Real Estate Companies: Consider These Tax Planning Moves Before Year-End

Many real estate companies have been able to benefit from COVID-19 relief, in the form of Paycheck Protection Program (PPP) loans, tax credits, tax deferrals, temporary tax changes and relaxing of certain Opportunity Zone rules. These changes have made year-end tax planning more important than ever this year.

Some Opportunity Zone deadline extensions and rule relaxations end on December 31, 2020, and certain tax deferrals must be taken advantage of before the year ends. Other changes may affect your capital strategy and even bonus decisions in the final weeks of the year. Read on for a few key considerations to discuss with your tax advisor sooner rather than later.

Opportunity Zone deadlines extended, but you may need to take action now

The Internal Revenue Service (IRS) extended deadlines and “suspended” countdowns for several Opportunity Zones provisions. You can find the details in IRS Notice 2020-114. The IRS also made clear that President Trump’s emergency declaration related to COVID-19 means that all Opportunity Zones are located within presidentially declared disaster areas, and several extensions and suspensions kick in because of this.

These are the key extensions you should know about:

• You may have until December 31, 2020, to gain tax benefits by investing capital gains incurred from October 2019 through July 3, 2020. For capital gains incurred after July 3rd, you have 180 days to reinvest those gains and defer taxes.
• If you have an asset testing period that falls between April 1, 2020 and December 31, 2020, and your Qualified Opportunity Fund does not meet the required threshold of 90% of assets (outside of the exemption for working capital) invested into Opportunity Zone holdings, you can disregard the asset ratio and will not be assessed a penalty. However, the IRS notice was unclear about asset testing of asset ratio for Qualified Opportunity Zone Businesses. As of now, you will need to meet asset threshold requirements for the 2021 asset testing periods, so all funds should prepare a plan to cure any testing deficiencies as soon as possible.
• Funds with 12-month reinvestment of proceeds periods that included January 20, 2020, were given up to 12 additional months to reinvest in Opportunity Zone property. Be cognizant of when your deadline is.
• For property acquired before April 1, 2020, the nine months from April 1 through December 31 don’t count in your 30-month substantial improvement period. As of right now, though, that clock begins ticking again on January 1, 2021.
• If your working capital safe harbor period for cash and short-term investments would have expired during 2020, you have an additional 24 months to invest those funds, provided you continue to follow your written investment plan and meet all other working capital safe harbor requirements.

Reporting requirements for Qualified Opportunity Funds that invest in Opportunity Zones are expected to increase this year. Consult with your tax advisor for more information.

CARES Act provided temporary relief from limitations on business interest deductions

The limitation on allowable deductions for business interest expense under Internal Revenue Code Section 163(j) has been increased to 50% of the taxpayer’s adjusted taxable income (ATI), for both 2019 and 2020 (after a reduction to 30% beginning in 2018). This provision of the Coronavirus Aid, Relief and Economic Security (CARES) Act also allows the use of your 2019 ATI to calculate the limitation for 2020. Note: That 30% limit is set to return for 2021.

Tax year 2022 will bring further reductions in the ability to deduct business interest. For now, ATI will be computed without accounting for depreciation, amortization or depletion, but beginning in 2022 those items will be included. This could decrease your ATI, and thus limit your interest expense deductibility further. Tiered entity structures can further complicate these calculations.

This might be a non-issue for some real estate businesses that elect to use the alternative depreciation system (ADS) – the 40-year alternative depreciation system for non-residential real property – which remains an option. There is also a new 30-year ADS period for residential property acquired subsequent to 2017.

Any time you consider a highly leveraged transaction, discuss the possible tax ramifications with your advisor. Electing ADS may be a strategy to consider to help you deal with the new limitations on excess interest deductibility.

You may be able to take larger deductions for net operating losses

The CARES Act grants temporary reprieve from Tax Cuts and Jobs Act (TCJA) provisions that stopped carryback of net operating losses (NOLs) and limited their use to 80% of taxable income. Whether your real estate company is a corporation or pass-through entity, here are two important changes to note:

• For NOLS arising in tax years beginning January 1, 2018, and ending December 31, 2020, you now have a five-year carryback period in which to use them.
• You can temporarily use NOLS to fully offset taxable income during the allowed tax years, regardless of when the NOL was generated, because the CARES Act temporarily suspended the 80% of taxable income limitation on the use of NOLs.

