Considerations for Real Estate: Electing Real Property Trade or Business

As a result of the Tax Cuts and Jobs Act (TCJA), numerous businesses encountered a modified interest expense limitation effective after December 31, 2017, as outlined in Section 163(j). Businesses with debt may be limited in the amount of interest expense they are allowed to deduct. However, qualified real property trades or businesses may elect to bypass this Section 163(j) interest limitation. This option presents notable benefits to real estate businesses with highly leveraged properties, but it is also essential to consider the associated limitations. The Internal Revenue Service (IRS) released updated guidance on July 28, 2020, offering further clarity on the election that a real property trade or business can make to opt out of the Section 163(j) limitation.

Background

Prior to TCJA, the previous Section 163(j) primarily aimed to prevent multinational taxpayers only from evading U.S. taxation and to discourage taxpayers from becoming too highly leveraged.

The TCJA broadened the scope of Section 163(j) interest expense deduction limitation to all taxpayers, except for certain small business taxpayers meeting the gross receipts test, and to certain excepted trades or businesses that are eligible and choose to elect out. Qualified real property trades or businesses have the option to elect out of Section 163(j).

The TCJA significantly limited the amount of deductible business interest expense to the sum of the taxpayer's business interest income, 30% of the adjusted taxable income and the taxpayer's floor plan financing interest expense for the taxable year which is not applicable to real estate trades or businesses.

Real Property Trade or Business Election

Section 163(j) interest limitation does not apply to eligible real property trade or business that makes an election under IRC Section 163(j)(7)(B). A qualified real property trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. Taxpayers may make the real property trade or business election by attaching an election statement with their original federal income tax return, including extensions. The election statement must clearly outline the taxpayer's real property trade or business to demonstrate eligibility for the election. Once the election is made, it is generally irrevocable. A real property trade or business election must be made for each of the taxpayer's eligible trades or businesses. A taxpayer may make elections for multiple trades or businesses on a single election statement.

Depreciation

In exchange for the exemption from Section 163(j), an electing real property trade or business must utilize the alternative depreciation system to depreciate its nonresidential real property, residential rental property and qualified improvement property. The alternative depreciation system (ADS) is a slower cost recovery method than the general depreciation system (GDS) typically used by real property trades or businesses. The depreciable life for nonresidential real property is 40 years under ADS, as opposed to 39 years under GDS. For residential rental property, the depreciable life is 30 years under ADS compared to 27.5 years under GDS. For qualified improvement property, the depreciable life is 20 years under ADS compared to 15 years under GDS. Therefore, electing real property trade or business may deduct less depreciation expense each year in exchange for their exclusion from Section 163(j) interest expense limitation. Additionally, an electing real property trade or business will not be able to claim bonus depreciation on qualified improvement properties.

In an elected real property trade or business, the ADS rules specifically pertain to real property and not personal property. Real property encompasses land and any structures or fixtures permanently attached to the land, such as buildings. Personal property refers to movable items not permanently attached to the land, like furniture and vehicles. Personal properties with recovery periods of 5 years, 7 years and the majority of those with a 15-year recovery period, except qualified improvement property, are not affected by the election. The depreciation method for personal property remains unchanged and is still eligible for bonus depreciation deduction.

For example, assume a taxpayer owns a commercial building. He constructed a parking lot and made qualified improvement on the building in 2024. The depreciation on these assets under GDS and ADS would be as follows:

The ADS rules apply to both existing properties and newly acquired properties that have been placed in service by the electing real property trade or business under "change of use" principles. A modification in the depreciation allowance computation in the year of change is not a change in method of accounting. Therefore, the taxpayer is not required to file Form 3115, Application for Change in Accounting Method. If the taxpayer had claimed additional bonus depreciation for any existing properties, the additional depreciation deduction allowable for that property is not redetermined.

If you need help navigating the complex landscape of real property trades and business, or any other tax-related topics, contact Weaver today. We're here to help.

Authored by Joann Wang

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