Due to COVID-19, taxpayers in the real estate industry have concerns as to the timing of certain transactions, e.g. 1031 Exchanges. Additionally, the CARES Act has provided additional tax issues to consider, including the correction of the class life of Qualified Improvement Property (“QIP”). While additional guidance is required, this FGMK Tax Alert highlights some key issues that merit consideration by real estate professionals.
In Notice 2020-23, the Internal Revenue Service (“IRS”) amplified its guidance provided in Notice 2020-18 (initial guidance on postponement of federal tax return filing and payment to July 15, 2020) and Notice 2020-20 (additional relief postponing certain federal gift (and generation-skipping transfer) tax return filings and payments). The latest Notice specified all of the tax return filings and payments that are postponed to July 15, 2020. Besides the postponement of individual, entity, estate, and trust tax return filings and associated payments (detailed in Notice 2020-23), the following are items of interest.
Notice 2020-23 also determined that any person performing a time-sensitive action listed in Revenue Procedure 2018-58 which is due to be performed on or after April 1, 2020 and before July 15, 2020 is an “Affected Taxpayer”, and thus the date of such actions are postponed to July 15, 2020. Since this revenue procedure includes guidance on Section 1031 exchanges, the reference to the revenue procedure has created confusion as to the extent of relief provided by the IRS.
Status of Section 1031 Tax-Free Exchange Relief
In a deferred Section 1031 Exchange, a taxpayer has various dates of concern:
If such 5-day, 45-day or 180-day period ends within the date range of April 1, 2020 through July 14, 2020, Notice 2020-23 clearly postpones such action date to July 15, 2020. However, there is uncertainty as to whether additional relief may be available beyond the relief provided under Notice 2020-23.
Specifically, potential additional relief exists under Revenue Procedure 2018-58 which pertains to the postponement of many federal tax-related acts by affected taxpayers including critical dates under Section 1031 discussed above. For such taxpayers, the relief provides that if any such required action date falls on or after the date of a federal declared disaster, the required date of action is postponed to the later of 120 days after such original action date or the last day of the general disaster extension period. As it currently stands, the IRS’ drafting of guidance to date has left tax professionals uncertain as to whether such relief has been provided at this time.
Thus far, while the IRS has released notices referencing the President’s issuance of an emergency declaration under the Robert T. Stafford Disaster Relief and Emergency Assistance Act in response to the COVID-19, the IRS has not released a separate news release declaring a federal disaster. Consequently, while Notice 2020-23 clarified the postponement to July 15, 2020 for many critical dates, including those required under Section 1031, falling within the April 1, 2020 through July 14, 2020 period, it is unsettled whether such a taxpayer can take full advantage of the 120-day extension relief provided in Revenue Procedure 2018-58.
On April 14, 2020, the IRS indicated that it is aware of the varying interpretations and interest in the issue. The IRS plans to provide Q&A guidance in the near future. FGMK will continue to track this issue and will provide updates once such guidance is released.
CARES Act Tax Issues of Interest
Qualified Improvement Property
As a reminder, the Tax Cuts and Jobs Act of 2017 (the “TCJA”) created a new definition of QIP in Section 168(e)(6)(A) (previously QIP was a concept inserted in Section 168(k)). The TCJA also grouped property formerly identified as qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property under QIP. However, a drafting error in the TCJA resulted in QIP (and thus all property grouped under its definition) being classified as 39-year property, rather than the intended classification of 15-year property. This classification not only elongated the depreciable life but eliminated the ability to elect bonus depreciation for such property (property must have a depreciable life of 20 years or less to be eligible for bonus depreciation). Bonus depreciation provides depreciation of 100 percent of the cost of a qualified asset, generally, in the year acquired and placed in service.
The CARES Act amended the error and provided that QIP is 15-year property (20-year under the alternative depreciation system). There are two important issues to note regarding this correction:
Taxpayers now have the ability to re-analyze the 2018 and 2019 tax years to determine the additional tax benefits that the QIP correction may provide. The ability to expedite deductions for accelerated depreciation may reduce tax liability or create losses that now may be carried back to prior tax years, as discussed below.
