The CARES Act: Changes to the Limitation on Deductibility of Business Interest Expense
The Coronavirus Aid, Relief, and Economic Security (‘‘CARES”) Act contained a number of provisions that may provide cash and tax relief to taxpayers that were affected by the COVID-19 pandemic. One of the provisions in the Act was a temporary relief of the limit on the deductibility of business interest under section 163(j).
What’s the limit on deductibility of business interest expense?
For tax years beginning in 2018, the Tax Cuts and Jobs Act (“TCJA”) imposed a new limit on the deductibility of business interest expense. Unless one of the exceptions could be met, taxpayers could deduct net business interest expense (i.e., business interest expense in excess of business interest income) only to the extent that it did not exceed 30 percent of adjusted taxable income (“ATI”) with respect to the taxpayer’s current tax year. Any excess business interest expense was disallowed as a current deduction and carried forward to future tax years.
What changed under the CARES Act?
For most taxpayers, except partnerships, in tax years beginning in 2019 and 2020, the limit on the deductibility of business interest was increased from 30 percent to 50 percent of ATI. This increased limitation does not apply to partnerships for tax years beginning in 2019, but only for tax years beginning in 2020. There are some additional beneficial rules that apply to the computation in 2020 and partners will be able to deduct some of the excess business interest from 2019 in 2020.
Furthermore, in 2020, taxpayers can elect to substitute their 2020 ATI for 2019 ATI for purposes of computing their 2020 limit on the deductibility of 2020 business interest expense. If the ATI in 2019 was higher than it is in 2020, substituting 2019 ATI in 2020 will result in a higher limit in 2020.
Although partnerships are still subject to the 30 percent of ATI limit in 2019, and even though disallowed 2019 business interest expense, if any, is passed through to the partners and carried forward by the partners to future years, there is a special relief provision regarding disallowed 2019 business interest expense carried forward by the partners. In 2020, 50 percent of the disallowed 2019 business interest expense being carried forward can be deducted by the partners in 2020 without being subject to the additional limitations that normally apply at the partner level.
What happens if I am an electing real estate trade or business that made the irrevocable election out of section 163(j) in a previous tax year, but now it would be beneficial to revoke that election due to the increased ATI limit?
Normally, such elections out cannot be revoked without IRS consent. However, the IRS recently issued Rev. Proc. 2020-22, which allows certain taxpayers to make a late election or to withdraw such election previously made, as applicable, on an amended federal income tax return or an administrative adjustment request.
Can partnerships file amended returns?
Normally, partnerships that are subject to the new IRS audit rules (i.e., “BBA partnerships”) cannot amend Form 1065 for partnership tax years beginning after December 31, 2017, unless they were eligible to elect out of the BBA rules and did so on a timely filed return. In such situations, changes can only be made to a prior return by filing an Administrative Adjustment Request (“AAR”) which allows the partners to take the cumulative changes (with respect to the adjustment year) into account on the tax return filed for the year in which the AAR is filed. In other words, the cumulative tax effect of an AAR filed by a partnership with respect to its 2018 Form 1065, filed in 2020, would be taken into account by the partners on their 2020 tax returns, filed in 2021.
For tax years beginning in 2018 or 2019, BBA partnerships that filed Form 1065 and furnished all required Schedules K-1 prior to April 8, 2020, may now amend those returns by filing Form 1065, checking the “amended return” box, and furnishing corresponding amended Schedules K-1 to the partners prior to September 30, 2020, pursuant to Rev. Proc. 2020-23. This will allow partnerships and their partners to benefit from the provisions of the CARES Act now without waiting to file AARs and take those adjustments into account in 2021.
Changes to Depreciation for Qualified Improvement Property
The CARES Act has also corrected an error in the TCJA. Qualified Improvement Property (“QIP”) is now eligible to be depreciated over 15 years and therefore is also eligible for 100 percent bonus depreciation. These changes are retroactive to any property that was impacted by the TCJA and placed in service after January 1, 2018.
Although the increased limitation on the deductibility of business interest expense isn’t effective for most taxpayers until 2019, or 2020 in the case of partnerships, a taxpayer may have previously filed an election out of those rules. The consequence of doing so is the requirement to use Alternative Depreciation System (“ADS”) for all real property; ADS property is not eligible for 100 percent bonus depreciation even if it otherwise meets the definition of QIP. If such an election out of the business interest expense limitation rules was made by an electing real estate or farm business, such taxpayers will not be able to take advantage of the technical correction for QIP for the year that such election was made or for any subsequent tax year, unless such election is revoked by filing an amended partnership return or AAR for the tax year in which the election was originally made.
The CARES Act is designed to ensure the viability of the American economy as it rebounds from the COVID-19 pandemic. Real estate businesses can benefit from advice on how to take advantage of and maximize the support offered by its various provisions. For additional information about how the CARES Act impacts your business, please contact a Cherry Bekaert team member.