Further guidance issued for real estate businesses that elect out of interest expense limitations
Published March 1, 2019
In April 2018, the IRS released temporary guidance on the limit on deductions for business interest expense for tax years beginning in 2018. According to the new rules, interest expense is limited to 30% of the adjusted taxable income. For some businesses, this limitation is going to catch taxpayers by surprise. Essentially, interest expense that was fully deductible in 2017 may now be subject to limitation that could ultimately increase taxable income.
The IRS recently published proposed regulations that taxpayers can rely on until final regs are released.
The proposed regs significantly expand on the temporary guidance. They include, among other notable provisions, a discussion on the ability of a “real property trade or business” to elect out of the interest limitation rules. A real property trade or business includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.
This language is somewhat vague, and while there was some further enlightenment shared in the recently issued regs, we would recommend speaking with your MCM professional to determine whether your business qualifies as a real property trade or business.
If you do indeed qualify, and choose to exercise your ability to avoid the interest limitation rules, there are some drawbacks to keep in mind. To fully deduct your interest expense, you must depreciate your non-depreciable real property, real property, and qualified improvement property (QIP) using the “alternative depreciation system” (ADS).
Under the ADS, the normal 39-year depreciation life for non-residential property becomes 40 years. For residential rental property placed in service after December 31, 2017, the normal 27.5-year depreciation life becomes 30 years. For residential rental property placed in service prior to December 31, 2017, the normal 27.5-year deprecation life becomes 40 years. Qualified improvement property goes from 39 to 40 years (though it is anticipated to go from 15 to 20 years once a technical correction is finalized).
Additionally, Section 168(k) requires that you cannot claim 100% bonus depreciation on any asset depreciated using the ADS method, though this is only relevant to qualified improvement property. Starting in 2018, qualified improvement property includes any improvement made to the interior portion of a nonresidential building any time after the building is placed in service. This is an unfortunate side effect of a Congressional oversight, as QIP is currently still stuck with a 39-year life, and as such, is ineligible for 100% expensing. (It was originally intended to have 15-year life under tax reform.)
While the above is all relevant to newly acquired property, there were still a lot of questions on how already owned property would be treated. The new regs shed some light. According to Revenue Procedure 2019-8, while an electing real property trade or business is required to switch existing properties to the ADS method, the change is not in the accounting method, but rather a “change in use.”
When a business has to switch to a longer ADS life because of a change in use, the depreciation deductions beginning with the year of change are determined as though the property has been originally placed in service by the taxpayer with the longer recovery period and/or the slower depreciation method.
The business then takes its remaining tax basis in the asset and depreciates it straight-line over the remaining life of the asset as though it had originally been placed in service with the ADS life.
All businesses with average 3-year gross receipts of less than $25 million are exempt from the interest limitation rules, except for a tax shelter as defined by Section 448. This can create a problem for smaller rental activities with partners that have limited involvement. If they are allocating a loss to more than 35% or more limited partners, the partnership is considered a syndicate, and thus a tax shelter for 2018.
If the partnership’s interest expense would otherwise be limited, its only opportunity to deduct interest in full is to elect out of the interest rules as a real property or trade business. However, in doing so, it must switch to the ADS method for all past and future acquisitions. This election is irrevocable, meaning it will still be left with the ADS method if it doesn’t qualify as a tax shelter in 2019.
We will be looking for further guidance from Congress on these issues, so stay tuned. In the meantime, please get in touch with your MCM professional or MCM Tax Partner Andy Ackermann, CPA, CVA via e-mail or phone (812.670.3453) or Tax Principal Dan Sullivan, CPA via e-mail or phone (317.224.1272) for more information on how these new regulations may apply to your organization.