To help refill drained coffers across CRE, the CARES Act resolved a much-discussed drafting error from the 2017 federal tax reform and enshrined two other significant tweaks to real estate tax law.
“These are wish-list items with huge impact,” said Brian Newman, federal tax practice leader at CohnReznick. “If I had been asked to choose three changes to help the real estate industry, these would have been the three I picked.”
If real estate companies move quickly enough, these changes offer unprecedented flexibility to recoup taxes that have already been paid and defer new taxes, allowing businesses to keep more cash on hand.
Let’s break down each of the changes and how CRE companies can receive the full benefit.
1. Qualified Improvement Property
When Congress passed the Tax Cuts and Jobs Act (TCJA) in 2017, its intention was to let commercial non-residential property owners deduct the cost of interior capital expenditures – known as Qualified Improvement Property, or QIP – entirely in the year they were placed in service. An owner that spent $10 million on renovations to a commercial building lobby, for instance, should have been able to deduct that expense immediately, lowering their tax exposure for that year.
However, an error in the drafting meant that owners would have to depreciate QIP over 39 years. Though the error was caught quickly, issuing a revision became a political standoff, according to Richard Shevak, a national tax principal at CohnReznick.
“It wasn’t a foregone conclusion that this change was coming,” Shevak said. “It was dragging on, but the push for coronavirus relief accelerated the process of issuing the change.”
With the CARES Act, the drafting error has officially been fixed, and commercial property owners are allowed to deduct those capital expenditures. Thanks to new changes on how net operating losses are being handled – more on that below – these accelerated deductions can potentially generate quick infusions of cash from tax refunds and deferrals on new taxes.
Shevak did point out that while QIP benefits are not open to multifamily or residential properties, they are available to other property types, such as commercial office, hotels, retail and industrial.
2. Interest expense limitations – 163(j)
While it attempted to give CRE businesses a break on QIP depreciation, the TCJA also placed a cap on interest expense deductions, which, for a highly-leveraged industry like real estate, was a painful blow, Shevak said.
Businesses in real estate could avoid the cap by making a one-time, binding election (Qualified Real Property Trade or Business Election – or “the election”). However, that election would bar them from using the accelerated QIP depreciation described above.
The CARES Act generally raised the interest expense cap from 30% of adjusted taxable income to 50%, with partnerships not receiving a benefit until 2020. But more importantly, the IRS has decided to let businesses withdraw their elections for the 2018 and 2019 tax years.
“It’s unprecedented for the IRS to let taxpayers go back and undo an election they made without the consent of the Commissioner,” Newman said.
The IRS’s leniency offers CRE taxpayers a great deal of flexibility. For example, companies that have already made the election can withdraw, receive the accelerated depreciation on QIP for 2018 through 2020, and then immediately remake the election, without ever having to limit their interest expense deductions once the election is made.
Before the QIP fix, businesses were less likely to be adversely affected by making the one-time election because accelerated depreciation was not available for QIP. But with the drafting error fixed, the consequences of the election are more tangible.
“It comes down to how long you intend to hold the property and how much capital expenditure you expect in the coming years in terms of tenant improvements and building improvements, and weighing that against your interest expense,” Newman said. “Since the cap is keyed off of adjusted income, it also depends on how profitable you expect your building to be. It’s not a simple choice, and requires projecting future operations and capital improvements.”
3. Net operating loss (NOL) changes
Prior to 2018, companies could carry a net operating loss (NOL) back for two years and forward for 20 years. TCJA eliminated the practice of carrying losses back, allowing losses to be carried forward indefinitely. The law also limited the loss that could be utilized in subsequent years to 80% of taxable income.
The CARES Act has eliminated the 80% limitation, and allowed businesses to carry back losses for five years. If a taxpayer had taxable income in the carryback period, these carrybacks can create immediate infusions of cash by recouping taxes that have already been paid and possibly at higher rates.
The CARES Act also eliminated the TCJA’s excess business loss limitation for tax years beginning in 2018, 2019, and 2020. Many real estate owners were adversely affected by the limitation; its suspension could potentially create or increase a NOL that could be carried back.
Newman described how CohnReznick has been reviewing its clients’ filed returns for QIP and excess business losses that can create opportunities to put more cash back in the hands of taxpayers. The IRS, he said, is expecting a deluge of inquiries for repayment, so it is incumbent on CRE businesses to file early and reserve their spot in the queue.
“Revenues may be halted, but rent payments and loan payments haven’t stopped,” Newman said. “These changes are here to help businesses keep up their cash flow, sustain their payroll, and do the right thing for their future and their employees.”
This feature was produced in collaboration between the Bisnow Branded Content Studio and CohnReznick. Bisnow news staff was not involved in the production of this content.
By: Brian Newman