IRS lets taxpayers change horses mid-pandemic (Section 163(j) and QIP)

In the age of COVID-19, “irrevocable” doesn’t always mean “forever.” The IRS is providing significant tax advantages to companies that are now permitted to take back their once irrevocable elections regarding the deduction of interest expenses for improvements to non-residential real estate.

Previously, businesses with more than $25,000,000 in average annual gross receipts for tax years beginning after 2017 were subject to a rule limiting the amount of interest deductions they could take to their interest income plus 30% of their Adjusted Taxable Income (ATI which is akin to EBITDA). Certain real property and farming businesses were allowed to elect out of the application of the rule. Once made, however, the election was irrevocable. One downside for a business that chose to elect out was the extension of the cost recovery period for certain real property. For non-residential real estate businesses, the longer depreciation only added a year to the recovery period (from 39 to 40 years), so most elected out of the interest restrictions.

The CARES Act gave qualified improvement property a 15-year recovery period, making it eligible for bonus depreciation (i.e., full expensing in the year placed in service) if the taxpayer has not elected out of the interest deduction limitation rules. Qualified improvement property (QIP) is generally defined as improvements made by the taxpayer to the interior of a non-residential building after the date the building is placed in service.

The CARES Act made three taxpayer-friendly changes to the interest deduction limitation rules:

  1. For non-partnership taxpayers, the limitation was increased to 50% of ATI for 2019 and 2020 (the “50% ATI Increase”).
  2. For partnerships, the limitation was increased only for 2020, but partners who were allocated excess business interest expense (EBIE or disallowed interest deductions) from a partnership in 2019 are allowed to deduct 50% of such EBIE in 2020 with no limitation (the “50% EBIE Rule”).  
  3. All taxpayers benefit from an election to use the taxpayer’s 2019 ATI in calculating its 2020 limitation (the “2019 ATI Election”).  

These changes make being subject to the interest deduction limitation rules less burdensome, and for real estate businesses with qualified improvement property, it is now more attractive not to elect out. As noted earlier, however, the decision to elect out – once made – was irrevocable.

On April 10, 2020, however, the IRS promulgated Revenue Procedure 2020-22 (the “Revenue Procedure”), which allows taxpayers to make a late election, or to withdraw the otherwise irrevocable election, under the interest limitation rule by amending their tax returns. It also provides guidance on the new elections under the CARES Act.

The Revenue Procedure provides an opportunity for taxpayers to withdraw a prior election out of the interest limitation rule, under which the taxpayer is treated as if the election was never made. Further, it provides an automatic extension of time for real property and farming businesses to elect out of the interest limitation rule for tax years 2018, 2019, and 2020 by filing amended returns, even partnerships. Generally, the amended returns must be filed on or before October 15, 2021. These changes permit the applicable taxpayers to take the previously unavailable bonus depreciation on qualified improvement property and reduce the negative effects of being subject to the interest deduction restriction. This is of major importance to many businesses with real property such as office buildings, retail locations, hotel, restaurants and more.

Finally, the Revenue Procedure provides that to elect out of the 50% ATI Increase, the taxpayer must simply file a return or amended return using the 30% limitation; to make the 2019 ATI Election, the taxpayer need only file a 2020 return with a calculation based on 2019 ATI; and to elect out of the 50% EBIE Rule, a partner makes the election by simply filing a return not using the 50% EBIE Rule in determining its 2020 taxable income and interest deduction limitation.