Effect of QIP Fix on Interest Deduction Limitation Opt-Out Elections
The TCJA also provided a new limitation on the deduction of business interest in Section 163(j). The provision limits the deduction of business interest to the sum of a taxpayer’s business interest income, floor plan financing interest, and 30 percent of adjusted taxable income. However, it allowed certain taxpayers to make an irrevocable election to be treated as an “electing real property trade or business” and thus not be subject to the limitation. As a result of the election, such taxpayers are required to depreciate nonresidential real property, residential rental property, and QIP under the alternative depreciation system (“ADS”). Prior to the CARES Act, this meant a taxpayer had to depreciate QIP over 40 years, rather than 39 years.
The CARES Act’s correction of the class life of QIP raised the question of whether taxpayers that had made an irrevocable election under Section 163(j)(7) could obtain relief. On April 10, 2020, the IRS provided such relief in Revenue Procedure 2020-22. As a result, taxpayers that had previously made an election to be treated as an electing real property trade or business may re-analyze and revoke such election if taxpayers determine whether the ability to depreciate QIP over 15-years or elect bonus depreciation for such property provides more tax benefit than opting out of the business interest deduction limitation.
Such an analysis should include consideration of the increase of the interest deduction limitation threshold for the 2019 and 2020 tax years, as provided by the CARES Act. Specifically, taxpayers may calculate the business interest deduction limitation based on 50 percent of adjusted taxable income, rather than 30 percent of adjusted taxable income. However, it should be noted that partnerships are still subject to the 30 percent of adjusted taxable income for the 2019 tax year. Rather than obtaining the increased limitation threshold at the partnership level for the 2019 tax year, 50 percent of any excess business interest expense (“EBIE”) passed through to a partner for the 2019 tax year will be treated as paid or incurred in the 2020 tax year, and thus a taxpayer may have use of such business interest expense without concern of whether the partner has received excess taxable income or excess business interest income from the partnership in 2020 to otherwise “release” EBIE, i.e. treat as paid or incurred (though the balance of the 2019 EBIE remains subject to the standard rules). The remaining 50 percent of 2019 excess business interest will be treated as business interest incurred in 2020 and subject to the interest limitation rules (50 percent of adjusted taxable income).
Further regarding business interest expense deductions, the CARES Act provides taxpayers the ability to use 2019 adjusted taxable income in computing 2020 allowable interest deductions under the 50 percent of adjusted taxable income limit.
Modification to NOL and Excess Business Loss Rules
The CARES Act made two significant modifications to rules governing net operating losses (“NOL”):
The CARES Act also delayed the application of the excess business loss limitation for individuals, trusts and estates, which was created by the TCJA, to any taxable year beginning after December 31, 2020 (as opposed to taxable year beginning after December 31, 2017 as provided in the TCJA). This will eliminate the limitation on the use of losses by affected taxpayers.
These modifications to the utilization of tax losses may provide taxpayers additional tax benefits. Prior year tax losses may also be augmented by the correction of the QIP class life as discussed herein.
Procedural Considerations Moving Forward
Taxpayers will need to evaluate the best procedure for obtaining the tax benefits provided by the CARES Act. In many cases, an amended tax return may prove the best avenue for maximizing the utilization of these modifications, including the carry back of NOLs. However, in some cases, particularly if a taxpayer is able to make use of the QIP correction without concern of a prior year election under Section 163(j), taxpayers may be able to obtain tax savings by filing a Form 3115 to effectuate an accounting method change. Taxpayers should also consider the guidance provided in Revenue Procedure 2020-24 that instructs taxpayers as to how to claim a tentative carryback adjustment using Form 1045 (non-corporate taxpayers) or Form 1139 (corporate taxpayers).
The IRS also recently issued Revenue Procedure 2020-23 which provided relief to partnerships under the centralized partnership audit regime that are typically precluded from filing amended returns, by allowing such partnerships to file amended returns and Schedules K-1 for the 2018 and 2019 tax years, as long as such filings are made before September 30, 2020. While such partnerships may also file an administrative adjustment request (“AAR”) in lieu of amended return, taxpayers should carefully consider the rules governing an AAR and the partners’ ability to use tax adjustments effectuated by an AAR.
Please contact your FGMK engagement team to discuss how we can help you maximize the tax relief provided by the federal government.
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
Section references herein are to the Internal Revenue Code of 1986 and the Treasury Regulations thereunder.
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