The Coronavirus Aid, Relief and Economic Security (“CARES”) Act became law[i] on March 27, 2020. Almost immediately, “small” businesses[ii] from every industry – including real estate – began the process of determining whether they would be eligible for the forgivable, unsecured, non-recourse loans to be made under the Paycheck Protection Program, which is viewed by most closely held businesses as the centerpiece of the legislation.[iii]
However, there are a few tax-related provisions in the legislation that may assist a qualifying business to obtain through a refund – or to retain through lower taxes – some of the liquidity needed for the operation of the business. Although most of these tax provisions represent the temporary – and in some cases retroactive – relaxation of certain amendments made by the Tax Cuts and Jobs Act of 2017,[iv] they promise to mitigate the adverse economic effects of the health crisis [v]for many businesses.
Not to be outdone by Congress,[vi] the IRS has acted quickly to implement these changes. In addition, with the President’s declaration of a national emergency, the IRS has taken steps to address some of the specific concerns of taxpayers in the real estate industry.[vii]
We begin with a brief description of certain provisions of the Act that may be of interest to real estate businesses. This is followed by a summary of actions undertaken by the IRS with respect to like kind exchange transactions that were “interrupted” by the health crisis.
The Act temporarily reinstates and expands the NOL carryback that had been eliminated by the TCJA.[viii] Specifically, the Act allows a business that realizes a net operating loss (“NOL”) during a taxable year beginning after December 31, 2017 and before January 1, 2021 to carry its NOL back to each of the five taxable years preceding the year of the loss.[ix] If the business had taxable income during those earlier years, the carryback of the NOLs may create an opportunity for an immediate refund claim and more liquidity.[x]
The Act also suspended the TCJA’s “80 percent of taxable income” limitation for NOL carryovers arising in taxable years beginning before January 1, 2021.[xi] Thus, for a taxable year beginning in 2018, 2019 or 2020, an NOL carryover may be utilized to offset all of the business’s taxable income for that year; it is not limited to 80 percent thereof. As in the case of the carryback, the retroactive elimination of the “80 percent” cap may give rise to a refund claim for an eligible taxpayer.
The TCJA’s elimination of the NOL carryback, and its imposition of the 80 percent limitation on NOL carryovers, are reinstated for taxable years beginning after December 31, 2020.
As indicated above, taxpayers whose NOLs may now be carried back to an earlier taxable year will generally be able to file amended returns to claim refunds resulting from the temporary change in the law. Unfortunately, the Act did not provide additional time for certain taxpayers to file tentative carryback adjustment applications[xii] – basically, an expedited procedure for tax refunds resulting from the carryback of the NOL.
In response, the IRS has extended the deadline[xiii] for filing an application for a tentative carryback adjustment with respect to the carryback of an NOL that arose in any taxable year that began during calendar year 2018 and that ended on or before June 30, 2019.[xiv]
For example, in the case of an NOL that arose in a taxable year ending on December 31, 2018, a taxpayer normally would have until December 31, 2019, to file an application; because of this relief, however, the taxpayer will now have until June 30, 2020, to file.
Excess Business Loss
For taxable years beginning after December 31, 2017 and before January 1, 2026, the TCJA limited the ability of a non-corporate taxpayer – basically, individuals – to offset their nonbusiness income with losses arising from their business. Instead, such losses are required to be treated as part of the taxpayer’s NOL carryforward to subsequent taxable years.[xv]
The Act retroactively defers the effective date of these “excess business loss” rules. Specifically, the rules will now apply only to taxable years beginning after December 31, 2020 and before January 1, 2026.[xvi]
Consequently, an individual taxpayer who realized, or realizes, a loss from an operating business in a taxable year beginning before January 1, 2021 – whether as a sole proprietor, as a partner in a partnership, or as a shareholder in an S corporation – and who successfully runs the gauntlet of the basis limitation, at risk and passive loss rules,[xvii] will be allowed to apply such losses against their other income for such taxable year, including salary and investment income.
This change may afford those taxpayers, to whom the excess business loss rules have already been applied, an opportunity to claim a refund with respect to their taxable years beginning in 2018 and 2019.
