IRC Section 163(j) Guidance Affects Real Estate Industry
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31 July 2020 IRC Section 163(j) guidance affects real estate industry In addition to the regulations, the IRS issued Notice 2020-59, which creates a safe harbor allowing taxpayers that manage or operate qualified residential living facilities to be treated as a real property trade or business (RPTB) solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7). The IRS also released FAQs on the aggregation rules that apply for purposes of the gross receipts test and determining whether a taxpayer is a small business exempt from the Section 163(j) Limitation. The FAQs provide a brief summary of existing authorities but do not shed any new light on the aggregation rules. The Proposed Regulations apply to tax years ending after the date they are published as final regulations. Taxpayers may, however, apply the Proposed Regulations to a tax year beginning after December 31, 2017, so long as they and their related parties consistently apply the relevant section of the Proposed Regulations to those tax years. Background The CARES Act made several temporary changes to IRC Section 163(j), including increasing the 30% of ATI limitation on business interest expense to 50% of ATI for any tax year beginning in 2019 or 2020. (See Tax Alerts 2020-0806, 2020-0872, 2020-0979, 2020-1061). IRC Section 163(j) does not apply to any "electing real property trade or business" (electing RPTB) (IRC Section 163(j)(7)(A)(ii)). An electing RPTB includes any trade or business that is described in IRC Section 469(c)(7)(C) and makes an election under IRC Section 163(j)(7)(B). A trade or business described in IRC Section 469(c)(7)(C) includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. An electing RPTB must depreciate its nonresidential real property, residential rental property and qualified improvement property (QIP) using the alternative depreciation system. Once the election is made, it is generally irrevocable. The Final Regulations answered many of the questions practitioners had about making an IRC Section 163(j)(7)(B) election to be an electing RPTB. Taxpayers can make an RPTB election regardless of whether they are otherwise subject to the small-business exemption, which exempts small businesses from the Section 163(j) Limitation if their average annual gross receipts for the preceding three years were $25 million or less. Under the Old Proposed Regulations, taxpayers exempt from IRC Section 163(j) by virtue of being a small business could not elect to be an electing RPTB. An RPTB election must be made for each of the taxpayer's eligible trades or businesses. A taxpayer may make elections for multiple trades or businesses on a single election statement. Taxpayers may make the RPTB election by attaching an election statement (containing specific information set forth in the Final Regulations) to their timely filed original federal income tax return, including extensions (this process is unchanged from the Old Proposed Regulations). The Final Regulations clarify that the election statement must sufficiently describe the taxpayer's RPTB to demonstrate qualification for an election. Depreciation Interest carryforwards In determining whether these disallowed amounts are properly allocable to an excepted or non-excepted trade or business, the Final Regulations permit taxpayers to apply a historical approach by either (1) looking to the tax year(s) in which the disallowed disqualified interest was paid or accrued or (2) applying an effective date approach treating all of the taxpayer's disallowed disqualified interest as if it were paid or accrued in the taxpayer's first tax year beginning after December 31, 2017. This would permit taxpayers who are electing RPTB for the 2018 tax year to treat these amounts as allocable to an excepted trade or business and claim a deduction. When disallowed business interest expense is carried forward to a tax year in which the small-business exemption applies to the taxpayer, the interest expense is no longer subject to limitation. The Final Regulations clarified how to allocate tax items between excepted and non-excepted trades or businesses. The Final Regulations allocate expenses (other than business interest expense), losses and other items that are "definitely related" to a trade or business to the trade or business to which they relate. An item is definitely related to a trade or business if the item giving rise to the deduction is incurred as a result of, or incident to, an activity of the trade or business or in connection with property used in the trade or business. An exception to the allocation rule applies when a taxpayer with qualified nonrecourse indebtedness under Treas. Reg. Section 1.861-10T(b) must directly allocate interest expense from the debt to the trade or business incurring that debt. The Final Regulations helpfully change the treatment of directly allocated items by reducing basis only by the amount of qualified nonrecourse indebtedness, rather than the entire basis of the property securing the indebtedness for purposes of allocating items. The Final Regulations retain the rules allowing partners in partnerships to electively look through to the partnership's adjusted tax basis in its assets to determine the amount of the partner's outside basis that is allocable to an excepted or non-excepted trade or business. If a partner elects not to look through, the partnership interest would be treated as a non-excepted trade or business asset. For partners owning more than 80% of the capital or profits of the partnership, the look-through rule is mandatory. When looking through, the partner allocates the basis of its partnership interest between excepted and non-excepted trades or businesses based on the ratio in which the partner's share of the partnership's adjusted tax basis in its trade or business assets is allocated between excepted and non-excepted trade or business assets.
