Paradigm shift in new Sec. 163(j)
The 2017 tax law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, fundamentally shifted the scope of the interest expense deduction limitation under Sec. 163(j) from targeting "earnings stripping" by highly leveraged foreign-owned U.S. C corporations to broadly targeting debt utilization by business taxpayers operating in any form (i.e., C corporations, S corporations, partnerships, and sole proprietorships).
Effective for tax years beginning after Dec. 31, 2017, Sec. 163(j) generally limits the deductibility of a taxpayer's net business interest expense that exceeds 30% of adjusted taxable income (calculated similar to earnings before interest, taxes, depreciation, and amortization (EBITDA) for tax years beginning before Jan. 1, 2022, but for tax years starting in 2022, without the ability to add back deductions taken for depreciation, amortization, and depletion). This new limitation applies regardless of when the loan to which the interest relates was originated and thus affects existing debt financing structures. However, certain businesses are either exempt from Sec. 163(j) or may make an irrevocable election to "opt out" of Sec. 163(j), which requires adopting a less favorable depreciation method.
Exemption for certain businesses
Sec. 163(j) does not apply to taxpayers whose average annual gross receipts for the prior three years do not exceed $25 million, unless the business is considered a "tax shelter" (notably, broadly defined to include certain partnerships or other entities with passive investors incurring losses). In addition, regardless of whether this gross receipts threshold is exceeded, certain trades or businesses listed in Sec. 163(j)(7) are exempt from the application of Sec. 163(j):
- The trade or business of performing services as an employee;
- An electing real property trade or business;
- An electing farming business; or
- Certain regulated utility trades or businesses.
Electing real property trade or business
Under Sec. 163(j)(7)(B), an electing real property trade or business is (1) a trade or business that is a real property trade or business, as described in Sec. 469(c)(7)(C) and Prop. Regs. Sec. 1.469-9(b)(2), or real property trades or businesses conducted by real estate investment trusts, as described in Prop. Regs. Sec. 1.163(j)-9(g), that (2) makes the election to be a real property trade or business under Sec. 167(j)(7)(B) and Prop. Regs. Sec. 1.163(j)-9.
A trade or business under Sec. 469(c)(7)(C) encompasses "any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business." Prop. Regs. Sec. 1.469-9(b)(2) defines "real property" to include land, buildings, and other inherently permanent structures that are permanently affixed to land, or any interest in real property (such as a leasehold). However, assets that serve an "active function" are excluded, even if permanently affixed to land (e.g., elevators, escalators, and HVAC systems). "Real property operation" is defined as day-to-day activities by a direct or indirect owner of the real property relating to maintenance and occupancy that affect the availability and functionality of the property used, or held out for use, by customers paying primarily for the use of the property. Providing significant personal services in connection with real property, where the use of the real property is incidental, is not a qualified activity. "Real property management" is defined as the handling, by a professional manager, of the day-to-day operations of a trade or business relating to the maintenance and occupancy of real property that affect the availability and functionality of the property used, or held out for use, to customers paying primarily for the use of the property.
Opt-out election and Rev. Proc. 2019-08
The proposed regulations under Regs. Sec. 1.163(j)-9 outline how real property trades or businesses can make a one-time, irrevocable election under Sec. 163(j)(7)(B) to opt out of the interest expense deduction limitation of Sec. 163(j) (opt-out election). An electing real property trade or business will not be eligible to depreciate certain capital expenditures under the modified accelerated cost recovery system (MACRS) (Regs. Sec. 1.168(a)-1) and must instead use the alternative depreciation system (ADS) (Sec. 168(g)). Rev. Proc. 2019-08 provides guidance on how electing real property trades or businesses should apply the ADS for tax years beginning after Dec. 31, 2017.
Section 4.02(1) of Rev. Proc. 2019-08 provides that the real property trade or business must use the ADS for the following types of MACRS property: nonresidential real property (as defined in Sec. 168(e)(2)(B)), residential rental property (as defined in Sec. 168(e)(2)(A)), and qualified improvement property (as defined in Sec. 168(e)(6)).
Section 4.02(2) of Rev. Proc. 2019-08 provides that when an electing real property trade or business makes the opt-out election, 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.
Regs. Sec. 1.168(i)-4 provides guidance on the depreciation allowance for MACRS property, the use of which has changed while being held by the same taxpayer. The depreciation allowance in this case constitutes the amount of depreciation allowable under Sec. 167 for the year of change and any subsequent tax year.
For existing properties, Regs. Sec. 1.168(i)-4(d) provides that all depreciation must be redetermined beginning in the year the opt-out election is made, resulting in a change of use. The year of change is thus the tax year in which a change in the use of the property occurs.
