An Electing Real Property Trade or Business can Revoke its Election on Account of the Change to Qualified Improvement Property Enacted by the CARES Act; Other Elections Relating to Business Interest Expense Limitation

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On April 10, 2020, the Internal Revenue Service (the “IRS”) issued Revenue Procedure 2020-22 (the “Revenue Procedure”), which (1) permits an “electing real property trade or business” that elected not to be subject to the limitation on business interest expense deductions under section 163(j) of the Internal Revenue Code of 1986 (the “Code”) to revoke its election in light of the correction enacted by the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) to the treatment of “qualified improvement property” and (2) provides guidance regarding the manner in which certain other new elections established by the CARES Act under Code section 163(j) are to be made.

Revoking a Real Property Business Election under Code Section 163(j)(7)(B)

The Tax Cuts and Jobs Act of 2017, P.L. 115-97 (the “TCJA”) amended the interest deductions rules under Code section 163(j) to create a cap on a business’s current deduction (the “Business Interest Limitation”) for any business interest expense that exceeds 30% of the taxpayer’s adjusted taxable income (“ATI”). Any excess business interest expense must be carried forward to the next taxable year and treated as accruing in that year. The TCJA also included an election under Code section 163(j)(7)(B) (the “Real Property Business Election”) that permitted certain real estate businesses to elect out of the Business Interest Limitation, but required them to use longer depreciation periods for its real estate (especially multifamily property) and improvements and denies it the ability to take advantage of the amendments that TCJA made to the cost recovery rules under Code section 168. Specifically, the TCJA also amended the cost recover rules to permit (at least until the end of 2023) full and immediate expensing of certain qualified property. Congress, however, inadvertently excluded “qualified improvement property” (which, generally, is any improvement, including leasehold improvements, made to the interior portion of a nonresidential building after the building was placed in service) from being eligible for such expensing. As a result, real estate businesses were faced with a choice: On the one hand, the Business Interest Limitation is a substantial limitation for real estate businesses because they tend to heavily lever their real estate, making the Real Property Business Election very attractive as far as the Business Interest Limitation is involved. On the other hand, the election may not be as advantageous because it requires the electing real estate business to use longer depreciation periods for its real estate (especially multifamily property) and improvements and denies it the ability to take advantage of the amendments that TCJA made to the cost recovery rules under Code section 168. Certain real estate businesses were not, however, heavily discouraged from making the Real Property Business Election due to the Congressional inadvertent oversight with respect to qualified improvement property.

Congress took advantage of the CARES Act to correct the mistake it made when enacting the TCJA, providing that qualified improvement property can be depreciated over a 15-year period and is eligible for immediate expensing, and made this amendment retroactive to January 1, 2018, when the TCJA became effective in this regard.

Consequently, following the CARES Act, a real estate business’s decision to make the Real Property Business Election - foregoing the Business Interest Limitation in exchange for longer depreciation periods based on the presumption that the adverse depreciation cost was not significant - may be called into question in retrospect. The Real Property Business Election, however, can only be revoked with the consent of the IRS.

Luckily, the IRS made the right call and the Revenue Procedure now permits taxpayers to reevaluate and, if desirable, change their choice between foregoing the Business Interest Limitation and taking advantage of the full and immediate expensing of qualified improvement property. Accordingly, taxpayers can revoke the Real Property Business Election retroactively by filing amended tax returns for any taxable year beginning after December 31, 2017, as applicable, without requiring any further consent from the IRS. Besides comparing the impact of the Business Interest Limitation, as further revised by the CARES Act (see below) and the benefit of the shorter depreciation periods, or even full expensing, of qualified improvement property and other real estate, taxpayers should also consider all collateral changes required to be made to affected succeeding taxable years as a result of making the retroactive revocation.

Accordingly, the Revenue Procedure allows taxpayers to revoke, or make a late, Real Property Business Election by filing an amended applicable federal income tax return including, in the case of a partnership for federal income tax purposes, an amended IRS Form 1065 or an administrative adjustment request under Code section 6227 (“AAR”). The Revenue Procedure provides that the amended return should include a withdrawal statement or an election statement and provides the information that must be contained in each such statement, and requires the taxpayer to make all collateral adjustments on amended federal income tax returns, amended Forms 1065, or AARs, as applicable, for any affected succeeding taxable year.

Other Elections relating to the Business Interest Limitation

The CARES Act changed the rules applicable to the Business Interest Limitation by (1) increasing the 30% of ATI cap to 50% of ATI for taxable years beginning in 2019 or 2020 (but see below for a modified rule relating to partnership taxable year beginning in 2019) (the “Business Interest Cap Increase”), (2) allowing businesses to elect to use their 2019 ATI rather than their 2020 ATI when determining the Business Interest Limitation for any taxable year beginning in 2020 (the “2019 ATI Election”), and (3) in the case of partnership taxable years beginning in 2019, instead of the above rule, 50% of the 2019 excess business interest a partnership allocated to a partner that is carried forward to 2020, is treated as business interest expense paid or accrued by the partner in the partner’s first taxable year beginning in 2020 that is not subject to the Business Interest Limitation (the “Partnership Rule”). The CARES Act permits taxpayers to elect out of either the Business Interest Cap Increase or the Partnership Rule.

The Revenue Procedure provides that taxpayers can make the aforementioned elections or, if made, revoke such elections without further consent from the IRS, on the taxpayer’s applicable federal income tax return or amended federal income tax return. In the case of a partnership for federal income tax purposes, it is the partnership that can elect (and then revoke such election) (i) out of the Business Interest Cap Increase for 2020, and (ii) making the 2019 ATI Election, while it is the partnership’s partners that can elect (and then revoke such election) out of the Partnership Rule.