Tax implications of the CARES Act on the real estate industry

The COVID-19 pandemic has halted the economy and created liquidity concerns across all industries. There has been particular worry in real estate, as many tenants across all sector types have faced difficulties and are unable to make rent payments. On March 27, 2020, the Coronavirus Aid, Relief and Economic Security (CARES) Act was signed into law to assist businesses and individuals dealing with this current economic hardship. A key portion of the act led to significant tax changes, many of which will be helpful to real estate owners and operators. 

Technical change to qualified improvement property

The CARES Act amends a drafting oversight in the 2017 Tax Cuts and Jobs Act (TCJA) by defining qualified improvement property (QIP) as 15-year property. This makes QIP eligible for a 100% additional first-year depreciation deduction, also known as bonus depreciation. The technical amendment is retroactive and applicable to property placed in service after Dec. 31, 2017. Before the CARES Act, QIP was depreciated as 39-year property and therefore, did not qualify for bonus depreciation. IRS code section168(e)(6) defines QIP as “any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service.” QIP excludes improvements attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. Note also that QIP does not apply to residential rental property. 

Taxpayers may consider revisiting tax returns to identify eligible QIP that was acquired after Sept. 27, 2017, and placed in service after Dec. 31, 2017. In order to take the benefit, taxpayers may consider filing an amended tax return—or filing an administrative adjustment request if the taxpayer is an eligible partnership—to claim 100% bonus depreciation on eligible QIP and to change the recovery period from 39 years to 15 years. The recovery period changes from 40 years to 20 if the alternative depreciation system was elected or required due to making the real property trade or business (RPTB) election. 

As an alternative, some taxpayers may consider filing a Form 3115, Application for Change in Accounting Method, to obtain the benefit through a section 481(a) adjustment. The IRS recently released multiple sets of guidance specifically related to QIP. They provide administrative relief on matters such as making a late RPTB election or withdrawing a previously made election. For more information on how to take advantage of the change to QIP, see here.

Interest limitation changes and impact to real property trade or business evaluation

The CARES Act provides a unique opportunity for eligible taxpayers to revisit the potential cost and benefit associated with making the RPTB election. With the passing of 2017 tax reform, all real estate entities had to evaluate the costs and benefits of potentially making the RPTB election. At the time, this analysis yielded a somewhat one-sided conclusion, with the majority of entities opting to make the election. One of the main factors that drove this decision was the “QIP glitch” discussed above. With QIP not eligible for bonus depreciation, the benefit of not limiting business interest expense largely outweighed the cost of having to depreciate QIP and real property over a 40-year alternative depreciation system (ADS) life instead of a shorter 39-year life of a modified accelerated cost recovery system. At the time, this election was irrevocable. 

A lot has changed in the past few weeks. Taxpayers’ primary focus has been on various loan options, and rightfully so, as the loan programs could address immediate cash needs. However, three very important changes could cause taxpayers to reevaluate tax positions on certain entities that qualify as real property trades or businesses:

1. The much talked about QIP glitch was fixed, which is discussed in detail in this article.
2. Rev. Proc. 2020-22 allows entities to either make or revoke an election under section 163(j)(7)(B) as a real property trade or business that was made, or missed, in 2018 or 2019. For more information, see here. 
3. The deductible business interest expense limitation increased from 30% to 50% of adjusted taxable income (ATI) for 2019 and 2020, with a special rule for entities that file partnership returns on the application of the ATI increase for 2019. For more information, see here.

Original analysis of the 2017 tax reform and whether a real estate entity should elect RPTB may need to be revisited. Following the CARES Act, if an entity did not make the election, it would be allowed to take 100% bonus depreciation on QIP, but potentially have to limit business interest expense. However, if the entity elected to be a RPTB or kept the election from a previous year, QIP would not be bonus eligible (although it would now be subject to a 20-year ADS life instead of a 40 year), but there would be no limitation on business interest expense.

Because of these changes, the decision to make the RPTB election may not be as clear as it once was. Examples of properties where taxpayers may want to model out the potential changes include retail, hotel and resort, office building and industrial. Other factors should be considered when reviewing these changes. For instance, as a result of COVID-19, the potential holding periods of real estate assets may now be longer. Additionally, these entities may require increased levels of debt, which could result in more excess business interest expense being limited in current and future years in the event an RPTB election still has not been made. However, given that a previous RPTB election can now be revoked, this should be reviewed to ensure it would not be more beneficial to revoke the election and take 100% bonus depreciation on QIP.

Changes to net operating loss rules

The CARES Act caused numerous changes to the application of net operating losses (NOLs). Previously, due to the TCJA, NOLs could not be carried back and could only offset up to 80% of taxable income in subsequent years. However, under the new rules established by the CARES Act, NOLs incurred in tax years 2018 through 2020 may be carried back to the previous five tax years. Additionally, the 80% limitation is suspended through 2020. 

Due to the changes in tax rates as part of tax reform, there are opportunities of tax arbitrage to the extent that these NOLs can be applied before 2018. This can result in significant cash savings and tax refunds for taxpayers. It is important to note that real estate investment trusts are not allowed to take advantage of these NOL carryback provisions. Further details of this change can be found here.

Removal of excess business loss limitations

In an effort to provide taxpayers with the maximum benefit of their losses generated during the COVID-19 pandemic, the CARES Act temporarily eliminates the excess business loss (EBL) limitations under section 461(l) of the Internal Revenue Code. The EBL limitation was a change brought on by the TCJA. This rule limited a noncorporate taxpayer’s ability to utilize losses from their trades or business to offset income from nontrade or business activities such as interest and dividends. An individual would have an EBL limitation if their net losses attributable to their trades or businesses exceeded $250,000 (or $500,000 if married filing jointly). This limitation was an unwelcome change to the real estate industry because real estate developments often generate substantial losses in the early years of operation as the property works toward stabilization.

While initially effective for tax years beginning in 2018, the CARES Act retroactively eliminates the EBL limitation rules for 2018 and 2019 tax years. Taxpayers who previously filed their 2018 or 2019 tax returns and had an EBL limitation will need to amend those returns to deduct the additional loss. The effective date of the EBL limitation rules is now tax years beginning in 2021.  

Changes to section 461(l) as a result of the CARES Act also include clarifications to the way capital gains are treated and that W-2 wages are not business income for purposes of the EBL limitation. The latter change is believed to be a technical correction to a drafting error from the TCJA.

The postponement of the effective date of the EBL limitations of section 461(l) is a great complement to the changes surrounding QIP. It will help taxpayers in the real estate industry maximize the amount of trade or business losses that are deductible in a given year. The losses will be available to offset all sources of income and minimize the amount of taxes owed by the taxpayer in a given year. If losses exceed income in a given year, it can generate a NOL, which now can be carried back to prior tax years to refund taxes previously paid. In totality, these changes brought on by the CARES Act all work together to provide relief to taxpayers during the COVID-19 pandemic.

Summary

It is important that every individual and business connected to real estate collaborate with their tax advisor to review their situation and take advantage of these new opportunities. When applied properly, each can reduce income and provide cash back to real estate owners.