain assets.
Notice 2020-59 was also released with the 2020 final and proposed section163(j) regulations. This Notice provides taxpayers that manage or operate qualified residential living facilities with a safe harbor rule, which would enable the taxpayers to be eligible to be an electing RPTB. The notice defines a qualified residential living facility as a facility that:
- Consists of multiple rental dwelling units that provide supplemental assistive, nursing or other routine medical services,
- Includes the provision of supplemental assistive, nursing or other routine medical services, and
- Has an average customer use of the dwelling units of 90 days or more.
Notice 2020-59 is welcome guidance, as prior to its release there was uncertainty surrounding residential living facilities eligibility to be an electing RPTB. For further discussion of Notice 2020-59, see our Alert IRS proposes 163(j) safe harbor for residential living facilities.
REIT safe harbor
The Final Regulations further elaborate the 2018 Proposed Regulations’ safe harbor regarding a REIT’s eligibility to make the real property trade or business election. A REIT is eligible to make the real property trade or business election if it holds real property directly or indirectly through tiers of partnerships or other REITs. A partnership can also be eligible for this safe harbor if:
- 50% or more of its capital and profits are owned directly or indirectly by one or more REITS and
- The partnership satisfies the REIT asset and income tests as if the partnership were a REIT.
The final regulations provide enhanced opportunities for REITs and partnerships primarily owned by REITs to qualify for the RPTB election.
Opco-Propco anti-abuse provision
A business entity that rents real property to a related business entity faces restrictions on its ability to make an RPTB election. The arrangements, commonly known as ‘Opco-Propco’ structures, were targeted by an anti-abuse provision in the 2018 Proposed Regulations. That rule would have precluded RPTB elections where 80% or more of the business’ real property is leased to a related party. The 2018 Proposed Regulations contained an exception permitting RPTB elections for REITs that lease qualified lodging facilities and qualified health care facilities (as defined in sections 856(d)(9)(D) and 856(e)(6)(D), respectively). The Final Regulations, while retaining the anti-abuse provision and the REIT exception, also add two new exceptions.
First, a lessor will be eligible to make the RPTB election if at least 90% of the lessor’s real property is leased to unrelated parties and/or a related party that uses the real property in an excepted RPTB.
Second, a lessor is eligible to make a RPTB election with respect to a portion of its business that leases real property to either an unrelated party or a related party that has made a RPTB election. This “look-through” provision gives the RPTB the ability to look to the ultimate lessee in situations where subleasing is involved.
Excess business interest expense and subsequent real property trade or business elections
The 2018 Proposed Regulations contained a rule that stated that excess business interest expense (i.e., section 163(j)-disallowed interest) of a passthrough entity that later becomes exempt from section 163(j) is treated as paid or accrued in the year that the entity is no longer subject to section163(j). The Final Regulations clarify that while this rule applies only to section 163(j)-exempt entities, not to entities whose businesses become section 163(j)-excepted such as businesses that become electing RPTBs.
This clarification means that unless the taxpayer becoming an electing RPTB either (1) has other non-excepted trades or businesses or (2) becomes small business taxpayer in a later year, the taxpayer’s excess business interest expense from prior periods typically will be suspended until the entity liquidates or the partner disposes of their interest in the partnership. At that point, the excess business interest expense will be added back the partner’s basis in the partnership interest immediately before liquidation or disposition.
Interest tracing rules and section 163(j)
Previously there was limited guidance on the interaction between the application of the business interest expense limitations of section 163(j) and the interest tracing rules under Reg. section 1.163-8T and Notice 89-35. Within the 2020 Proposed Regulations, Prop. Reg. section 1.163-14 provides rules for the allocation of interest expense among the expenditures of passthrough entities.
The 2020 Proposed Regulations maintain the principle that the character of the interest expense related to these debt proceeds is determined based on the type of expenditure that the debt proceeds are traced to, and closely mirror previous guidance under Reg. section 1.163-8T and Notice 89-35. However, the proposal would provide new requirements for a passthrough entity tracing debt proceeds to types of expenditures.
