What if you were told that your commercial real estate (CRE) group needed to make an important decision that could greatly affect your profit, loss, and tax planning strategy now AND in future years to come, but the decision could only be based on a proposed or even reserved set of regulations, and the election is irrevocable. Would that seem fair? Wouldn’t you rather have all the facts and data points before making a decision that could greatly impact the company, investors, and shareholders? Unfortunately, this is the exact situation a lot of large CRE groups faced at the end of 2018 because of the regulations that were imposed under Section 163(j) of the Tax Cuts and Jobs Act (herein “TCJA”) of 2017.
In its simplest form, a large CRE group needed to decide whether to take an immediate interest expense and give up future accelerated depreciation benefits, or lose a current interest deduction for a future tax benefit of accelerated depreciation. Debt financing is common practice in the CRE world, and thus, interest expense tends to be a large expenditure to fund development, construction, and operations. Understandably, many CRE groups were left in a significant bind.
For large or closely held tiered-entity taxpayers with over $25 million in gross revenue (averaged over the last 3 years), the TCJA has several key provisions to note. Most importantly, as it relates to this article, interest expense cannot exceed 30% of the taxpayer’s adjusted taxable income for the year.
If the interest expense exceeds the calculation noted above, it is limited and suspended to future years. This causes a lot of real property trade or businesses to defer a large expense and subsequently increase their current tax liabilities.
To offset this challenge, CRE groups can make an election, on a timely filed return, to be treated as a real property trade or business. This allows the entity to take interest expense without limitations. But under Section 168(k), depreciation on nonresidential real property, residential rental property and qualified improvement property is not eligible for bonus depreciation, now at 100% first-year depreciation. The company is forced to make an immediate irrevocable election based on future variables such as interest rate changes, alterations in operations, economic volatility, development of new real property, regulation changes, or technical corrections of existing rules.
What if a CRE group made the real property trade or business election in 2018, when there were no buildings or tenant improvements being placed in service? Then, congress issued a technical correction changing qualified improvement property from a 39-year to 15-year recoverable life as it was originally written- before the drafting error in the code?
What if the entity is in pre-construction, pre-rent, or revenue and only has interest expense on their financials for 24 months? If you make the real property trade or business election, you can deduct the interest but not future accelerated depreciation. If you do not make the election, the interest expense losses are suspended until possibly being released in future years.
While the TCJA produced a bevy of positive developments for CRE groups, there is ample planning that must be done to make the best-informed decision based on each individual company’s facts and circumstances as the landscape continues to evolve.