For the real estate industry, several favorable components of the Tax Cuts and Jobs Act (TCJA) enacted Dec. 22, 2017, and the Coronavirus Aid, Relief, and Economic Security (CARES) Act enacted March 27, 2020 are expiring, and the implications to taxpayers involved in the real estate industry could be significant.
The ability to write off 100% of qualified property when acquired (new or used) is obviously a fan favorite for real estate developers and investors, as well as the tax community at large. The TCJA continues to allow 100% bonus depreciation, but only through Dec. 31, 2022, when the amount of allowable bonus depreciation then phases down annually for property placed in service as follows:
- 80% for 2023
- 60% for 2024
- 40% for 2025
- 20% for 2026
Unless a future law change modifies the above schedule, no amount of bonus depreciation will be available for fixed assets placed in service after 2026. Considering the boon to after-tax internal rates of return that bonus depreciation can provide, real estate owners should keep a watchful eye on the above timing, at least when close to year-end if an asset can be placed in service in December rather than letting timing slip to January.
Limitation on Deducting Business Interest Expense
One of the most frustrating tax provisions created by the TCJA, due to its threat of limited deductions and unnecessary complexity, is the limitation on deducting business interest expense for businesses that do not qualify to be exempt. Fortunately for the oft-favored real estate industry – which is especially impacted by this provision due to its heavy reliance on debt – at least two very favorable mitigation techniques have been available.
The first mitigation technique, an ability to elect out of the limitation regime affecting interest expense, comes with a price of having to slow down depreciation on certain assets. For most taxpayers this price is fairly easy to stomach since the primary impact is slowing down building depreciation from 27.5 to 30 years for residential property or 39 to 40 years for nonresidential property, but it is a trade-off nonetheless.
Note: The depreciation trade-off related to electing out of the interest limitation that is most material is only narrowly applicable to certain owners of nonresidential property. In addition to lengthening the building lives as noted above, “qualified improvement property” (QIP) loses its eligibility for bonus depreciation. QIP includes interior improvements to real estate occurring after the original placed in service date of the building, e.g., tenant improvements.
The second mitigation technique had no trade-offs but was short-lived. Recognizing that the pandemic was causing reduced (or nonexistent) profits for businesses in 2020, the CARES Act very favorably modified the interest expense limitation calculations. For example, instead of setting the maximum interest deduction available to a business equal to 30% of its “adjusted taxable income” (ATI) under the TCJA’s original rules, the CARES Act increased this threshold to 50% of ATI. For many real estate businesses that had not yet opted to elect out of the interest limitation (technique #1) in 2018 or 2019, the CARES Act changes were sufficient to avoid deduction limitations in 2020 without depreciation-related trade-offs.
This brings us to the 2021 tax returns which are being prepared/filed currently, during 2022. Unfortunately for 2021, the prior, favorable CARES Act changes no longer apply (i.e., the maximum interest deduction returns to 30% of ATI). Real estate business that have not yet elected out of the interest limitation may need to do so on their 2021 tax returns, newly introducing the depreciation trade-offs as mentioned above.
Finally, for the current 2022 tax year, a very significant change to the interest limitation calculations may force all remaining real estate businesses that do not qualify as exempt to have no choice but to elect out of the interest limitation. Specifically, prior to 2022 all taxpayers have been able to add back depreciation and amortization to their calculation of ATI. Very punitively and new for the 2022 tax year, taxpayers (of all industries) can no longer add back depreciation and amortization. For businesses that are highly leveraged, losing the addback for depreciation and amortization in 2022 may result in significantly limited interest expense deductions. Fortunately for real estate businesses, they still have the ability to elect out as noted above, but other industries do not have this luxury and may be in for a rude awakening in 2022.
Net Operating Losses
Another area of unfavorable changes brought about by the TCJA relates to the treatment of net operating losses (NOLs). For many real estate professionals, NOLs are commonly generated thanks to accelerated depreciation. Unfavorable TCJA changes included both:
- Removing the old law ability for taxpayers to carry back NOLs two years (the TCJA only allows NOLs to be carried forward)
- NOLs can only offset 80% of taxable income when carried forward (no longer 100%)
The only benefit the TCJA enacted relative to NOLs was allowing an indefinite carryover period, rather than a maximum 20-year carryover period under pre-TCJA law.
Once again coming to the rescue, though only temporarily, the CARES Act retroactively altered the TCJA’s NOL rules. Under the CARES Act, NOLs generated in tax years 2018 through 2020 were allowed to be carried back up to five years and were able to offset 100% of taxable income whether carried back or forward.
So where do NOL rules stand now? Beginning with the 2021 tax year, rules attributable to newly generated NOLs rules revert back to the less favorable TCJA treatment. This means that taxpayers’ losses generated in 2021 or later years can only be carried forward and can only offset up to 80% of future years’ taxable income. As a remnant benefit from the CARES Act, if a taxpayer has NOLs generated from tax years before 2021 that continue to be carried forward, these losses can continue offsetting 100% of taxable income. If a taxpayer has NOLs from multiple years, the oldest year’s NOL is used first.