The expanded application of the business interest limitations imposed by Internal Revenue Code (IRC) Section 163(j) forced many real estate owners and investors to make difficult decisions this year.
If Section 163(j) applies, interest deductions are now limited to the sum of the following:
- The taxpayer’s business interest income for the year
- 30% of the taxpayer’s adjusted taxable income for the year
- The taxpayer’s floor plan financing interest expense for the year
Although this may seem like a huge obstacle at first, understanding the options and planning carefully can help avoid complications.
Small Business Exemption
One possible option for exemption from the limitations set forth in Section 163(j) is qualification as an exempt small business. An entity is generally considered an exempt small business if it meets the gross receipts test of Section 448(c) —meaning it has average annual gross receipts of $25 million or less in the previous three years—and it’s not a tax shelter as defined in Section 448(d)(3). It’s important to note that entities in tiered ownership structures may be denied exemption based on the controlled group’s gross receipts total as aggregation may be required among related entities.
Tax Shelter Restriction
Property owners with qualified tangible property eligible for the new 100% bonus allowances should consider the implication of being considered a tax shelter if claiming the deduction would create a taxable loss. Determining if they’re a tax shelter is based on whether operating losses from the business are allocated to partners or S corporation shareholders who aren’t active in the business. Specifically, any partnership or S corporation that allocates more than 35% of its losses for the year to limited partners or limited entrepreneurs is considered a tax shelter, though some exceptions apply.
Here’s a possible problem scenario for a taxpayer.
A partnership with less than $25 million of average annual gross receipts purchased a commercial building in 2018 and estimates their taxable income will only be $400,000 because of high vacancy, low rents, and maintenance costs. Assume more than 35% of the partnership interests are held by limited partners where losses allocated to such members would trigger the tax shelter restriction. If they conducted a cost segregation study and took advantage of 100% bonus depreciation for eligible property that pushed them into a loss position, they would be considered a tax shelter subject to tax shelter requirements even though they had less than $25 million of average annual gross receipts.
If the partnership expects that 2019 will bring in significantly more income, they could defer the cost segregation study at least a year and file a method change to recover eligible depreciation on a prospective basis and avoid the tax shelter designation. Another option might be for the taxpayer to complete the study now and implement the different asset classes over more than one year by filing a method change in a future year, as long as it doesn’t put or keep them in a loss position.
Exemption Election and ADS
Another option for eligible taxpayers to avoid the limitation on deducting business interest is to elect exemption. An eligible real property trade or business may elect to be an excepted trade or business by following the procedures outlined in Section 1.163(j)-9 of the proposed regulations.
To make this election, taxpayers must agree to depreciate the following assets that they hold in the electing real property trade or business using the alternative deprecation system (ADS):
- Nonresidential real property
- Residential rental property
- Qualified improvement property
These assets also aren’t eligible for a bonus depreciation deduction under section 168(k).
While a change from 39 to 40 years for non-residential real property—or 27.5 to 30 years for residential rental property placed in service after December 31, 2017—may not seem like a significant difference, there are a few considerations.
For instance, residential rental property with an original in-service date prior to 2018 would follow the old ADS rules, meaning the change would be from 27.5 to 40 years. This may be a substantial loss in yearly depreciation.
Perhaps more significantly, electing alternative depreciation system (ADS) could preclude the taxpayer from ever taking bonus depreciation on future qualified improvement property (QIP) should the rules change. Congress initially intended QIP to have a 15-year lifespan and qualify for bonus depreciation. An error resulted in qualified improvement property having a 39-year lifespan with no bonus. Bills have been introduced in both the House of Representatives and Senate to correct this error. Should these bills pass, those who’ve made a permanent election may be locked out of bonus on those types of improvements indefinitely if provision isn’t made.
Careful planning around fixed assets may help in managing these risks. For example, performing a cost segregation concurrently with a switch from 27.5 to 40-year life will help offset delayed depreciation since the requirements for ADS depreciation and loss of bonus don’t include tangible personal property or land improvements.
Additionally, loss of bonus depreciation and short depreciable lives for qualified improvement property can be offset by segregating personal property, taking advantage of partial disposition elections, and carefully considering the generally taxpayer-friendly repair and maintenance rules set out in the tangible property regulations. Over the past year, many owners stopped focusing on these options because bonus depreciation and shorter lives were often considered a simpler approach to depreciating special improvement property, though they continue to be available and could present significant benefits when bonus depreciation is not available.
We’re Here to Help
It’s important to consider all options for exemptions and fixed asset solutions in order to make good decisions based on your unique set of circumstances. For more information, contact your Moss Adams professional.