Tax Changes That Should “Interest” Landlords

The confluence of 2017’s Tax Cut and Jobs Act (TCJA), 2020’s Coronavirus Aid, Relief, and Economic Security Act (CARES Act), and the new Consolidated Appropriations Act (CAA), has taxpayers (and tax professionals) on their toes, to say the least. Along with a new guard in Washington D.C., these sweeping changes created a dynamic situation for multitenant landlords and lessors of other real estate.

More precisely, COVID-19 relief and shifting governmental priorities now allow real estate businesses to avoid business interest deduction limits without a huge penalty in the form of reduced depreciation. For firms with sizable interest expenses (e.g., mortgages), this new environment could prove quite favorable.

Electing a Future Path

The TCJA limited business interest expense deductions exceeding the total of:

  • 30 percent of adjusted taxable income
  • Business interest income
  • Floor plan financing interest

However, firms with average gross revenues of $25 million or less over the previous three years (excluding tax shelters) were exempted from this limit. The definition of tax shelters is somewhat unexpected for real estate operations. Any business activity with a loss for the current year in which owners have limited liability, such as a limited liability corporation (LLC) or S corporation, is likely to be considered a tax shelter and therefore subject to interest deduction limitations. As a result, this tax shelter definition expands the deduction limitation to a broad range of real estate activities. So, while owners have better depreciation options and more liberal expensing of large repairs as tools to help reduce taxable income, it is also possible that claiming larger deductions could create a loss. In such cases, the entities would be classified as tax shelters and subject to interest deduction limits.

Additionally, certain types of businesses were exempted from the limit, including real property trades or businesses. That means firms in development, construction, rentals, management, leasing and more, were not subject to the limitation, even those exceeding the $25 million revenue threshold.

However, to be exempt from the limitations, eligible taxpayers must make a one-time, irrevocable election to be considered a real property trade or business specifically for this purpose under the TCJA. The election required longer alternative depreciation schedules but exempted taxpayers from the business interest expense deduction limits. The CARES Act adjusted the situation a bit. It allowed firms to retroactively make the real property election, revoke any previously made elections, and increased the business interest deduction limit to allow 50 percent of adjusted taxable income.

Now with the CAA, real property firms can deduct more interest expenses and there is less of a depreciation penalty for making the real property election. For residential rental properties, the alternative depreciation schedule is reduced to 30 years, which is a big change:

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Previously, if residential rental firms wanted the reduced business interest limits, they would encounter a trade-off of significantly less-favorable depreciation expense deductions. Now, making the election could be advantageous because of higher limits on business interest expense deductions and more favorable depreciation. With the CAA, some real estate activities essentially can have the best of both worlds.

Clarity to the Complex

While many of these legislative changes are aimed at residential landlords, there can be benefits for commercial property too. But no matter the type of property, the analysis is complex.

If you are unsure about what’s right for your business, Rehmann can help. Our experts are on top of these matters and can bring clarity to the complex (see our webinar on the CAA at the Rehmann website).

For help determining your best path forward, please call me at 248.614.6454 or send an email to carol.wright@rehmann.com.

Published in COVID-19

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