Presented By: Marks Paneth LLP
Tax Reform Dilemma: Uncertainty Surrounds Business Interest Deduction
There’s an old adage: “Don’t ask how laws and sausages are made.” Seldom has this been more relevant than with the recently enacted Tax Cuts and Jobs Act (“TCJA”). Due to incomplete drafting, the TCJA raises as many—if not more—questions as it answers.
One example of this uncertainty that is of particular relevance to the real estate industry is the new business interest deduction provision. Broadly speaking, the TCJA limits a taxpayer’s business interest expense deduction to 30 percent of its “adjusted taxable income.” A real property trade or business may elect out of this limitation but at a cost. And here is where it gets interesting.
“Electing” real property trades or businesses will be required to depreciate any residential rental property, nonresidential rental property and qualified improvement property under the Alternative Depreciation System (ADS), rather than the “regular,” or Modified Cost Recovery System (MACRS). At first glance, one could assume that the decision to elect out would be based on weighing the additional interest expense against the less accelerated depreciation under ADS. (ADS provides for depreciable lives of 30 years for residential rental property and 40 years for nonresidential rental property, compared to 27-and-a-half years and 39 years respectively under MACRS.)
A wrinkle in the analysis is that “bonus depreciation” (i.e., immediate expensing of certain assets) is not available to taxpayers under ADS. Although residential rental property and nonresidential rental property is not eligible for immediate expensing, it was intended that qualified improvement property would be. However, there is a glitch in the law as it was drafted, regarding the depreciable life of such property. This glitch must be corrected (via what is known as a “technical correction”) in order for qualified improvement property to be eligible for immediate expensing.
Another issue to consider when deciding whether to elect out of the interest expense limitation and thereby become subject to the ADS is, What do I do with assets that are already being depreciated under MACRS? Generally, a change to ADS depreciation involves assets “placed in service” after Dec. 31, 2017. However, for electing real property trades or businesses, the change is effective for “tax years” after Dec. 31, 2017, thereby creating uncertainty as to how ADS depreciation will be calculated.
For example, how does a taxpayer that is 25 years into the 39-year MACRS depreciable life period switch suddenly to the 40-year ADS life? Does one take the remaining unadjusted basis over the former remaining ADS life, or start the clock over? Will taxpayers be required to file for a change in accounting method? None of these answers are clear, and IRS guidance is needed. You can expect your business tax returns to be even more complex.
Adding to this complexity are some additional issues to consider with respect to the business interest expense limitation, such as the following:
- Certain “small” taxpayers are exempt from the business interest expense limitation and do not need to elect out. Such taxpayers must have annual average gross receipts of less than $25 million (certain related taxpayers are combined in calculating this limitation).
- “Tax shelters” are not eligible for the small taxpayer exception. This definition includes, among others, limited partnerships or LLCs with losses—if more than 35 percent of the losses are allocated to partners who are not actively involved in management.
- If a taxpayer is subject to the limitation, the disallowed interest expense is carried forward indefinitely. In the case of a partnership, the carry forward is at the partner level. Any remaining disallowed interest expense is freed up when an activity is disposed of.
While the TCJA appears to offer the real estate industry a clear advantage in its ability to elect out of the business interest deduction limitation, the value of this benefit is far from clear. Tread carefully and consult your tax adviser to understand the potential positive and negative implications of this new provision on your individual and corporate tax returns.