IRS Releases Guidance on CARES Changes to Business Interest Expense Limitation and Bonus Depreciation for Qualified Improvement Property
The IRS has released guidance on certain business tax provisions of the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act. Released on Friday, April 10, Rev. Proc. 2020—22 informs taxpayers how to make certain elections with respect to the newly relaxed business interest expense limitation and provides real estate and farming businesses with the option to make late elections or withdraw pre-CARES elections. One week later, on Friday, April 17, 2020, the IRS announced in Rev. Proc. 2020—25 that taxpayers may change their depreciation for certain qualified improvement property. It also allows taxpayers to make late, revoke, or withdraw certain depreciation elections. While both revenue procedures are separately significant, their interplay, and the interplay of the associated CARES provisions, may be especially important for certain electing real property and farming businesses.
Rev. Proc. 2020—22 and Changes to the Business Interest Expense Limitation
Under the 2017 Tax Cuts and Jobs Act (TCJA), business interest deductions were generally limited to interest income and 30% of adjusted taxable income (ATI). This limitation generally applies to all taxpayers with a business interest expense, other than taxpayers with annual gross receipts less than $25 million. However, certain types of businesses are excluded from or allowed to elect out of the business interest deduction limitation. Real property businesses and farming businesses are two such businesses that may elect to avoid the limitation, and under the income tax regulations, such an election is irrevocable. Importantly, an electing business is also subject to the alternative depreciation system (ADS) rather than modified accelerated cost recovery system (MACRS) depreciation.
The CARES Act provides special rules for 2019 and 2020 tax years in applying the business interest deduction limitation. It relaxes the limitation by increasing the percentage of ATI that can be reduced by a business interest deduction from 30% to 50%. Taxpayers may, however, elect out of the increased limitation. They may also opt to use 2019 ATI in determining the business interest deduction limitation for 2020, assuming that a more profitable 2019 will allow for a greater deduction in 2020. Rev. Proc. 2020—22 now gives taxpayers guidance as to the time and manner for implementing the forgoing newly enacted provisions. To elect out of the 50% limitation for the 2019 or 2020 taxable year, no formal statement is required, rather a taxpayer merely timely files its return or Form 1065 (or timely filed amended return, Form 1065 or Administrative Adjustment Request) and uses the 30% ATI limitation. Similarly, no formal statement is required to use 2019 ATI in a taxpayer’s 2020 ATI computation, rather a taxpayer merely uses its 2019 ATI in its calculation on its timely filed return or amended return.
Additionally, Rev. Proc. 2020—22 provides an extension of time for taxpayers to file an election to be treated as an electing real property or farming business for the 2018, 2019, and 2020 taxable years, and also provides an opportunity for certain taxpayers to withdraw prior elections made to be treated as an electing real property or farming business. To make a late election to be treated as an electing real property or farming business, a taxpayer must file a formal election statement in accordance with the relevant proposed income tax regulations, along with an amended return. The time and manner to withdraw prior elections to be treated as an electing real property or farming business is similar: it must be done with a timely-filed amended return, but the election statement should be in accordance with Section 5.03 of Rev. Proc. 2020—22, essentially, informing the IRS the taxpayer is withdrawing their previously-made election under the authority of the new revenue procedure.
Rev. Proc. 2020—25 and the Qualified Improvement Property Fix
The 2017 TCJA also unintentionally classified qualified improvement property (QIP) as nonresidential real property, which does not qualify for bonus depreciation. The CARES Act fixed this mistake, known as the “retail glitch,” by making QIP 15—year property such that it retroactively qualifies for bonus depreciation or additional first-year depreciation.
Rev. Proc. 2020—25 explains how taxpayers can change their depreciation for QIP (under section 168(e)) placed in service after Dec. 31, 2017, in a tax year ending in 2018, 2019, or 2020 to take advantage of the fix. Certain taxpayers can elect to take 100% bonus depreciation on the qualified improvement property by filing an amended return, an administrative adjustment request (AAR), or a Form 3115, Application for Change in Accounting Method, to change their depreciation of QIP placed in service after Dec. 31, 2017, in the taxpayers’ 2018, 2019, or 2020 tax year.
The Revenue Procedure also allows a taxpayer to make a late election for, or to revoke or withdraw the following elections made for the 2018, 2019, or 2020 tax years, for property placed in service by the taxpayer during its 2018, 2019, or 2020 tax years, for a limited period:
- an election to depreciation under the ADS (168(g)(7) election);
- an election to deduct additional first-year depreciation for certain specified plants that are planted in the ordinary course of a farming business (168(k)(5) election),
- an election not to deduct additional first-year depreciation for any class of qualified property placed in service by the taxpayer during the tax year (168(k)(7) election), or
- and election to deduct 50%, rather than 100%, of additional first-year depreciation for certain qualified property (168(k)(10) election).
The Interplay of the Business Interest Deduction and QIP Fix
The guidance provided in Rev. Proc. 2020—22, means that certain real property and farming business taxpayers will want to closely reconsider past elections made to opt-out of the business interest limitation, as well as this election moving forward, in light of the temporary relaxation of the business interest limitation and the QIP fix. Following the passage of the TCJA, certain companies elected to be treated as a real property or farming business. The benefit of the election is the exclusion from the business interest deduction limitation, but the downside of the election is the requirement to use ADS depreciation. ADS depreciation uses longer recovery periods than MACRS depreciation and also does not allow bonus depreciation.
The difference between ADS and MACRS depreciation was not significant prior to the QIP fix under the CARES Act. However, a larger business interest deduction together with the availability of QIP bonus depreciation may now mean that companies receive a greater benefit by not electing to be treated as a real property or farming business for purposes of the business interest expense limitation rules.
It is important to note that there are certain limitations within Rev. Proc. 2020—25 for taxpayers who use the procedures of Rev. Proc. 2020—22. To the extent a taxpayer has QIP placed in service after December 31, 2017, but made a late election, or withdrew an election to be treated as a real property or farming trade or business in accordance with Rev. Proc. 2020—22, any changes to depreciation for such property must be made in accordance with Rev. Proc. 2020—22, rather than Rev. Proc. 2020—25. As noted above, this means that taxpayers who use the procedures under Rev. Proc. 2020—22 will be limited to the amended return process to make accompanying depreciation adjustments (as opposed to Form 3115, Application for Change in Accounting Method).