The skilled nursing industry is currently struggling with challenging issues, like shrinking margins from Medicaid billings, changes in Medicare billings and pressure from state surveyors by imposing costly capital expenditures to maintain facilities. The Internal Revenue Service is imposing even more challenges on the owners of skilled nursing real-estate buildings and skilled nursing operators. The “Tax Cut and Jobs Act” signed into law at the end of 2017, imposed some costly new regulations beginning January 1, 2018, that impact the skilled nursing industry.
About IRS Code Section 199A
Among these regulations enacted by Congress was a new Code Section 199A. The intent of this legislation was to provide flow-through entities such as subchapter S-corporations and limited liability companies, some benefits that were provided to C-corporations by reducing the maximum tax rate to 21%. Very simply stated, Section 199A provides a deduction up to 20% of “qualified business income.” This is to reduce the flow-through business income to the individual for their tax calculations to reduce the impact of the higher individual rates over the C-corporation rates. When proposing this reduction, Congress eliminated certain types of professional service businesses called “Specified Service Trade or Business” (SSTB) from being allowed this 20% reduction. Some of the service providers included in this category are attorneys, accountants, physicians, nurses, and financial advisory services providers.
The IRS recently issued final regulations to further explain the applications of Code Section 199A. Skilled nursing facilities now fall into the net of service providers that are disallowed from taking advantage of this reduction. Because skilled nursing (SNFs) operators bill their residents for services performed by registered nurses, the SNFs were lumped into the category of professional service providers just as physicians. During the hearing period for input on the temporary regulations, the IRS acknowledged many skilled nursing facilities provide many other services not performed by a professional service provider (i.e. housing, food, housekeeping) but still upheld their decision that had the professional services been billed directly to a resident (similar to assisted living or independent living facilities) and not to the skilled nursing facility, the operators would be subject to the Code Section 199A benefit. The IRS also instituted a new Sub-Section to the Internal Revenue Code referred to as 163(j); which provides for a cap on interest deductions of 30% on adjusted taxable income and business income.
How Does this Impact Operators of SNFs?
If an operator of a skilled nursing facility also owns the real estate in which they are operating their facility, the rental real estate activity falls into one of two categories: a qualified trade or a “triple net lease.” A trade or business would normally qualify for the 20% reduction of income as discussed above. However, since the real estate entity is leasing to an “SSTB” (the SNF), they are “tainted” and assume the same characteristics of the nursing operations. Therefore, they do not qualify for the 20% reduction in the real estate holding company.
In addition, if an SNF operator has trade or business income, then they are subject to the 30% interest limitation. According to the IRS temporary regulations, your real estate entity is a trade or business if it is not a “triple net lease.” Therefore, in the event the real estate company is paying for expenses other than mortgage interest (i.e. repairs and maintenance, insurance, taxes), the real estate company is a trade or business for purposes of Sub Section 163(j) and is subject to the 30% interest limitation. This would be especially troublesome for HUD financed SNFs. These long-term financed facilities are very heavily loaded upfront with interest and the potential for many years of disallowed interest which must be carried forward is likely.
What Should SNFs Do Now?
Numerous comments on correcting these regulations have been submitted to the IRS by Mueller Prost and other advisors. We are waiting for the final regulations on this issue.
In the meantime, we suggest that you review your leases as they currently appear. We believe the best scenario under these current regulations for an owner of real estate leasing to a skilled nursing facility is that the lease be a triple net lease. As such, this will ensure the owner is out of the 30% interest limitation proposed in the temporary regulations.