The Tax Cuts and Jobs Act, signed into law in December 2017, brought a multitude of changes to the Internal Revenue Code. We continue to learn more about the effects of this bill and its impact on real estate as the IRS continues to issue guidance and instructions on how to comply with the new law. This article will explore a potential trap real estate and other entities may unknowingly fall in as a result of tax reform changes.
The Tax Cuts and Jobs Act implemented §163(j), which limits the business interest deduction each year to (1) the amount of business interest income for the tax year, (2) 30% of adjusted taxable income, and (3) floor plan financing interest expense (i.e. car dealerships). As with most things tax-related, the calculation of adjusted taxable income can be quite involved. The most significant modifications made to taxable income is the addback of interest expense, net operating losses, the new §199A deduction, and for tax years beginning before 2022 depreciation, amortization and depletion deductions. Any business interest expense that is disallowed will be carried forward to succeeding years and will be subject to the same limitation described above. The focus of this article won’t be on the mechanics of the calculation though, but rather who is and who is not subject to this limitation.
Is your entity subject to the business interest limitation? The answer is generally no if one of five exceptions applies. The most common exception being the small business exemption. To be considered a small business, your entity must meet the “less than $25 million gross-receipts” test of §448(c). This test can get a bit tricky, especially if you have ownership in more than one entity. Complex aggregation rules must be applied to entities with common ownership to determine whether those entities must be combined for purposes of the gross receipts test. Taking the easy way out, let’s assume your entity has passed the test. Does that mean you are no longer subject to the business interest limitation? Well, maybe. The exemption does not apply if – and here’s the trap – your business is a tax shelter (hint – don’t stop reading here).
As the name implies a tax shelter is an arrangement made to avoid or minimize taxes. Most people, tax practitioners included, think the businesses they are dealing with are not tax shelters. However, what’s relevant is how the Code defines a tax shelter. §448 defines a tax shelter in a number of ways. The definition that we want to bring to your attention in this article is a “syndicate” as defined by §1256(e) (3)(B). A “syndicate” is a partnership or other entity (other than a C corporation) where more than 35% of the losses of the entity during the current year are allocable to limited partners or owners not actively engaged in the operations or management of the business.
This can cause a problem for small businesses in the real estate industry. For example, a limited partnership with a 25% general partner and three 25% limited partners has a commercial rental property subject to a mortgage. If the limited partnership has a loss in 2018, 75% of the loss would be allocated to the limited partners. Because more than 35% of the 2018 losses are allocated to limited partners, the entity is a syndicate, and therefore, a tax shelter making it subject to the new interest limitation.
A couple more things to note. Most tax practitioners do not believe it was the intent of Congress to have small businesses get caught by the tax shelter rules. In fact, the AICPA requested relief from the Department of Treasury and IRS in February but at this time a response has not been received. Also, know that some businesses can circumvent the limitation by being treated as an electing real property trade or business. However, such an election comes with additional considerations and consequences (such as the loss of bonus depreciation) beyond the scope of this article. The key takeaway from all this is the new business interest limitation rules are quite complex and careful consideration should be given to them. If you think this limitation may affect you and want to learn more or have any questions, please contact me. Jennifer Larson