The CARES Act, enacted on March 27, 2020, contains several tax law changes that are especially beneficial for real estate investors. Some of the most significant changes are summarized below.
Depreciation of Qualified Improvement Property
Qualified improvement property (“QIP”) includes most tenant improvements made to the interior of non-residential buildings. For many years, the cost of such improvements was depreciable over 15 years or was even eligible for up to 100% bonus depreciation. However, due to an apparent drafting error in the Tax Cuts and Jobs Act of 2017 (the “2017 Act”), QIP placed in service in 2018 or later was ineligible for bonus depreciation and had to be depreciated over 39 years instead of 15.
The CARES Act reinstates the 15-year depreciation period and bonus depreciation eligibility for QIP placed in service in 2018 or later.
Deduction of Business Interest
Under the 2017 Act, taxpayers may deduct net business interest expense only up to 30% of their adjusted taxable income (“ATI”). Taxpayers with average annual gross receipts of $26,000,000 or less are exempt from this limitation. Real estate businesses with annual gross receipts greater than $26,000,000 can elect out of this limitation, but the trade-off is having to use the alternative depreciation system (“ADS”), which generally results in less rapid depreciation. For example, under ADS, QIP is ineligible for bonus depreciation and must be depreciated over 20 years rather than 15.
The CARES Act temporarily increases the business interest deduction limitation to 50% of ATI for 2019 and 2020 (only for 2020 for partnerships). It also allows taxpayers to make various elections in computing the limitation, including electing to use their 2019 ATI for purposes of computing their 2020 deduction limitation. Real estate businesses can make late elections out of the deduction limitation, and can even withdraw elections previously made. These elections give taxpayers flexibility in maximizing interest deductions for 2019 and 2020.
NOLs and Excess Business Losses
Under the 2017 Act, net operating losses (“NOLs”) could be carried only forward to future tax years and could be used to offset only up to 80% of taxable income in those years. However, the CARES Act allows NOLs arising in 2018 through 2020 to be carried back up to 5 years and to offset up to 100% of taxable income in those years (and if carried forward to offset up to 100% of taxable income through 2020).
The 2017 Act also limited the amount of excess business losses that could be deducted against non-business income to $250,000 per individual (or $500,000 for joint filers). However, the CARES Act allows excess business losses arising in 2018 through 2020 to be deducted against non-business income without being subject to this limitation. This temporary change has potentially great benefit for real estate professionals whose rental real estate losses are not subject to the passive loss limitations––such losses could be used, for example, to offset large investment gains in 2018 through 2020.
Any one of the CARES Act changes described above has potential benefits for real estate investors. Together, however, these changes can result in surprisingly large reductions in tax liability. To the extent the changes are retroactive to 2018 or 2019, the benefits are generally claimed by filing amended tax returns (which result in refunds of taxes already paid) or by filing administrative adjustment requests or accounting method changes (which reduce taxes otherwise payable for 2020). Either approach results in cash savings, which can be especially welcome in today’s economic uncertainty.
This article was published as part of the Fall/Winter 2020 issue of ke kumu, Cades Schutte’s client newsletter. Read the full article, which explores some of the laws unique to Hawai‘i.