The economic slowdown caused by the coronavirus (COVID-19) outbreak has significant effects on the real estate sector. The federal government has implemented stimulus measures most notably, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) to combat the economic impact of the COVID-19 pandemic on businesses, individuals and families. In addition to loan programs, mortgage relief and other measures that may benefit real estate businesses and investors, the CARES Act contains tax relief provisions that could benefit property owners and real estate-related businesses. While these measures are not focused on real estate businesses, many real estate-related businesses should be eligible to benefit from one or more of these provisions.
In addition to the CARES Act provisions, the Internal Revenue Service (IRS) has introduced procedural relief in response to the crisis by delaying the due dates for certain tax filings and payments. Other federal tax provisions may also be implicated as a result of certain economic adjustments made to real estate ventures and entities.
This Holland & Knight alert provides a summary of the key CARES Act and other federal tax provisions that real estate businesses and consumers should consider as they navigate through this crisis.
Under the 2017 Tax Cuts and Jobs Act (TCJA), corporate NOLs arising in 2018 or subsequent years are 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 Jan. 1, 2021, and allows taxpayers to carryback NOLs arising in tax years beginning after Dec. 31, 2017, and before Jan. 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).
Under Section 163(j) of the Internal Revenue Code (Code), enacted by the TCJA, taxpayers may deduct business interest expense only up to 30 percent of their "adjusted taxable income" (a concept similar to earnings before interest, taxes, depreciation and amortization or EBITDA). The CARES Act increases the limitation to 50 percent for taxable years beginning in 2019 and 2020, and allows taxpayers to elect to use their 2019 adjusted taxable income to calculate their Section 163(j) limitation for their 2020 taxable year.
For partnerships, the Section 163(j) limitation applies at the partnership level. The 30 percent limitation will continue to apply to partnership interest expense in 2019. However, 50 percent of any excess business interest allocated to a partner and carried over from 2019 will be treated as business interest paid by the partner in 2020, and will not be limited to the partner's business interest income for 2020. The remaining 50 percent will continue to be subject to such limitations.
The TCJA eliminated the 20 percent corporate AMT, and provided that only 50 percent of the AMT credits carried forward by a corporation could be refundable in tax years beginning after Dec. 31, 2017, and before Jan. 1, 2021. After Dec. 31, 2020, 100 percent of any excess AMT credits could be refunded. The CARES Act permits corporations to claim a refund for 2018 equal to the full amount of their excess AMT credit carryforwards. For corporations that do not elect this refund, the CARES Act eliminates the 50 percent limit on AMT credits for taxable years beginning in 2019. This provision will benefit corporations with excess AMT credits by permitting refunds of 2018 taxes.
The CARES Act permits employers to defer payment of the 6.2 percent employer portion of Social Security taxes and one-half of the payroll tax paid by self-employed taxpayers (i.e., one-half of the 12.4 percent) otherwise required to be deposited during 2020 (after the enactment of the CARES Act).
The deferred tax payments must be paid over the following two years: 50 percent by Dec. 31, 2021, and the remaining 50 percent by Dec. 31, 2022.
Employers that have received a U.S. Small Business Administration (SBA) Paycheck Protection Program (PPP) loan may benefit from such deferral through the date the lender issues a decision to forgive the loan in accordance with the CARES Act. Thereafter, the employer is not eligible for deferral.
Eligible employers with operations that were fully or partially suspended because of orders from a governmental authority as a result of COVID-19, or who experienced a significant decline in gross receipts as determined under a quantitative test, are entitled to a refundable payroll tax credit of 50 percent qualified wages paid to an employee, up to a maximum of $10,000 in wages, paid from March 13, 2020, through the end of the year (i.e., up to a $5,000 credit per employee). This provision will ease the strain on employers' cash flow and may encourage employers to retain current employees.
For employers with more than 100 full-time employees, qualified wages only include those paid to employees who are not providing services because of the foregoing suspensions of their employer's trade or business or reduced gross receipts. Employers with fewer than 100 full-time employees may include all employee wages, regardless of whether the employees work or not.
To the extent that affected businesses expect business disruption to be temporary, the refundable payroll credit for wages paid during COVID-19 may help companies retain and pay employees during this time. Employers that receive loans under the CARES Act are ineligible for the employee retention credit.
