Property, Pandemic and Politics: “PPP” for the Real Estate Industry

As with every segment of the global economy, the U.S. real estate market was not immune to the pandemic. In fact, there are four great forces at play in the determination of tax policy as it pertains to the real estate industry:

• The Tax Cuts and Jobs Act of 2017 (TCJA), as augmented by the CARES Act in 2020;
• The economics of the pandemic;
• The Presidential election; and
• The Congressional elections.

Below are some of the key developments in these areas during 2020 that may affect real estate businesses for investors, developers, builders and owners, and what to look for in 2021.

Retroactive Bonus Depreciation for Qualified Improvement Property (“QIP”)

It took a pandemic to persuade legislators to correct a “technical glitch” in the TCJA. The CARES Act, signed into law in March 2020, corrects a drafting error in the TCJA, which failed to provide that certain improvement property (QIP) would be treated as having a recovery period of 15 years. The TCJA, as originally issued, erroneously provided for a recovery period of 39 years, thus making it ineligible for bonus depreciation of 100% in 2018 and later years.

The CARES Act corrects this error, reducing the recovery period of QIP to 15 years and making the QIP eligible for 100% bonus depreciation. The correction is retroactive to January 1, 2018. This allows taxpayers to amend their 2018 returns to benefit from bonus depreciation and reduce taxable income.

A complicating factor in the QIP windfall in the CARES Act is that bonus depreciation generally is unavailable to taxpayers in a real estate business that elects out of certain interest expense limitations under Internal Revenue Code Section 163(j). Taxpayers that elect as real estate trades or businesses would still benefit from a shorter 15-year recovery period versus the former 39 year recovery period.

Interest Limitation Changes and the CARES Act.

The TCJA modified Internal Revenue Code Section 163(j) to limit the deductibility of business interest expenses, generally capping the interest expense deduction at 30% of adjusted taxable income (ATI). ATI is defined as earnings before interest, tax, depreciation, and amortization (EBITDA), with a few adjustments for tax years beginning before January 1, 2022. Any interest expense in excess of the 30% limit is disallowed in the current tax year and carried forward to future tax years as “excess business interest.”

As discussed above, not all real estate businesses are impacted by this limitation, as some will have elected out in exchange for longer depreciation periods on certain real property.

The CARES Act temporarily modifies Section 163(j) in three important ways:

• It increases the Section 163(j) limitation to 50% of ATI for the 2020 tax year, allowing taxpayers to deduct a larger amount of interest expense.
• Taxpayers may (but are not required to) use their 2019 ATI to calculate the Section 163(j) limitation on their 2020 returns, which will create a more favorable limitation for taxpayers with higher ATI in 2019 than in 2020 (a highly likely scenario given the recent, sharp economic downturn).
• In the case of a partnership with excess business interest from 2019, 50% of the excess business interest of each of its partners (unless a partner elects out) will generally be deductible against their tax year 2020 income without regard to the limitations under Section 163(j).

These three temporary modifications may be helpful to many real estate ventures, allowing them to take advantage of higher interest expense deductions. These deductions could prove especially beneficial for those businesses operating with higher leverage. With the drop in interest rates due to the pandemic, many deal organizers are looking to restructure debt, with lower interest costs.

Excess Business Losses and Net Operating Losses (NOLs)

The TCJA limited a non-corporate taxpayer’s ability to deduct “excess business losses” for tax years beginning after December 31, 2017, and before January 1, 2026. Excess business losses are the amount by which the total deductions attributable to all of a taxpayer’s trades or businesses exceed such taxpayer’s total gross income and gains attributable to those trades or businesses, plus $250,000 (or $500,000 in the case of a joint return). The rules effectively limit a taxpayer’s ability to use business deductions to offset nonbusiness income. Disallowed losses are carried forward as NOLs.

The CARES Act retroactively delays this limitation to tax years starting on January 1, 2021, or later. As a result, excess business losses that would otherwise be disallowed for taxable years 2018 through 2020 will be permitted. This provision may enable taxpayers to claim significant tax refunds for 2018 and 2019 to the extent that these losses were not included on federal income tax returns.

Under the TCJA, corporate NOLs arising in 2018 or subsequent years were not permitted to be carried back to offset prior years’ taxable income, and corporate NOL carryforwards may be used to offset no more than 80 percent of taxable income. The CARES Act postpones the 80 percent carryforward limitation to taxable years beginning before January 1, 2021, and allows taxpayers to carryback NOLs arising in tax years beginning after December 31, 2017, and before January 1, 2021, over a five-year period. Certain exceptions and special rules may apply (e.g., consistent with prior law, real estate investment trusts, or REITs, cannot carryback NOLs to non-REIT years).

Special care is required to make sure these tax attributes are effectively utilized. Taxpayers should understand what their 5-year projected income will be, the possibility of increased tax rates, and the known value of what the carried back losses could generate. For example, it might not be prudent to carryback losses to recover capital gain income taxes paid, versus carrying forward the losses to offset a possible cancellation of debt scenario with a property that is underwater due to the pandemic.

What to Watch for in 2021

The economics of the pandemic are of concern to many taxpayers, especially in the real estate industry. The CARES Act was instrumental in infusing needed capital and liquidity into the economy, benefiting the real estate industry.

What will happen once the forbearance agreements and stimulus payments, or hopes of future stimulus payments, cease to exist? Will there be a need for debt restructuring with lenders? What will be the consequences?

The principal tax concern in connection with a debt restructuring is cancellation of indebtedness (COD) income or loss of valuable tax attributes. Whether or not a debt modification results in COD income depends on the terms of the modification, which requires an analysis of all of the features of the modified obligation when compared with the original obligation.

If the debtor is insolvent at the time that the COD income is recognized then some or all of the COD can be excluded from income. If the debtor is in bankruptcy, then all of the COD income is excluded. Any amount of COD excluded from income under the bankruptcy or insolvency exceptions will reduce tax attributes; for example, any NOLs remaining after those losses are used in the current year, and tax basis in assets.

In the case of partnerships, the bankruptcy and insolvency exceptions are applied at the partner, rather than the partnership, level. Thus, COD income arising from a partnership in bankruptcy will only be excluded if the partner is also is in bankruptcy.

Federal Tax Policy

The politics of tax policy will be highlighted in 2021. With the election passed, a renewed battle over tax policy may be the focus of Congress and the White House. Due to the pandemic, the federal budget deficit has ballooned to more than $3 trillion. Regardless of party, revenue will need to be raised in order to pay for the pandemic relief.

Here are some of the issues raised by the political campaigns, for which the country awaits answers:

• Will the top income tax rate be increased?
• What personal income level will become the highest bracket?
• Will the capital gains rates increase?
• Will the tax benefit of like kind exchanges survive?
• Will decedents continue to receive a “step-up” in basis on estate assets?
• Will there be a capital gains tax at death?
• What will be the estate tax exemption?

What We Know for Sure

For real estate owners and investors, there is a tremendous amount of uncertainty about the economy and tax policy under the next Administration. Here’s what we know for sure:

• There is currently an $11,580,000 estate tax exemption per person, or $23,160,000 for a married couple.
• Interest rates are at historically low levels.
• The ability to utilize marketability and minority discounts still apply to closely held businesses.
• The estate tax exemption will “sunset” in 2026.

For taxpayers that have made real estate investments in partnerships or limited liability companies that are taxed as partnerships, 2020 is a “must” year to review estate planning. An open dialogue with your tax advisor regarding family goals, valuations, projected estate growth, hedging the step-up in basis issue at death, and all of the other components of an estate plan is a pressing need.