Recent guidance, including Revenue Procedure 2020-22, released on April 10, 2020, offers additional clarity to taxpayers affected by changes to the treatment of Qualified Improvement Property included in the CARES Act. The guidance gives taxpayers significant flexibility to make or withdraw a prior real property trade or business election under Section 163(j), and provides procedures for implementing the electing real property trade or business election and modified depreciation schedules.
On March 27, 2020, President Trump signed The Coronavirus Aid, Relief, and Economic Security (CARES) Act into law. The Internal Revenue Service (IRS) has recently issued additional guidance, Revenue Procedure 2020-22 and Revenue Procedure 2020-25, which will help taxpayers engaged in real property trades or businesses evaluate the law’s impact and make key decisions moving forward.
Prior to the enactment of the CARES Act, taxpayers engaged in a real property trade or business could elect out of the interest expense limitations under Section 163(j) of the Internal Revenue Code. The election out of Section 163(j) came at a cost. The election was irrevocable, and an electing taxpayer was required to use the alternative depreciation system (ADS) rather than the modified accelerated cost recovery system (MACRS). At the time Section 163(j) was enacted, qualified improvement property (QIP) was subject to 40-year depreciation under ADS and 39-year depreciation under MACRS. Many electing taxpayers viewed the one-year difference as immaterial.
The CARES ACT retroactively changed the depreciation provisions for QIP. QIP is now eligible for bonus depreciation under Section 168(k) and depreciation over 15 years under MACRS. QIP is now subject to 20-year depreciation under ADS. This change in depreciation period and methods makes the Section 163(j) election significantly more expensive for many taxpayers. This retroactive change applies to any taxable year that begins after January 1, 2018.
On April 10, 2020, the IRS released Revenue Procedure 2020-22 providing additional guidance to taxpayers impacted by changes made by the CARES Act. Proposed regulations under Section 163(j) require taxpayers to make an electing real property trade or business election by attaching an election statement to the taxpayer’s timely filed federal income tax return (including extensions). The election is irrevocable under the proposed regulations. Revenue Procedure 2020-22 provides an exception to these procedures and a method for taxpayers to make or withdraw an electing real property trade or business election for the 2018, 2019 and 2020 taxable years. On April 17, 2020, the IRS released Revenue Procedure 2020-25 providing still more guidance regarding the election or withdrawal of several elections under Section 168 concerning the ADS and MACRS.
Section 163(j) Background
The Section 163(j) business interest expense limitation was enacted as part of the Tax Cuts and Jobs Act of 2017 (TCJA). In very general terms, Section 163(j) limits the deductibility of business interest expense to the sum of (i) business interest income and (ii) 30% of “adjusted taxable income.” For a more complete description of Section 163(j) and the proposed regulations thereunder, please see our On the Subject entitled “IRS Proposes Section 163(j) Regulations – New Business Interest Expenses Deduction Limit.”
Section 163(j)(7) exempts certain trades or businesses from the application of Section 163(j), including an “electing real property trade or business.” For this purpose, an electing real property trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage business that makes an election to be excluded from Section 163(j). Proposed regulations provide the procedure to make this election and provide that it is irrevocable.
While an electing real property trade or business is not subject to Section 163(j), it is also ineligible to depreciate nonresidential real property, residential rental property and QIP under MACRS. Instead, a taxpayer making the election must use ADS under Section 168(g).
Section 2307 of the CARES Act includes a technical correction to the depreciation periods for QIP. QIP consists of improvements to nonresidential real property that are placed in service after the date the underlying real property was placed in service. The CARES Act modified the definition of QIP to require that improvements be made by the taxpayer.
QIP encompasses a broad range of assets and includes upgrades to plumbing, electrical equipment, fixtures and most other updates to a commercial building’s interior. Although additions to nonresidential real property, elevators and escalators are excluded from QIP, the category still covers many potential renovation and improvement projects. The TCJA created QIP as a separate category of depreciable property in an attempt to consolidate several prior categories of depreciable property. QIP was intended to benefit from a materially shorter depreciation period than other types of real property, but the TCJA, as enacted, failed to provide any specific depreciation method or period for QIP. The omission is widely viewed as a technical oversight. Consequently, prior to the CARES Act, QIP was subject to 40-year depreciation under ADS and 39-year depreciation under MACRS.
The CARES Act corrected this error and clarified that QIP is depreciable over 15 years under MACRS and 20 years under ADS. This correction also makes QIP eligible for bonus depreciation under Section 168(k). The correction is intended to take effect as though it were originally enacted in the TCJA.
Impact on Electing Real Property Trades or Businesses
Prior to the CARES Act, the rule limiting an electing real property trade or business to ADS had little impact on most taxpayers’ evaluation of whether to make a real property trade or business election. QIP was treated as nonresidential real property under Section 168(c). QIP was not eligible for Section 168(k) bonus depreciation under either MACRS or ADS, which among other things requires qualifying property to have a recovery period of 20 years or less. Therefore, the benefit a taxpayer lost because of the election was minimal.
Now that the CARES Act has corrected the status of QIP, such property is subject to depreciation over 15 years under MACRS and depreciation over 20 years under ADS. It is also eligible for Section 168(k) bonus depreciation under MACRS. These changes could have a large impact on taxpayers with significant amounts of QIP, and taxpayers will have to seriously consider these changes in the cost/benefit analysis of making an electing real property business election in the future. In most cases, the costs of making the election will now be higher.
Revenue Procedure 2020-22 gives taxpayers significant flexibility to make or withdraw a prior real property trade or business election under Section 163(j), and provides guidance for implementing the electing real property trade or business election and modified depreciation schedules. The Revenue Procedure grants an automatic extension for taxpayers to file an electing real property trade or business election for 2018, 2019 and 2020. Taxpayers can also withdraw a prior timely filed election (including extensions) for a 2018, 2019 or 2020 taxable year. If a taxpayer withdraws an election, it is treated as if it was never made.
Taxpayers can make or withdraw an election by filing an amended federal income tax return, amended Form 1065 or an administrative adjustment request under Section 6227. The amended filing must include an adjustment to taxable income for the election or withdrawal and any collateral adjustments. A collateral adjustment includes the amount of depreciation allowed or allowable in the applicable taxable year. Given the added expense of an electing real property trade or business election, many taxpayers likely will consider withdrawing their elections through the procedures outlined in Revenue Procedure 2020-22.
Revenue Procedure 2020-25 provides additional guidance to taxpayers regarding the CARES Act technical correction for QIP. Revenue Procedure 2020-25 generally provides that taxpayers changing the depreciation of QIP will be treated as though they were changing from an impermissible to a permissible method of accounting. However, this portion of the Revenue Procedure does not apply to taxpayers making or withdrawing a real property trade or business election. Such taxpayers are directed to follow the process in Revenue Procedure 2020-22 outlined above. Revenue Procedure 2020-25 also provides consent for taxpayers to revoke prior elections under Sections 168(g)(7) (allowing a taxpayer to elect depreciation under the ADS), 168(k)(5) (relating to special rules for depreciation of certain plants bearing fruits or nuts), 168(k)(7) (providing an election out of first year bonus depreciation) and 168(k)(10) (allowing a taxpayer to elect to deduct 50% instead of 100% bonus depreciation). Finally, the Revenue Procedure outlines the method and manner for taxpayers to make a late election or withdraw elections under the above provisions. Taxpayers evaluating their status as electing real property trades or businesses may also need to consider the impact of these additional elections in fully evaluating the best course of action given their particular circumstances.