By Stephen Bertonaschi,
senior managing director,
FTI Consulting, Inc.
As part of the Tax Cuts and Jobs Act (TCJA), IRC §163(j) was amended to potentially limit the amount of business interest expense that a taxpayer can deduct.
The general rules are simple — taxpayers can deduct business interest expense to the extent that such expense does not exceed the taxpayer’s business interest income and 30 percent of its adjusted taxable income (ATI).
These interest limitation rules apply to all types of taxpayers. However, there is a special carve-out for real estate trade or businesses which allows them to elect out of these rules.
While the decision of real estate owners to elect out seems like a no brainer (and widely panned as such), the proposed regulations and application of the rules is anything but straightforward.
Owners and investors would be well advised to evaluate the merits and potential downside to making a Real Property Trade or Business (RPTB) election.
An RPTB is broadly defined to include any real property development, redevelopment, construction, acquisition, rental, operation, management, leasing or brokerage trade or business.
As eluded to above, electing RPTBs are not subject to §163(j). The “penalty” for such taxpayers is that the cost for real property will be recovered over longer depreciable lives – non-residential real property will now be depreciated over 40 years instead of 39, and residential real property over 30 years instead of 27.5.
These changes hardly seem onerous, especially given the fact that the longer lives only pertain to “real property” and thus any “personal property” owned by the taxpayer could still be subject to accelerated depreciation, including 100 percent (full write-off) bonus depreciation.
Given the limited “penalties” associated with making a RPTB Election, wouldn’t there be almost no downside to doing so? Well that certainly depends on many different factors.
For corporations, including REITs, that own real estate directly, they may want to consider:
Whether electing out and taking the full interest deduction would increase an NOL that may be limited in the future (TCJA limits post 2017 NOLs to 80 percent of taxable income).
If an election is not made, then any business interest not allowed as a deduction will be treated as paid in the succeeding taxable year, presumably allowing the corporation to make the real estate election in a future year and deduct all the interest then.
Any other trade or business that the corporation is engaged in and how that impacts the allocation of interest expense to separate businesses.
Unlike under old IRC §163(j), partnerships now fall under these new rules, which brings up a myriad of issues:
As a passthrough entity for tax purposes, a partnership must perform its own calculations each year and determine how it affects its partners. That is why it is so important to review the scenarios and consider all the alternatives. Ultimately, the RPTB election is irrevocable once made.
Partnerships whose interest expense is not limited, can ultimately produce Excess Taxable Income (“ETI”), which can increase the deductibility of the partner’s other business interest expense.
If the partnership makes the RPTB election, then the ETI does not flow through and thus will not produce a benefit.
If a partnership does not make the RTBP election and passes through excess business interest (“EBI” or disallowed interest), then the partner cannot make an RPTB election with respect to such investment.
Partners should also consider whether to make an RPTB election for their own business interest expense.
Finally, there is also a “small business exception” for taxpayers with average annual gross receipts for the three prior tax years of $25 million or less.
However, this exception is narrower than it appears and may not apply to many real estate enterprises.
The reason is that the small business exception does not apply to “syndicates” which include any partnership if more than 35 percent of the partnership’s losses are allocable to partners who do not actively manage the entity. This is an annual determination and no election is necessary.
The proposed regulations certainly provided a lot of color, if not complexity, to the application of the IRC §163(j) rules. However, there are still issues that have not been addressed or need more clarity.
For example, the proposed regulations reserve comment on tiered partnership structures altogether.
Furthermore, the much-anticipated legislative fix on the treatment of qualified improvement property – both recovery period and 100 percent bonus depreciation – would further complicate the decision to make the real property trade or business election (i.e., taxpayers who make the election would not be able to take bonus depreciation on such “real property”).
As taxpayers and tax professionals embark on 2018 tax return preparation, it is important to realize that there is no “one size fits all” for real estate companies and decisions shouldn’t be made in a vacuum. Talk to your partners, your tax professionals, and peers.