Opportunities for taxpayers with residential rental properties and residential living facilities

Editor: Greg A. Fairbanks, J.D., LL.M.

During 2021, the IRS issued a series of taxpayer-favorable procedures that allow certain taxpayers that have made the real property trade or business election under Sec. 163(j)(7)(B) with residential rental property to depreciate such property using the shorter 30-year recovery period, using the alternative depreciation system (ADS), and certain other taxpayers with qualified residential living facilities to be eligible for the real property trade or business election. Both of these developments create favorable opportunities for affected taxpayers, who may want to reevaluate their current status and make a change.

Background

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, enacted a limitation on how much interest expense a taxpayer can deduct each year, known as the Sec. 163(j) interest limitation. The TCJA, however, allowed certain taxpayers that make a real property trade or business election to be exempt from applying the Sec. 163(j) interest limitation. The TCJA defines an electing real property trade or business by reference to Sec. 469(c)(7)(C), which defines a real property trade or business as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

As a trade-off, electing taxpayers are required to depreciate their nonresidential real property, residential rental property, and qualified improvement property using the ADS. The TCJA also modified the ADS recovery period of residential rental property placed in service after Dec. 31, 2017, from 40 years down to 30 years but did not apply that change to property placed in service on or before that date. Rev. Proc. 2019-8 clarified that for real property trades or businesses with real property placed in service prior to the date of election, a change in use occurs for such properties, and the applicable ADS life for residential rental property placed in service before Jan. 1, 2018, would be 40 years, not 30 years.

After the TCJA, some taxpayers with a trade or business of providing housing in residential living facilities, and which also included supplemental assistive, nursing, or routine medical services, were left wondering if they could also make the real property trade or business election under Sec. 163(j) to claim that benefit.

The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (TCDTRA), Division EE of the Consolidated Appropriations Act, 2021, P.L. 116-260, retroactively changed the applicability of the 30-year ADS recovery period to include residential rental property placed in service prior to Jan. 1, 2018, that is owned by an electing real property trade or business and that had not previously been subject to the ADS prior to making the election. Affected taxpayers needed guidance that would allow them to effect the changes from the TCDTRA.

Qualified residential living facilities

Rev. Proc. 2021-9 provides a safe harbor to taxpayers that operate residential living facilities to be eligible for the real property trade or business election under Sec. 163(j). A qualified residential living facility is a residential living facility that: (1) qualifies as residential rental property under Sec. 168(e)(2)(A); or (2) consists of multiple rental dwelling units within one or more buildings or structures that generally serve as primary residences on a permanent or semipermanent basis; provides supplemental assistive, nursing, or other routine medical services; and has an average customer use of at least 30 days.

Examples of qualified residential living facilities include nursing homes and similar long-term-care facilities. In other words, taxpayers that operate qualified residential living facilities that did not previously make the real property trade or business election due to being uncertain about whether they qualified now have an opportunity to make the election and be exempt from the interest limitation. Consequently, those trades or businesses that depreciate property as residential rental property with a depreciable life of 27.5 years would use the 30-year ADS recovery period that was provided by the TCJA and expanded retroactively by the TCDTRA.

Application of 30-year ADS recovery period

As discussed above, taxpayers with residential rental properties affected by changes enacted in the TCDTRA needed guidance to correct their depreciation. In response, Rev. Proc. 2021-28 allows those taxpayers to change from an impermissible ADS recovery period of 40 years to a permissible ADS recovery period of 30 years by: (1) filing an amended federal income tax return no later than April 15, 2022; (2) filing an administrative adjustment request (AAR) for an eligible partnership under the Bipartisan Budget Act of 2015 on or before April 15, 2022; or (3) filing an accounting method change on Form 3115, Application for Change in Accounting Method.

If a taxpayer chooses the option to file an amended return or an AAR, as applicable, the taxpayer should be aware that the taxpayer must do so in the original year that the real property trade or business election was made and for all subsequent years for which tax returns have been filed.

