Retailers are filing bankruptcy at record levels as the industry suffers from mass exits, employees who have vacated the office space are most likely not returning and many public companies are establishing new norm policies allowing employees to work from home indefinitely. The future brick and mortar traditional office set up looks to shrink drastically. Hotels are vacant as people are reluctant to travel and convention centers have become ghost towns. Landlords are going broke.
The government, recognizing the grave situation, changed tax law in the Coronavirus Aid, Relief and Economic Security Act to help give hope to real estate investors and give them a fighting chance at survival.
Let's examine the pre-CARES versus post-CARES Act tax changes and why it matters to real estate investors.
For the past two years, lawmakers were constantly being accused of making a technical error in the tax reform by forgetting to make qualified improvement property a short term asset for depreciation purposes. Pre-CARES, this drafting error in the Tax Cuts & Jobs Act required using a 39-year depreciable life for qualified improvement property (certain improvements to a building's interior).
The CARES Act corrected this error and makes qualified improvement property eligible for 15-year depreciable property allowing possible immediate expensing of these improvements, as they would now also be eligible for 100% bonus depreciation. This is retroactive, so taxpayers and certified public accountants need to determine the best option to go back and claim this.
For some cases, it may be amended returns and in others a 3115 can be filed which simply allows the taxpayer to change the depreciation method of qualified improvement property in the current year from a permissible method to permissible method. What does this mean practically? Let's take a hotel that spent $4 million in leasehold improvements in December of 2017. Under the previous Pre-CARES tax law they would expense $100,000 a year over a 40-year period. Under the new tax law, the hotel owner can now fully expense the full $4 million immediately. Here's what that matters.
Pre-CARES tax rules for net operating losses were limited to 80% of current year taxable income without the ability to be carried back. Post-CARES, net operating losses tremendously helped real estate investors. The rules changed so that now, net operating losses are limited to 80% of current year taxable income and may not be carried back to prior tax years (i.e., to generate refunds).
The CARES Act now permits a loss from taxable years 2018, 2019 and 2020 to be carried back 5 years prior to generate refunds and remove taxable income limitation allowing net operating losses to fully offset income in current taxable years. Additionally, the act removes excess business loss limitation applicable to pass-through business owners and sole proprietors so they can also benefit from the modified NOL carryback rules.
Another big change in the CARES Act for the real estate investor is the removal of the excess loss limitation of $500,000. Real estate business loss limitations were capped at $500,000 with any excess amounts available to carry forward. The CARES Act removed these limitations and resolved the excess business loss limitation applicable to pass-through business owners and sole proprietors for taxable years beginning in 2018, 2019 and 2020. This allows businesses to benefit from the modified net operating losses carryback rules.
Looking back at the hotel owner example mentioned earlier, the owner has $4 million in immediate expensing, less the $40,000 he took in depreciation for 2017 and 2018. Instead of having an additional $40,000 deduction for 2019 for the improvements made in 2017, the expense now under the change in qualified improvement property rules allows the hotel owner $2.92 million in additional tax deductions for 2019.
In this example, if net income prior to depreciation is $1 million for 2019, the rule changes now create a profit into a year-end tax loss of $2.92 million. Under the old rules, our hotel owner would have to carry these losses into the future, but now, our owner has to carry back the losses from the previous year for refunds.
If the owner had paid in taxes over the past 5 years of $2 million, the owner would now be able to carry back these losses to get the full $2 million refunded and also carry forward losses of $920,000. The owner now generates $2 million in cash that, under the old tax rules, would simply not be available. These are significant tax changes that can help all property owners.
Real estate investors can also further increase potential losses by getting a cost segregation study, which is a report done by an independent engineering firm that quantifies the cost of components of the building that exhaust quickly and thus can be immediately expensed as well as the qualified improvement property.
A cost segregation study for a hotel owner can on average quantify 25% of the cost of a property as immediately expansible short lived assets. These additional expenses generated by a cost segregation study and the new tax changes can add up to more refunds for property owners.
The CARES Act also increased interest deduction amounts very favorably for the real estate investor. Pre-CARES Act, you were only allowed up to 30% of total interest expense to be tax deductible. The CARES act increased this limit to 50%. This change is also retroactive, so taxpayers and their tax attorneys need to determine the best option to go back and claim this. In some cases it may be amended returns or through the 3115 method.
Like the other tax changes, this can amount to more refunds and new sources of cash flow. Further expenses under the current tax law system that can help with these new tax provisions is in federal tax code 179D. This tax benefit awards property owners who make their properties energy efficient, with tax benefits up to $1.80 per square foot in additional tax deductions. These additional deductions will create more losses and mark more significant carry back dollars with bigger refunds.
New tax laws have opened the door for significant tax refunds that all real estate investors must explore. Although the changes are new, the ability to generate cash today from these changes is immediate. The knowledge of these new tax laws can be the difference between solvency and bankruptcy for all property owners and potentially allow property owners to keep their buildings and their doors open during this crisis.
Julio Gonzalez is CEO at Engineered Tax Services Inc.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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