Ever since the Tax Cuts and Jobs Act (TCJA) taxpayers and tax preparers have been wrestling with many key issues. One of these is the limitation on interest expense deductibility under 163(j). As most taxpayers are now aware the TCJA limits interest deductibility to 30 percent of the Taxpayer’s taxable income. Many taxpayers believe they are not subject to this limitation due to a $25 million gross receipts test, however it may not be so simple for many real estate companies.
Under the TCJA businesses with gross receipts of $25 million or less are not subject to this limitation, unless they are considered a tax shelter under Section 448. Most taxpayers and practitioners read over this portion quickly and assume that they are not subject to this limitation. However many real estate companies are subject to the tax shelter rules without realizing it. Under Section 448 a tax shelter has multiple definitions one of which is a “syndicate”. Under these rules a syndicate is “a partnership or other entity (other than a C corporation) if more than 35 percent of the losses of such entity during the taxable year are allocated to limited partners or limited entrepreneurs”. Limited Entrepreneurs are defined in Section 461 as a person who “has an interest in an enterprise other than as a limited partner, and does not actively participate in the management of such enterprise.” This means that limited partnerships where losses are posted could be caught in the tax shelter definition without realizing it.
Take a partnership with a 40% general partner and two limited partners splitting the remaining 60%. If that partnership posts a loss during the taxable year they would be considered a tax shelter for that tax year. This would make the partnership subject to the interest limitations even if the gross receipts are well under the $25 million threshold. It gets even more confusing, since the tax shelter rules are calculated on a year by year basis, which means that a Limited Partnership that generates positive income in 2018 is not subject to this limitation, but if they post a loss in 2019 the tax shelter rules would kick in at that point in time.
Congress does allow taxpayers to elect out of the interest limitations by making an election to be treated as a real property trade or business. Unfortunately this is an Irrevocable election. Once a taxpayer makes the election to be treated as a real property trade or business they must depreciate all Real Property, and Qualified Improvement Property using the ADS lives. Currently this is not a big issue for most taxpayers, however if Congress fixes QIP to make it bonus eligible, as originally intended, the ADS requirement would make QIP ineligible for bonus depreciation. For taxpayers that put in a large amount of QIP this could be a major issue, if Congress moves forward with a technical correction. Unfortunately many taxpayers will need to make this irrevocable election prior to knowing whether the correction will be issued.
Additionally consider that under the 163(j) rules the ADS life for real property is considered a “change in use”. This means that a taxpayer that chooses to elect to be treated as a real property trade or business, will need to have a change in use for all real property placed in service in prior years. This means that an apartment complex placed in service in 2012 with a 27.5 year life, will have a change in use in 2018 to a 40-year ADS life. The good news is that the IRS is seeing this change as a prospective change in use, and no recapture of depreciation is necessary.
As you can see from the above the interest deduction will affect many more taxpayers than originally thought. It is not enough to simply look at the gross receipts. All Limited Partnerships will need to look at this on an annual basis to see if the tax shelter rules will kick in.