Sections 6.04 and 6.05 of Rev. Proc. 2019-43 allow taxpayers that have had a previous change in use for some or all depreciable assets to file certain automatic changes in accounting method. Rev. Proc. 2021-28 expands the use of Sections 6.04 and 6.05 of Rev. Proc. 2019-43 to include taxpayers that made the real property trade or business election in the immediate prior year and waived the five-year scope limitation for any change filed for a tax year beginning in 2019, 2020, 2021, or 2022. Both of those changes made the automatic procedures broadly applicable for taxpayers, which is welcome news.

Because of that expansion, many taxpayers may choose to file a Form 3115 under the modified automatic procedures instead of amending one or more tax returns. Unless a taxpayer includes affected properties in a general asset account, it would file the change under Section 6.05 of Rev. Proc. 2019-43, as modified and amplified by Rev. Proc. 2021-28, which requires the taxpayer to calculate a Sec. 481(a) adjustment as of the first day of the year of change as if the proposed method of accounting had always been used by the taxpayer, beginning with the tax year in which the change in the use of the property by the taxpayer occurred.

Real property held by a taxpayer that makes the real property trade or business election is subject to a change in use as of the effective date of the election. Affected taxpayers with residential rental property would recompute depreciation from the date of the real property trade or business election using the 30-year ADS recovery period to compute the Sec. 481(a) adjustment. It should be noted that taxpayers that include applicable real property in general asset accounts would file a method change under Section 6.04 of Rev. Proc. 2019-43, as modified and amplified by Rev. Proc. 2021-28, which is made on a modified cut-off basis, and, accordingly, a Sec. 481(a) adjustment is neither permitted nor required.

An illustration of the Sec. 481(a) computation under Section 6.05 of Rev. Proc. 2019-43 may be helpful. A taxpayer placed in service a residential rental property with a $5 million basis in early 2016, depreciated the property straight line over a 27.5-year life, and claimed approximately $350,000 of depreciation expense as of Dec. 31, 2017. Therefore, the taxpayer had an adjusted basis in the property of about $4,650,000 immediately prior to making the real property trade or business election. In its timely filed 2018 return, the taxpayer makes the real property trade or business election and properly follows the change-in-use rules to begin depreciating the property using the 40-year ADS recovery period. As of Dec. 31, 2020, the taxpayer had claimed an additional $365,000 of depreciation using its new life.

The taxpayer chooses to use the revised automatic method change provided by Rev. Proc. 2021-28 to correct the ADS depreciable life of the property in 2021. To compute the Sec. 481(a) adjustment, the taxpayer calculates depreciation expense as if the property had been depreciated using the correct recovery period from the date that the real property trade or business election was made, which is Jan. 1, 2018. Therefore, the taxpayer recalculates its 2018, 2019, and 2020 depreciation expense using the 30-year ADS recovery period, which is about $495,000 of depreciation through Dec. 31, 2020. The additional $130,000 of depreciation expense is a favorable Sec. 481(a) adjustment that the taxpayer will include entirely in its 2021 tax return.

Taking advantage of taxpayer-favorable changes

The last year has brought several favorable changes for taxpayers that own residential properties. Taxpayers that own and operate residential living facilities were given a safe harbor to consider themselves eligible to be a real property trade or business, and taxpayers that had already made the real property trade or business election were given procedural guidance to allow them to take advantage of the shortened ADS recovery period. However, as noted above, the option to take advantage of the 30-year ADS recovery period by amending a tax return or filing an AAR is time-sensitive, as the due date for both is April 15, 2022. Taxpayers that either cannot meet that deadline or that do not want the administrative burden of amending several years’ worth of tax returns may request an automatic method change. This means that the taxpayers have additional time to assess their situations and take actions accordingly to take advantage of the taxpayer-favorable procedure.

EditorNotes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.