Changes to the definition of real property The Final Regulations generally retain the definitions in the Old Proposed Regulations of the terms "real property operation" and "real property management" but still reserve definitions for real property development, redevelopment, construction, reconstruction, acquisition, conversion and rental. In addition, the Final Regulations retain the example clarifying that a taxpayer's ownership and operation of a luxury hotel may constitute a "real property operation" and thus be an eligible RPTB. In the Preamble to the Final Regulations, the Treasury Department and the IRS indicate that businesses involving real property construction, reconstruction, development, redevelopment, conversion, acquisition or brokerage should not necessarily be required to have direct nexus with, or a relationship to, rental real estate to be treated as an RPTB under IRC Section 469(c)(7)(C). The end products or final objectives of these businesses, however, should at least have the potential to be used as rental real estate or as integral components in rental real estate activities. REITs The Final Regulations clarify that the REIT safe harbor RPTB election is available if a REIT holds real property directly or indirectly through tiers of partnerships or other REITs. Specifically, the Final Regulations consider a REIT eligible to make to an RPTB election if the REIT holds: or For this purpose, the definition of "real property" is consistent with the definition of real property under the REIT rules of IRC Section 856, rather than the more restrictive definition in the final regulations under IRC Section 469. Anti-abuse rule regarding RPTB elections Under the Final Regulations, an RPTB election may not be made for an RPTB if 80% or more of the RPTB's real property is leased to a related party. In recognition of the permitted exception in IRC 856(d)(9)(D) to the REIT related-party rent rules for qualified lodging facilities and qualified healthcare properties, the Old Proposed Regulations contained an exception to the general anti-abuse rule for REITs leasing qualified lodging facilities and qualified healthcare properties. The Final Regulations revised the exceptions to the anti-abuse rule in several ways. First, a new exception (the de minimis exception) allows a lessor to make the RPTB election if at least 90% of the lessor's real property is leased to a related party that uses the real property in an excepted RPTB and/or to unrelated parties. Third, the REIT exception for leases of qualified lodging facilities and qualified health care properties now excludes partnerships making the REIT safe harbor RPTB election from application of the anti-abuse rule. The Final Regulations add a new anti-abuse provision to prevent the formation and use of tiered entities to manipulate the Section 163(j) Limitation. Under the Final Regulations, the IRS can disregard or recharacterize arrangements that are entered with a principal purpose of avoiding the IRC Section 163(j) regulations, including the use of multiple entities to avoid the gross receipts test of IRC Section 448(c). Notice 2020-59, released concurrently with the Final Regulations, outlines a proposed revenue procedure that would allow operators and managers of certain residential living facilities to elect to treat those trades or businesses as an RPTB, solely for purposes of qualifying as an electing RPTB under IRC Section 163(j)(7)(B). Implications In addition, the Final Regulations make rental real property that is subject to triple net leases eligible for the RPTB election, again providing taxpayers with certainty regarding the permissibility of their RPTB elections, particularly when questions arose as to whether the activity qualified as an IRC Section 162 trade or business. REITs will generally find the changes in the Final Regulations helpful. The new provision permitting partnerships controlled by REITs to make the safe harbor RPTB election is especially helpful, as many REITs (e.g., Up-REITs) hold assets and related indebtedness through lower-tier partnerships. Similarly, operators of residential living facilities will find Notice 2020-59 helpful in providing clarity as to the availability of the RPTB election. ——————————————— Tag » Code Section 163 J Election
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