Expanded ability to use losses from active real estate trade or business against other taxable income

The CARES Act postpones the restrictive rule of section 461(l), which was enacted by the TCJA and limits the ability of individuals and other noncorporate taxpayers to use losses from an active trade or business against other sources of income (i.e., nonactive trade or business income).

The practical result of section 461(l) was that, since 2018, an individual has been able to annually use only up to $250,000 ($500,000 for married couples, filing jointly, with such amounts adjusted for inflation in subsequent years) of losses from an active real estate business to offset his or her other income. Note that for partnerships or S corporations, the excess business loss limitation applies at the partner or shareholder level.

The CARES Act postpones section 461(l)’s effective date to January 1, 2021. Because the postponement is retroactive, this means that the limit does not apply to 2018, 2019 or 2020. Accordingly, to the extent this limit prevented an individual from claiming losses for tax returns already filed for 2018 or 2019, the individual should file an amended tax return to claim these losses and thereby obtain a tax refund.

Increased business interest expense deductions

The CARES Act scales back the limit on business interest deductibility enacted by the TCJA. The TCJA enacted section 163(j), which generally limited business interest that could be deducted to only 30 percent of adjusted taxable income (similar to EBITDA). The CARES Act increases the limit from 30 percent of adjusted taxable income to 50 percent of adjusted taxable income for tax years beginning in 2019 and 2020 (unless the taxpayer opts out). The CARES Act also allows businesses to elect to use their earnings from 2019 for purposes of calculating the 2020 limitation.

A special rule is included for partnerships. The 50 percent cap is not effective at the partnership level for tax years beginning in 2019 (i.e., the 30 percent cap applies only for years beginning in 2020); instead a partner may treat 50 percent of its allocable business interest expense in 2019 as fully deductible in 2020 without further limitation under section 163(j).

Note that the TCJA provided certain real estate businesses a special election to opt out of the limit on business interest deductibility. If a business opts to be an “electing real property trade or business,” there is no limitation on the amount of business interest expense it may deduct. The tradeoff for being subject to no limit is that, in making this election, the business is required to use the Alternative Depreciation System (ADS) on certain depreciable assets (generally slowing depreciation deductions). Also, electing real property trades or businesses cannot claim 100 percent bonus depreciation on any assets depreciated under the ADS method.

Due to the tradeoff, after analyzing the amount of the interest expense that exceeded the limitation and comparing it with the decrease in depreciation expense that would result from using ADS, many eligible real estate businesses, including REITs, elected out of the interest deduction limitation of section 163(j). Once such an election is made, it is generally irrevocable. One question that has arisen is whether real estate businesses that may have made the irrevocable election under section 163(j) would be provided relief to modify this election. Happily, the IRS has released a taxpayer-favorable procedure allowing taxpayers to withdraw such an election to the extent it was made in tax returns for prior years. See discussion of Revenue Procedure 2020-22 immediately below. This provides real estate businesses with much needed flexibility and the opportunity to alter earlier tax planning that may no longer make sense.

IRS Procedure allowing real estate businesses to make changes to section 163(j) election

On April 8, 2020, the IRS released Revenue Procedure 2020-22, which allows taxpayers subject to the business interest deduction limitations to make late elections or withdraw earlier-made elections under Code section 163(j)(7) to be an “electing real property trade or business.” As noted above, there was uncertainty as to whether taxpayers may be able to do so. This is welcome guidance from the IRS and will provide real estate businesses the opportunity to adjust their earlier tax planning in light of the tax provisions of the CARES Act. In order to decide whether to make or withdraw elections, eligible real estate businesses should analyze anew the amount of the interest expense that would exceed the limitation and compare it with the decrease in depreciation expense that would result from using ADS (especially given the fix to the retail glitch discussed below).

Net operating loss (NOL) limitations expanded

The CARES Act rolls back limits placed on the ability to use NOLs, allowing individuals and others taxpayers to carry them back to the extent the losses are not usable in the year generated, thereby allowing them to obtain refunds.

