Real Estate Businesses May Avoid Interest Expense Limit

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In our last alert (LMC TCJA Alert #32), we discussed an exception to the new interest expense limitation rules for small businesses and how the receipts of related taxpayers may need to be combined for this $25 million exception. Another exception to these rules involves an election that allows real estate companies to deduct their full interest expense even when receipts exceed the $25 million threshold. This benefit comes at a cost, however - the company gets slower annual depreciation deductions and some bonus depreciation is eliminated forever.

 

Background

Starting in 2018, The Tax Cuts and Jobs Act (TCJA) limits the business interest expense a company may deduct from its taxable income (LMC TCJA Alert #7). The interest deduction is generally limited to 30% of the business's adjusted taxable income (the amount of interest income and certain financing of auto dealers also add to the allowed expense). The limitation is imposed on all business taxpayers, regardless of form, if average annual receipts exceeded $25 million over the prior three years.

 

The Real Estate Exemption

Often real estate companies are highly leveraged with mortgages, and produce tax losses. If a company with losses is subject to the interest limitation because its receipts exceed $25 million, it would be unable to deduct any of its mortgage interest expense. However, TCJA allows a real property trade or business to elect out of the business interest deduction limitation.

 

This applies not just to rental companies but to a broadly defined group of real estate activities including development and redevelopment, construction and reconstruction, acquisition, conversion, management, leasing, and brokerage. Hotel businesses also fall within this definition. The election is made for each eligible real estate trade or business by attaching a statement to a timely filed federal tax return. Once made, the election is irrevocable.

 

The drawback of electing out is that the company must switch to the Alternative Depreciation System (ADS). ADS lengthens the depreciable period of residential real estate buildings from 27.5 to 30 years (40 years for existing buildings), commercial real estate buildings from 39 to 40 years, and improvement property from 15 to 20 years. The switch does not just apply to new asset additions - depreciation deductions of existing assets must be recomputed for the remainder of their depreciable lives.

 

Leasehold improvements and other improvement property are usually eligible for 100% bonus depreciation through tax year 2022 (an inadvertent error in the language of TCJA eliminated that benefit, but Congress may fix that). But in addition to increasing these assets' depreciable period to 20 years, the irrevocable election removes the ability to ever use bonus depreciation for them.

 

The ADS election does not apply to property with shorter periods such as equipment, furniture, and fixtures. The lives and accelerated depreciation method applicable to those assets do not need to be changed, and they are eligible for bonus depreciation.

 

Contact your LMC professional to discuss whether your real estate business should elect this exemption. All our prior Tax Cuts and Jobs Act Alerts are available on the Updates page of our website.

 

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