The Interplay Between Bonus Depreciation, Interest Expense Limitation and The Result Of Potential Losses
Real estate owners have been provided some additional guidance from the IRS to ease the burden of correcting their depreciable lives of property and, as a result, the ability to change other tax positions that may be favorable in light of new tax laws. There could be a significant change in how depreciation, interest expense and losses were reported in prior years to what they should be under the guidelines.
As a result of the CARES Act, qualified improvement property was changed to provide for a 15-year class life rather than 39 years, which would make it eligible for bonus depreciation. The interest limitation rule under Section 163j changed the limitation from 30% to 50% of adjusted net income. In situations where a taxpayer was limited in the amount of interest expense they could deduct, an electing real property or farming business had the option to elect out of those interest limitation rules. In doing so, they were required to use the ADS class life for real property. The ADS class life for real property is 40 years for commercial real estate, 30 years for residential real estate, and 20 years for qualified improvement property (QIP). While QIP of 15 years qualifies for bonus depreciation, it would not when an electing real property trade or business elected out of 163j. As such, The CARES Act made changes to the business interest limitations that could affect decisions made in prior years.
The IRS recently issued guidance providing more flexibility for taxpayers when correcting their asset class lives from 39 to 15-year QIP. Taxpayers may have already elected out of bonus depreciation or, under the new rules, they may wish to now elect out. These elections are irrevocable, however, the IRS is making this process simpler by allowing taxpayers to either revoke this election or make a new election through a change in accounting method on a Form 3115, for a limited time.
The IRS recently issued guidance providing real estate and farming businesses the ability to revisit their prior election and allow them to withdraw elections under 163j. Taxpayers who revoke their election will be treated as if the election had never been made. Taxpayers will also be able to make a late election, should the effects of the provisions under the CARES Act create a situation whereby interest is limited when it wasn’t previously. The ability to revoke a previous election, or make a late election, could be a significant favorable result for real property trades and businesses.
Rev Proc 2020-22 allows taxpayers to amend returns for businesses that were subject to these interest limitation rules so they can apply the 50% limit and free up some of the previously disallowed interest.
The ability to amend your 2018 tax return, file for a change in accounting method and file a Form 3115, claim bonus depreciation, revoke or make an election out of bonus depreciation, revoke a previously made 163j election, and deduct more interest expense is available.
Implications of Creating a Loss
Previously, under the TCJA, losses from pass-through businesses were limited to $250,000 for single filers and $500,000 for those married filing joint. Any excess loss was carried forward and limited under the net operating loss (NOL) rules to 80 percent of taxable income. The CARES Act has also removed these restrictions for tax years beginning before January 1, 2021. The excess loss provision does expire in 2025, as previously drafted.
If any of these provisions created a net operating loss, taxpayers now have the option to carry-back the NOL and claim tax refunds. This could be a huge win!