Business Interest Deductions
Generally speaking, interest paid or accrued by a business is deductible in the computation of taxable income, subject to a number of limitations. The TCJA added one more limitation: for taxable years beginning after December 31, 2017, a taxpayer’s deduction for business interest for a taxable year is capped at 30 percent of the taxpayer’s “adjusted taxable income” for the taxable year. Any “excess interest deduction” will be carried forward to succeeding taxable years.[xviii]
The Act reduces the impact of this rule by increasing the limitation from 30 percent to 50 percent of adjusted taxable income for any taxable year beginning in 2019 or 2020.[xix] In this way, a taxpayer filing their income tax return for 2019 may take advantage of the increased limitation to reduce their income tax liability and to retain the tax savings in the business.
In addition, for a taxable year beginning in 2020, the Act permits a taxpayer to use their 2019 adjusted taxable income for purposes of determining their “interest deduction limitation” for 2020.[xx] Thus, if the taxpayer’s 2019 adjusted taxable income is greater than that for 2020 – which may very well be the case – the taxpayer may claim a greater interest deduction and, thereby, further reduce their tax liability.
Although the relaxation of the limitation on interest deductions[xxi] may entice a taxpayer to borrow funds during 2020, it is important for the taxpayer to recognize that the TCJA’s 30 percent cap will be reinstated in 2021.
Notwithstanding the foregoing, it should be noted that the limitation does not apply to taxpayers with average annual gross receipts, for the three-taxable year period ending with the prior taxable year, that do not exceed $25 million.[xxii]
In addition, at the taxpayer’s election, any real property trade or business is not treated as such for purposes of the limitation, and therefore the limitation does not apply to such a trade or business.[xxiii] The election to be excluded from the interest limitation rule, however, comes at a price: the electing taxpayer is not allowed to claim bonus depreciation,[xxiv] and is required to extend the depreciation period for its real properties.[xxv] In addition, once made, the election is irrevocable; thus, it is binding for all succeeding years.
However, the IRS has recognized that a taxpayer who made an election in 2018 to exclude their real property business from the TCJA’s “30 percent interest limitation” rule, may have acted differently had the Act’s 50 percent limitation been in effect instead. Thus, the IRS has issued guidance[xxvi] that allows a qualifying taxpayer to withdraw the otherwise irrevocable election.
Specifically, for a 2018 or 2019 taxable year, a taxpayer must timely file an amended Federal tax return for the year in which the election was made, along with an election withdrawal statement.[xxvii] The amended return must be filed on or before October 15, 2021, but in no event later than the applicable period of limitations on assessment[xxviii] for the taxable year for which the amended return is being filed. The amended tax return must include the adjustment to taxable income for the withdrawn election and any collateral adjustments to taxable income or to tax liability. A taxpayer also must file amended returns, which include such collateral adjustments, for any affected succeeding taxable years.
An example of such a collateral adjustment – and a possible reason for withdrawing the election in the first place – is the amount of depreciation, including bonus depreciation, allowed or allowable in the applicable taxable year for the property to which the withdrawn election applies.
In other words, a taxpayer may be able to take advantage of both the temporary 50 percent limitation on interest deductions, and the ability to claim an increased depreciation deduction (including bonus depreciation) for those years to which the election would otherwise have applied. Thus, the taxpayer will have another opportunity for a refund of taxes paid.
The Act corrects an error in the TCJA which prevented “qualified improvement property” from qualifying for bonus depreciation.
Qualified improvement property is generally defined as any improvement to an interior of a nonresidential building that is placed in service after the building was placed in service.[xxix]
The Act retroactively amended the Code, effective for property placed in service after December 31, 2017, to treat such property as 15-year property for which bonus (100 percent) depreciation may be claimed.[xxx]
A taxpayer affected by this change may be able to amend their 2018 returns in order to take the bonus depreciation deduction and thereby generate a refund claim. The change may also allow a taxpayer to claim a larger deduction in determining their 2019 income tax liability.