Regs. Sec. 1.168(i)-4(f) provides that a change in computing the depreciation allowance in the year of change is not a change in method of accounting under Sec. 446(e). Therefore, taxpayers are not required to file Form 3115, Application for Change in Accounting Method, nor are they required to compute and recognize any Sec. 481(a) adjustments. If the taxpayer had claimed additional first-year "bonus" depreciation under Sec. 168(k) for any existing properties, Regs. Sec. 1.168(k)-1(f)(6)(iv)(a) provides that the additional first-year depreciation deduction allowable for that property is not redetermined.
For newly acquired properties, taxpayers must determine depreciation deductions in accordance with the ADS for the placed-in-service year and subsequent tax years. Since the newly acquired property is depreciated using the ADS, it is not eligible for the additional first-year bonus depreciation deduction under Sec. 168(k).
If an electing real property trade or business fails to depreciate its existing properties using the ADS in the year of change and subsequent tax years, it is considered to have adopted an impermissible method of accounting for that item of MACRS property. The real property trade or business would be required to request permission to change its method of accounting for that item using Form 3115 under either the automatic change procedures or nonautomatic change procedures, depending on the facts and circumstances. If the taxpayer meets the criteria of the automatic change procedures, the method change would be described in Section 6.05 of Rev. Proc. 2018-31 (or any successor) and the Sec. 481(a) adjustment would be calculated as though the change in use occurred for the item of MACRS property in the opt-out election year.
For newly acquired properties (and assuming that the taxpayer has met the criteria for automatic change procedures), Section 6.01 of Rev. Proc. 2018-31 (or any successor) would apply, provided that none of the inapplicability provisions outlined in Section 6.01(1)(c) apply to the taxpayer. The Sec. 481(a) adjustment for newly acquired property would be calculated as though the taxpayer determined the depreciation deductions under the ADS method for the item of MACRS property beginning in the placed-in-service year.
Rev. Proc. 2019-08 also reflects changes to the recovery period of residential rental property under the ADS. Historically, the ADS recovery period for residential property was 40 years. However, the TCJA reduced the ADS recovery period for residential rental property from 40 years to 30 years, effective for property placed in service on or after Jan. 1, 2018. Section 4.01(2) of Rev. Proc. 2019-08 provides an optional depreciation table for residential rental property depreciated under the ADS with a 30-year recovery period.
Infrastructure safe harbor
To address concerns regarding the impact of Sec. 163(j) on — typically highly leveraged — infrastructure projects, Rev. Proc. 2018-59 provides a safe harbor allowing taxpayers to treat certain infrastructure trades or businesses as real property trades or businesses solely for purposes of qualifying as an electing real property trade or business under Sec. 163(j). Effective for tax years beginning after Dec. 31, 2017, the safe harbor may apply to infrastructure arrangements between a governmental entity and a private person, commonly known as a public-private partnership (or P3), whereby private persons maintain or provide services for infrastructure property.
To qualify, the trade or business must be conducted by a party contractually obligated to fulfill the terms of a "specified infrastructure arrangement," defined as a government contract of more than five years with a private trade or business that is responsible for designing, building, constructing, reconstructing, developing, redeveloping, managing, operating, or maintaining a ''qualified public infrastructure property'' (Rev. Proc. 2018-59, §4.11). Qualified public infrastructure property is infrastructure property that is either owned by the government or owned by a private trade or business operating under an arrangement where rates charged for the use of the infrastructure property are subject to regulatory or contractual government control. The property must also be available for use by the general public, for example, airports, mass transit, waste facilities, water facilities, or electric facilities.
Rev. Proc. 2018-59 grants a valuable tax benefit to qualifying P3 investors and contractors. If the safe-harbor requirements are met and the opt-out election is made, a full deduction is available for interest on debt. The loss of depreciation benefits is typically not a problem for P3 arrangements, as the property eligible for depreciation deductions is usually owned by a tax-exempt government agency.
The proposed regulations and revenue procedures provide much-needed clarification on the application of Sec. 163(j) to electing real property trades or businesses. In particular, guidance is provided as to what constitutes a real property trade or business eligible to elect out of the application of Sec. 163(j), and the effect of this election on the depreciation of real property. In determining whether to make the opt-out election, taxpayers and practitioners should keep in mind that the election is irrevocable and consider multiyear projections of the impact of ADS depreciation as compared to the impact of the Sec. 163(j) limitation.
It should also be kept in mind that Sec. 163(j) applies to net business interest expense, i.e., the limitation applies after other interest deferrals, disallowances, and capitalization provisions. Therefore, the exemption from Sec. 163(j) for an electing real property trade or business does not preclude other limitations provided in the Code that could apply before Sec. 163(j) has an impact.
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.