You may want to take advantage of the carryback by amending or modifying tax returns for tax years dating as far back as 2013. If you generated a loss this year, think about claiming it as soon as possible. If the IRS approves your request, you will receive a refund, plus interest, and the IRS has said it will expedite these refund requests.

Consider pandemic-relief credits before depositing payroll taxes

Federal, state and local governments may allow deferral of various tax payments, including income and payroll taxes. Some of these deferrals and credits can make it more complicated to calculate upcoming estimated tax payments, so talk with your tax advisor before making any payroll or income tax deposits. Discuss which payments you should make before year-end 2020 and plan for payments due during 2021.

Consider the impact of proposed rules for carried interest (i.e., promote)

In July, the Treasury Department and the IRS released long-awaited proposed regulations to the treatment of carried interest (also known as promote, profits interest or performance allocation). Some of the most important clarifications about carried interest for real estate companies are:

• Section 1061 of the Tax Cuts and Jobs Act (TCJA) applies to real estate funds in addition to other types of investment funds.
• Section 1061 does not apply to Section 1231 gains, which are gains from a real or depreciable property held for more than one year, taxed at the lower capital gains tax rate. This can include gains from buildings, machinery or leaseholds that you have used in a trade or business for a year or longer.
• Partnerships should not recharacterize carried interest gains on Schedule K-1s, but instead should footnote the long-term capital gains line to indicate that it might need to be recharacterized. This essentially leaves the decision on how to characterize carried interest income up to the general partner or fund manager, or their personal tax advisor.
• REITs that pay a capital gains dividend may designate which portion of it is attributable to property held for more than three years, but they are not required to do so. However, if they do not do so, the entire capital gains dividend is assumed to be property held for one year.

To learn more, read our blog post, “Proposed Change to Carried Interest Rules Prompts Strategic Reconsideration.”

Understand Paycheck Protection Program loan forgiveness

As it stands right now, PPP loans that are forgiven will not count as taxable income, but businesses also cannot deduct any expenses paid with those funds. If you obtained a PPP loan, maintain good records of how you spent it. And discuss with your tax and financial advisors whether you should apply for loan forgiveness now or wait until there is more clarity on how forgiveness will work.

Loan and lease modifications may affect your taxes

If you negotiated relief from lenders to help with cash flow, those modifications may have come with accounting, financial and tax implications. Seemingly minor changes to loan covenants, agreed-upon payment delays, term expansions or other types of relief might generate taxable income and/or affect your accounting. This includes modifications to traditional loans, lines of credit and other financing.

In addition, if you worked out any kind of modifications on office equipment leases, discuss these changes with your tax advisor. In some cases, such leases are capital leases, and treated like loans for tax purposes. That means any relief you received – such as monthly payment reductions, temporary payment suspensions or payment delays – may count as taxable income.

Renegotiating the lease on your office space or rent modification agreements may not affect your taxes, but you should still share the details with your tax advisor as these changes could affect your year-end accounting and financial reporting.

Maximize tax benefits of capital expenses

Consult with your tax advisor about whether and how to deduct some or all of the costs of capital expenses under Section 179 of the Internal Revenue Code, whether to use bonus depreciation, or whether to combine the two.

Under Section 179 of the Internal Revenue Code, businesses can deduct some or all of the costs of capital expenses, including new or used equipment and improvements to roofs, HVAC, fire alarm systems and security systems in commercial property. This includes assets on which you can not take bonus depreciation. The Section 179 deduction limit for 2020 is $1.04 million, with a spending cap between $2.59 and $3.63 million.

Bonus depreciation is 100% for tax year 2020. This may allow you to write off the full purchase price of equipment that is new to you, or the full cost of qualified improvements, and it can be less restrictive than Section 179. IRS Publication 946 details how to depreciate property.