The TCJA limited a noncorporate taxpayer's ability to deduct "excess business losses" for tax years beginning after Dec. 31, 2017, and before Jan. 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 Jan. 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.
The TCJA permitted taxpayers to deduct the full cost of certain depreciable property placed in service or acquired by the taxpayer in a taxable year before Jan. 1, 2027 (bonus depreciation). Property eligible for bonus depreciation included property with a depreciable life of 20 years or less. While these rules permit immediate expensing for equipment and other capital assets, it was intended to also apply to structural improvements made to commercial properties (i.e., retail establishments, restaurants, hotels), but the general 39-year recovery period for these improvements prevented them from being eligible.
The CARES Act corrects the error by assigning a 15-year depreciable life to "qualified improvement property," thereby permitting such improvements to be eligible for bonus depreciation. The provision is effective retroactively to property placed in service in 2018 and beyond. This provision may allow taxpayers to file amended returns and claim refunds for the 2018 and 2019 tax years if they placed qualified improvement property into service during those years, and may also encourage taxpayers to make needed improvements in the coming years as the economy recovers from the COVID-19 pandemic.
The CARES Act also revises the definition of "qualified improvement property" to limit that concept to "improvements made by the taxpayer" thereby eliminating the possibility of the taxpayer getting bonus depreciation for "used" property that was purchased by the taxpayer.
In addition to substantive tax relief offered by the CARES Act, the IRS has issued a number of Notices that extend the due date for filing most federal individual, partnership and corporate tax returns from April 15, 2020, to July 15, 2020.
The Notices also extend the due dates for quarterly estimated income tax payments (including those payable for self-employment income and estimated income taxes on unrelated business taxable income of tax-exempt organizations). First-quarter 2020 estimated income tax payments due April 15, 2020, and second-quarter 2020 estimated income tax payments due June 15, 2020, have both been postponed to July 15, 2020. A single tax payment may be made to cover both first- and second-quarter estimated tax payments on or before July 15, 2020.
No forms are required to be eligible for these extensions. In addition, there is no limitation on the amount of the payment that may be postponed and no interest, penalties or additions to tax with respect to such returns or payments will accrue during such postponement.
IRS Notice 2020-23 provides an extension period until July 15, 2020, for certain "time-sensitive actions" that are otherwise due to be performed on or after April 1, 2020, and before July 15, 2020. The specified time-sensitive actions include:
Thus, if the last day of any of these periods falls on or after April 1, 2020, and before July 15, 2020, then the applicable period is extended to at least July 15, 2020.
Late or unpaid rents will impact taxable income. For a cash basis taxpayer, no cash received translates to no taxable income. For an accrual basis taxpayer, however, an accrual for rental income is still required even if the cash payment is late or ultimately unpaid. An accrual basis taxpayer would not be eligible to reverse such income until a bad debt expense was allowed for tax purposes, which under the tax rules (unlike generally accepted accounting principles or GAAP) occurs only when the rent obligation is deemed worthless.
In addition, the tax implications of incentives offered to restart leasing activities such as rent holidays, or rent-free periods should be considered. In certain cases, Code Section 467 may require taxpayers to include rental income based on straight-line tax accounting notwithstanding a rent holiday or deferred rent period. A separate Holland & Knight alert on the application of Code Section 467 will be forthcoming.
A debt workout has tax considerations to the lender and borrower depending on the nature and details of the workout.
For the debtor, the principal tax concern in connection with a debt workout 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, (i.e., whether the modification is "significant 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 that is excluded from income under the bankruptcy or insolvency exceptions will reduce tax attributes such as any NOLs remaining after those losses are used in the current year and tax basis in assets (subject to certain limits).
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 also is in bankruptcy.
Other tax issues should also be considered where the modification includes equity or equity rights.
Lenders are also potentially subject to tax consequences where a debt workout results in a "significant modification" of the debt instrument or where the modification involves new advances or the receipt of equity or rights to acquire equity in the debtor.
The primary substantive tax considerations are whether, as a result of a "significantly modified" obligation, a new obligation is deemed created and exchanged, thus triggering gain or loss is triggered in connection with the workout and whether the modified instrument(s) result in special income recognition rules such as "original issue discount."