Like Kind Exchange
The TCJA amended the Code so as to restrict the tax deferral benefit of the like kind exchange rules to exchanges involving only real property held for productive use in a trade or business, or for investment.[xxxi]
Most like kind exchanges with real property are effected as deferred exchanges, with the replacement property being acquired sometime after the sale of the relinquished property. Generally speaking, in order for such a transaction to qualify for tax deferral as a like kind exchange, the replacement property must be identified no later than 45 days after the date of the sale of the relinquished property (the “identification period”),[xxxii] and it must be acquired no later than 180 days after the date of such sale (or, if earlier, by the tax return due date, determined with extensions, for the year of the sale; the “exchange period”).[xxxiii]
The above-described dates are prescribed by statute and, generally, cannot be changed by the IRS; however, an exception may apply where the President has declared a national emergency.[xxxiv]
On March 13, 2020, President Trump declared a national emergency[xxxv] regarding the COVID-19 outbreak.
The IRS recently invoked its power – arising under such a federally declared emergency – to postpone the time to perform specified “time-sensitive actions” for taxpayers who are affected by the health emergency.[xxxvi]
Among these time-sensitive actions[xxxvii] are the identification of a replacement property, and the acquisition of such replacement property, in connection with a transaction intended to qualify as a like kind exchange under Section 1031 of the Code, including a “safe harbor” reverse, or “parking,” exchange.[xxxviii]
The Treasury has determined that any person performing such an act which is due to be performed on or after April 1, 2020, and before July 15, 2020, will be treated as someone “affected” by the health emergency, and the period for performing the act will be automatically extended to July 15, 2020, unless the taxpayer elects out of the extension.[xxxix]
In other words, only identification and exchange period deadlines occurring between April 1 and July 15, 2020 (the “relief period”) are extended. For example, if a taxpayer sold real property on February 29, 2020, they would normally have until April 14, 2020 to identify a replacement property. As a result of the IRS’s response to the health emergency, however, the end of the identification period is extended to July 15, 2020.[xl]
It is worth noting that the exchange period in the above example does not appear to be affected because it does not fall within the relief period – thus, it remains August 27, 2020, a mere 43 days after the close of the identification period.
Alternatively, if the taxpayer’s 180-day exchange period for acquiring the replacement property would normally end within the relief period (say, for example, on April 15, 2020), the end of the replacement period would be extended to July 15, 2020.
The IRS will be implementing the foregoing measures over the coming weeks.
During that time, members of the real estate industry and their advisers will likely ask a lot of questions and to offer many suggestions; they are also likely to make a lot of requests – for clarification, and probably also for expansion of the relief already provided.
In light of the relatively brisk pace at which guidance under the Act has thus far been issued, updated, and then amended – all within the span of two weeks[xli] – and with the prospect of more legislation in the near future,[xlii] taxpayers and their advisers would be well-served to digest what has already been published, and to remain vigilant and keep informed of developments in our nation’s capital.
[i] P.L. 116-136 (the “Act”).
[ii] In general, a business is eligible for a loan under the PPP if it has no more than 500 employees or, if greater, the number of employees set by the SBA as the “size standard” for a particular industry. The SBA’s definition of “small business concern” also has to be considered. Section 1102(a)(2)(D) of the Act.
[iii] The liquidity to be provided under the PPP is intended to be used primarily for payroll costs, though borrowers may also apply a portion of the proceeds toward rent, utilities, and the interest on certain pre-existing indebtedness. However, in order to qualify for forgiveness of the loan, at least 75% of the proceeds have to be used to cover payroll costs. https://www.farrellfritz.com/sba-7a-loans-under-the-ppp/
[iv] P.L. 115-97 (the “TCJA”). See https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/ for a discussion of how the TCJA affected real estate businesses.
[v] More accurately, caused by the government-ordered shutdowns employed (pun intended) to combat the spread of the coronavirus.
[vi] The power of the purse under Article I of the Constitution. Similarly, though I am loath to quote Baron Harkonnen from Frank Herbert’s Dune, “He who controls the spice controls the universe.”