The CARES Act has given bonus depreciation a boost this year, in the form of fixing an oversight in 2017’s TCJA that classified qualified improvement property (QIP) as having a 39-year depreciation, which also made it ineligible for bonus depreciation. QIP covers most non-structural improvements made to the interior of a commercial building. It is now classified as having 15-year depreciation and is eligible for 100% bonus depreciation.

These QIP changes apply retroactively to property acquired and placed in service after December 31, 2017. If you feel you have QIP in prior years, discuss with your tax advisor which, if any, next steps you should take. It may make sense to amend your 2018 and 2019 taxes (if you haven’t already) to claim the extra depreciation, but the compliance costs may exceed any potential benefit.

Don’t overlook benefits of cost segregation

Developers, buyers and owners of commercial real estate often overlook the benefits of a cost segregation study because of the perception that the study will simply result in a timing difference in how a building is depreciated. However, an engineering-based cost segregation analysis can lead to significant tax deferrals, a boost in cash flow and an increase in capital immediately available for new projects.

Cost segregation looks at the costs associated with the construction or purchase of a commercial real estate property or a residential rental property with the objective of allocating the costs to either real property or personal property. Speak with your tax advisor to learn more about the benefits.

Maximize your deduction for qualified business income

If your real estate company is a pass-through entity, you may continue to receive a 20% deduction on qualified business income (QBI), which may reduce your maximum effective tax rate for 2020. And pass-throughs keep the deduction on entity-level state and local taxes.

Filers who claim the QBI deduction must now show how they calculated QBI by using Form 8995. Each qualified trade or business activity must stand separately and as such, will require its own line on Form 8995. If you aggregated any of your activities last year, continue to use that aggregation this year.

The QBI deduction limitations and restrictions are set at the owner level. Planning for year-end 2020 should include discussion of salaries, timing and distribution of income in order to maximize the deduction for the tax year.

Pay attention to Schedule K-1 changes

There are a few Schedule K-1-related changes for real estate companies structured as partnerships.

Starting with tax year 2020, partnerships will be required to report each partner’s capital account using a tax basis capital method. While this was expected to be effective for 2019 K-1s, Notice 2019-66 postponed it to 2020.

The IRS released an early draft of instructions related to tax basis capital reporting on October 22, 2020. These instructions indicate that partnerships should calculate partner capital accounts using the transactional approach as the tax basis method, and report the partner’s contributions, share of partnership net income or loss, withdrawals and distributions, and other increases or decreases using tax basis principles.

The draft of instructions also offers several allowable methods for calculating tax basis by partnerships that have not maintained tax basis capital account records. In those cases, each partner’s 2020 beginning tax basis capital account balance can be computed using one of these methods:

• Modified Outside Basis Method
• Modified Previously Taxed Capital Method
• Section 704(b) Method, as described in the instructions, including special rules for publicly traded partnerships

The IRS has also asked for public comment on other possible methods of reporting capital accounts to partners. Additionally, the agency has said it intends to issue a notice providing penalty relief for tax year 2020: It will not assess a partnership for errors in reporting partners’ beginning account balances if it takes “ordinary and prudent business care” in following the instructions.

As a reminder, as of tax year 2019, disregarded entity names, types and Tax Identification Numbers must be included on Schedule K-1s, along with the individual beneficial owner’s information. The IRS issued a useful FAQ to help clarify reporting on disregarded entities.

Other year-end planning considerations

• Assess whether you have current Form W-9s and W-8s for all your partners. Some of these forms have expiration dates and may need to be filled out and signed again.
• If you have foreign investors or foreign business connections (such as lenders), be prepared to provide more information this year to your tax advisor. This may include W-8s, copies of loan agreements, etc.
• If you haven’t already, consider reevaluating cash flow management to help your business weather additional uncertainty in the coming months.

Contact your Kaufman Rossin tax advisor to learn more about tax provisions, Opportunity Zone requirements, PPP loan forgiveness and other factors that could affect you or your business as you plan for the coming year.