In general, an NOL is the amount by which a taxpayer’s business deductions exceed his or her business gross income. Prior to the TCJA, NOLs could generally be carried back two years and forward 20 years. Beginning with 2018, the TCJA generally limited the ability of taxpayers to use NOLs in two significant ways. First, the TJCA precluded taxpayers from carrying back NOLs to prior years, so that only carryforwards were allowed. Second, it allowed NOLs to be used to offset only up to 80 percent of the taxpayer’s taxable income.

The CARES Act temporarily removes both of these limitations, potentially allowing for tax savings or a refund for taxpayers. Under the CARES Act, NOLs generated in 2018, 2019 and 2020 are permitted to be carried back to each of the five preceding taxable years. In addition, for the 2018, 2019 and 2020 taxable years, the 80 percent taxable income offset limitation is removed, so that NOLs may fully offset taxable income in those years.

While the relaxation of the carryback of NOLs should be helpful to owners of real estate businesses, the NOL carryback relaxation does not apply to REITs because REITs have already distributed income from prior years to shareholders; however, taxable REIT subsidiaries are eligible to carry back NOLs.

The IRS is granting a six-month extension to taxpayers filing applications for tentative refunds (Form 1045 for individuals, trusts and estates; Form 1139 for corporations) in relation to NOL carrybacks that arose in a tax year beginning in 2018 and ending by June 30, 2019.

Fix to technical glitch relating to 100 percent bonus deduction for qualified improvement property

The CARES Act retroactively fixes the “glitch” that prevented taxpayers from taking 100 percent bonus deprecation on qualified improvement property (QIP).

By way of background, one of the great benefits provided to businesses by the TCJA was that it allowed for 100 percent bonus depreciation for qualified property placed in service after September 27, 2017 and before January 1, 2023. Likely due to an oversight, and commonly referred to as the “retail glitch” (because of its large impact on the retail industry), the TCJA omitted improvements to an interior portion of nonresidential real property (qualified improvement property or QIP) from the definition of qualified property. The technical result was that QIP was required to be depreciated over 39 years. Many in Congress had been looking for a way to correct the glitch since the TCJA was enacted.

The CARES Act identifies QIP as “15-year property” (20-year property for ADS purposes), which makes the property eligible for 100 percent bonus depreciation and for 15-year depreciation if bonus depreciation was not elected. Taxpayers that had not claimed 100 percent depreciation with respect to QIP or who took annual depreciation deductions with respect to such improvements using a 39-year life should consider amending their 2018 and 2019 (if filed) returns to claim refunds.

Application of CARES Act changes to state and local income taxes

Whether the federal changes also will apply for calculating state income taxes will depend on whether (1) the state adopts the Code as in effect from time to time (“rolling conformity”) and, if it does so, whether state legislation opts out of specific Code provisions (such as bonus depreciation and loss carrybacks), or (2) its adopts the Code as in effect on a certain date.

For example, New York generally adopts the Code as in effect from time to time with certain exceptions and has included a provision in its recently enacted 2021 fiscal year budget to apply the Code as of March 1, 2020 for tax years beginning before January 1, 2022, thus precluding application of the above CARES Act changes for purposes of determining state and local income taxes for the current and prior tax years. Other states with rolling conformity may also decide to decouple from the CARES Act.

Employer payroll tax credit and payroll tax deferral

The CARES Act provides for a refundable payroll tax credit of up to $5,000 per employee against an employer’s share of employment taxes for employers that retain employees during the COVID-19 crisis.

Employers are eligible if their operations are fully or partially suspended due to a governmental shutdown order or if they experience a 50 percent reduction in quarterly receipts due to the crisis; the gross receipts test must be analyzed across all aggregated entities, rather than by location (i.e., areas more heavily impacted by COVID-19 will be aggregated with other locations to determine if the employer’s business as a whole qualifies). Employers must reduce their deduction for wages by an amount equal to the credit taken.

