CARES Act - Business Interest Deduction and Qualified Improvement Property

Modifications of the Limitation on Business Interest Deduction

• • The 2017 tax reform significantly changed the rules regarding the deduction of business interest expense by limiting the deduction to 30% of the “adjusted taxable income” (ATI). ATI generally equated to the accounting concept of EBITDA (i.e., earnings before interest taxes depreciation and amortization) for tax years beginning before January 1, 2022 and EBIT thereafter. Under such rules, in general, any interest that was not allowed as a deduction could be carried forward indefinitely. For partnerships this limitation is applied at the partnership level (and not at the partners level). Real estate businesses were able to elect an alternative limit on interest deductions. An electing real estate business’ interest deduction limits are not changed by the CARES Act.

• • The CARES Act temporarily changes the 30% limitation mentioned above to 50% for tax years beginning in 2019 and 2020. This increase is automatic, but taxpayers may elect not to have this rule apply.

• • Partnerships, however, are only eligible for the increase to 50% for tax years beginning in 2020. Instead, the interest expense in excess of the 30% limitation that is allocated to the partners in 2019, could be deducted as follows in tax years beginning in 2020.

• • • 50% of such excess would be deductible in such year (subject to any other limitations that may apply), and
    • 50% of such excess would continue to be subject to the limitations in accordance with the existing law.

In certain situations the partnership limit may result in a greater aggregate interest expense deduction over 2019 and 2020. Also, certain partnership transactions such as disposition of the partnership interest with respect to which a partner has an excess interest expense in 2019, may preclude the partner’s ability to deduct such excess in 2020.

• • In addition, taxpayers may elect to use their 2019 ATI in calculating their 50% limitation in 2020. This may provide a significant benefit to businesses that will suffer lower ATI in 2020 due to the economic impact of the COVID-19 pandemic. This rule is applicable to partnerships as well.

• • The 2017 tax reform provided certain real estate businesses with the option to elect out of the 30% limitation. A business that made such an election would be required to use the alternative depreciation system that provides for slower depreciation. In light of the higher limitation, we encourage real estate businesses that did not make an election in 2018, to take a closer look at the need to make such an election during 2019 and 2020. Taxpayers can use the general rule as long as it is beneficial and elect the real estate rules in a later year. The opposite is not true.  An election to use the real estate alternative limit is irrevocable.  Please refer to the discussion below regarding “qualified improvement property” in this context for additional consideration.

Correction to “Qualified Improvement Property” Classification

• • Due to a drafting error in the 2017 tax reform certain “qualified improvement property” (QIP) were classified as 39-year property for depreciation purposes. The CARES Act corrects this error and provides that such property will have a 15-year recovery period for general depreciation purposes and a 20-year recovery period for purposes of the alternative depreciation system.

• • Such QIP in general includes any improvement made to the interior of non-residential buildings that are placed in service after the building’s initial placed-in-service date. For this purpose, QIP does not include improvements that are attributable to elevators, escalators, building enlargement or the building’s internal structural framework.

• • QIP is now eligible for “bonus depreciation” as if the amendment were adopted as part of the 2017 law. Thus, for tax years after December 31, 2017 and before January 1, 2023, such costs could be fully expensed. This change could generate significant refunds for tax years 2018 and 2019, especially taken in tandem with the changes to NOL rules explained in a prior alert.

• • A real estate business that filed an election to opt-out of the 30% business interest deduction mentioned above, is required to use the alternative depreciation system for QIP, and thus cannot claim bonus depreciation on QIP and is required to depreciate such QIP over 20 years, instead of the new 15-year life or the previously required 39 years.

• • Certain real estate businesses might not have elected the alternative interest deduction if they had known the QIP omission would be fixed. As was previously explained, the election is “irrevocable.” However, there is some hope in the tax community that the IRS will issue blanket permission allowing revocation of the election by taxpayers who placed QIP property in service. This may turn out to be more hope than substance, but if this can apply to you watch for subsequent IRS announcements.

Real estate businesses should carefully consider and model the various options for maximizing the benefits of both changes discussed in this alert.

The Coronavirus Task Force at Klehr Harrison stands ready to assist you in your business and legal needs. We will continue to provide additional information and guidance as the COVID-19 situation develops.

For additional information or to discuss your options, please contact any member of the tax practice group:

Author Larry Arem is a partner in the tax practice group at Klehr Harrison.