[vii] Let me pause a minute, here. Following the TCJA, the IRS was presented with the challenge of issuing badly needed regulations – basically, legislating – to implement and clarify many of the very complex changes enacted by the TCJA. At the same time, the agency was told to make due with fewer resources – makes a lot of sense, right? Now, as the Service sees a light at the end of the TCJA tunnel, it is confronted with the Act. What’s more, like the rest of us, its personnel are working remotely. Oh, and yes, it is “tax return filing season.” I hope that folks in the White House and in Congress are not too forgetful.
[viii] IRC Sec. 172(b).
[ix] Sec. 2303(b) of the Act. Before the TCJA, the carryback period was two years. The five-year carryback affords taxpayers a greater chance of applying the loss to a profitable year.
The assumption, or expectation, of course, is that everything will have returned to normal before the end of 2020.
[x] IRC Sec. 6401 and Sec. 6511.
[xi] Sec. 2303(a) of the Act.
[xii] IRC Sec. 6411. See also IRS Forms 1139 (for corporations) 1045 (for other taxpayers).
[xiii] IRC Sec. 6081 authorizes the IRS to grant a reasonable extension of time to file.
The usual deadline for filing the application is on or after the date of filing for the return for the taxable year of the NOL from which the carryback results and within a period of 12 months after such taxable year.
[xiv] Notice 2020-26. The Notice also explains what a taxpayer must do to take advantage of the extension for requesting a tentative refund based on the carryback of the NOL.
[xv] IRC Sec. 461(l).
[xvi] Section 2304 of the Act. Again, the hope is that the economy will be back on its feet by the end of 2020.
[xvii] IRC Sec. 704(d)/1366(d), 465 and 469, respectively.
[xviii] IRC Sec. 163(j).
[xix] Section 2306 of the Act. Special rules apply for partnerships.
[xx] IRC Sec. 163(j)(10)(B).
[xxi] That, plus the low interest rate environment in which we find ourselves.
[xxii] IRC Sec. 163(j)(3).
[xxiii] IRC Sec. 163(j)(7)(B).
[xxiv] IRC Sec. 168(k)(2)(D).
[xxv] IRC Sec. 168(g)(8).
[xxvi] Rev. Proc. 2020-22. Among other things, this guidance requires the filing of an election withdrawal statement that should be titled, “Revenue Procedure 2020-22 Section 163(j)(7) Election Withdrawal.”
[xxvii] Special rules apply for “BBA partnerships” under Revenue Procedure 2020-23.
[xxviii] IRC Sec. 6501.
[xxix] IRC Sec. 168(e)(6). There are exceptions; for example, any improvement for which the expenditure is attributable to an elevator or escalator.
[xxx] Section 2307 of the Act. IRC Sec. 168(e)(3)(E), Sec. 168(k).
[xxxi] IRC Sec. 1031(a)(1).
[xxxii] Reg. Sec. 1.1031(k)-1(c)(4) provides special rules for the identification of alternative or multiple replacement properties.
[xxxiii] IRC Sec. 1031(a)(3).
[xxxiv] IRC Sec. 7508A. Rev. Proc. 2018-58.
[xxxv] Effective March 1, 2020.
[xxxvi] Notice 2020-23.
[xxxvii] See, for example, Rev. Proc. 2018-58.
According to Notice 2020-23, another “time-sensitive action” is the taxpayer’s investment in a qualified opportunity fund of an amount equal to the taxpayer’s capital gain; the investment must be made during a statutorily-prescribed 180-day period in order for the taxpayer to defer the recognition of such gain, and to take advantage of the other benefits offered under the qualified opportunity zone regime. IRC Sec. 1400Z-2(a)(1)(A).
[xxxviii] Rev. Proc. 2000-37.
[xxxix] Notice 2020-23. An election out may be appropriate if the taxpayer no longer want to complete a like kind exchange, and wants to obtain the relinquished property sale proceeds from the qualified intermediary sooner rather than after the end of the extended period. Reg. Sec. 1.1031(k)-1(g)(6).
[xl] Qualified intermediaries (“QIs”) are probably all over this change. If you are in the midst of an exchange, contact you QI immediately.
[xli] It feels much longer, doesn’t it? Working remotely has certainly contributed to our losing track of time. Thankfully, I have not yet experienced a Ground Hog Day moment.
[xlii] Perhaps by the end of April.