Debt financed distributions
The 2020 Proposed Regulations would bring clarity to several issues surrounding interest expense related to debt financed distributions. First, a partner’s share of interest expense allocated to debt financed distributions is the lesser of the interest expense they are allocated and the interest expense related to the debt that was deemed to be distributed to them. This rule insures that interest expense allocated to a debt financed distribution of passthrough entity owner A is not treated as interest expense on debt financed distributions to passthrough entity owner B.
Second, the tax treatment of a passthrough owner’s share of interest expense on debt financed distributions is determined by the passthrough entity owner under the interest tracing rules of Reg. section 1.163-8T and is not treated as interest expense of the entity. This would mean that interest expense on debt financed distributions would not be subject to limitation under section 163(j) by the passthrough entity that is the obligor on the debt. However, the passthrough entity owner may be required to subject the interest expense to section 163(j) at their level depending on the activity the interest expense is ultimately traced to.
Lastly, the 2020 proposed regulations provide for rules surrounding the treatment of transfers of an interest in a passthrough entity by owners who previously received debt financed distributions. Interest expense will lose its designation as interest expense on debt financed distributions when a transferee is unrelated to a transferor. However, in the case of a transfer between related parties, the transferee ‘steps into the shoes’ of the transferor with respect to the tax treatment of the interest expense on debt financed distributions. Meaning if the transferor treated such interest expense as personal interest on their income tax return, the transferee would be required to continue to treat future allocations of debt financed interest from the partnership as such on their income tax return. This guidance on transfers of interest is potentially in response to a recent court judgement surrounding a taxpayer who inherited an interest in a partnership from a related party (Lipnick v. Comm’r, 153 T.C. No. 1 (2019)).
Self-charged interest
The 2020 Proposed Regulations fulfill, in a limited manner, the promise made by Treasury and the IRS in the preamble to the 2018 Proposed Regulations. That preamble stated that Treasury and the IRS intend to adopt rules that would exempt certain interest expense related to self-charged lending transactions from limitation under section 163(j).
The 2020 Proposed Regulations include a favorable self-charged interest rule that would apply to loans to a partnership made by a direct partner. However, the proposal would not cover (1) loans to a partnership from an indirect partner, (2) loans to a partner from a partnership or (3) loan arrangements between an S corporation and its shareholder.
Under the proposal, a direct partner who is also a lender to the partnership borrower can reclassify the interest income recognized related to the self-charged lending transaction to be excess business interest income of the partnership to the extent that the partner receives an allocation of excess business interest expense from that partnership. In doing so, the partner is able to convert the excess business interest expense the partner has been allocated from the partnership into a current year deduction on a dollar-for-dollar basis to the extent the partner has sufficient interest income from the self-charged lending transaction.
A partner is only able to do this to the extent that the interest income is recognized in the same year as the allocation of excess business interest expense. To the extent that a lending partner has more self-charged interest income than excess interest expense allocated to them from the partnership, the excess generally remains investment income for purposes of the investment interest expense limitation under section 163(d).
It is important to note that the rule contained in the 2020 Proposed Regulations considers all business interest expense of the partnership that is limited under section 163(j), not just the interest expense related to the self-charged lending transaction. This rule may enable a partner to utilize their self-charged interest income to convert excess business interest expense unrelated to the self-charged lending transaction into a current year deduction.
Effective date
The final regulations are effective for tax years beginning on or after 60 days after publication in the Federal Register. For calendar year taxpayers, this typically means 2021 is the first year for which the Final Regulations will be binding. For tax years beginning on or after Dec. 31, 2017, but before the effective date of the final regulations, taxpayers may choose to rely on either the final regulations, or the 2018 proposed regulations, subject to a consistency requirement. The new 2020 Proposed Regulations generally would be effective for tax years beginning on or after 60 days after they are finalized, but also carry similar reliance language permitting taxpayers to rely on the proposal if certain consistency requirements are met.
Conclusion
The recently-released section 163(j) guidance provides taxpayers with additional clarity on how to apply the business interest expense limitation of section 163(j). Overall, the guidance is positive for those in the real estate industry making it worth the wait. Taxpayers operating real estate business should consult with their tax advisors regarding effects the recent guidance may have on them.