In addition, employers can defer their share of the 6.2 percent Social Security tax that would otherwise be due from March 27, 2020 through December 31, 2020 unless they have received a Paycheck Protection Program loan that has been forgiven.

See our earlier guidance relating to the employer payroll tax credit and deferral for greater detail.

IRS Procedure clarifying partnerships may file amended tax returns to take advantage of relief provided by CARES Act

The IRS issued Revenue Procedure 2020-23 on April 9, 2020, allowing eligible partnerships to file amended tax returns beginning in 2018 and 2019 and to issue an amended K-1 to their partners. This is in lieu of filing an administrative adjustment request (AAR).

As discussed above, the CARES Act provides certain retroactive relief that affects partnerships — for example, the fix to the retail glitch would allow partnerships to claim bonus depreciation with respect to QIP. The relief provided by the CARES Act extends to tax years ending in 2018 and 2019. However, for tax years as to which the partnership had already filed tax returns, there was uncertainty as to how the partnership could obtain this relief given that partnerships that are subject to the centralized audit regime are prohibited from filing amended tax returns. Revenue Procedure 2020-23 addresses this issue by allowing these partnerships to file amended tax returns.

Since many real estate businesses are conducted by entities that are partnerships for tax purposes, this is a welcome clarification for these businesses.

IRS Notice allowing many taxpayers to delay filing tax returns and making tax payments (without interest or penalties accruing) until July 15, 2020

The IRS released Notice 2020-23 on April 9, 2020, postponing the filing and tax payment dates for many taxpayers. The relief applies to a broad set of taxpayers and an equally broad set of tax payments. There is no limit on the amount that can be deferred without penalties or interest until July 15, 2020. The period beginning on April 1, 2020 and ending on July 15, 2020 is to be disregarded in the calculation of any interest, penalty or addition to tax for failure to file the relevant tax forms or pay the relevant tax payments.

The Notice also extends some key dates for certain tax-deferred transactions relating to real estate transactions. Below are answers to some frequently asked questions relating to these dates:

I have closed or am about to close on the sale of real property and intend to have the proceeds reinvested in a 1031 exchange. However, due to social distancing, I am unable to inspect properties that I would like to consider identifying as replacement properties. Can I obtain more time to identify replacement properties?

Yes. If the last day of the 45-day period during which you must identify replacement properties falls on or after April 1, 2020 and before July 15, 2020, the time for identifying such replacement properties is extended to July 15. This extension is automatic and you need not apply for an extension.

I have previously closed on the sale of real property and have identified replacement property in order to effectuate a 1031 exchange. However, due to the COVID-19 pandemic, I will be unable to close on the acquisition within 180 days of the closing of the sale of the relinquished property. Can I obtain an extension of the time to close on the acquisition of my replacement property?

Yes. If the last day of the 180-day period during which you must close on the acquisition of your replacement property falls on or after April 1, 2020 and before July 15, 2020, the time for closing the acquisition of your replacement property is extended to July 15. This extension is automatic and you need not apply for an extension.

I have realized a capital gain and wish to defer recognition of my gain by making an investment in an opportunity zone fund. However, I am unable to due diligence the opportunity zone businesses owned by opportunity zone funds that have been suggested to me due to the COVID-19 pandemic. Can I obtain an extension of the 180-day period during which I can make this investment?

Yes. If the last day of the 180-day period during which you must make an investment in an opportunity zone fund falls on or after April 1, 2020 and before July 15, 2020, the time for making this investment is extended to July 15. This extension is automatic and you need not apply for an extension.

The IRS indicated on April 14, 2020 that it is putting together an FAQ that will clarify the extension of deadlines for completing like-kind exchange transactions.

See Pepper Hamilton’s earlier published guidance relating to this Notice.