Last minute tax benefit considerations for real estate investors

The IRS’ decision to move the deadline for individual taxpayers to file their federal income tax returns to May 17, 2021, gives individual real estate investors a little more time to make decisions on key income strategies relating to changes in the alternative depreciation system (ADS) and stimulus payments included in the American Rescue Plan (ARP). The April 15 deadline to file protective refund claims related to Affordable Care Act (ACA) taxes remains, so investors need to pay attention to changes and deadlines, or consult with their tax advisors.

ADS changes

Figuring out the best course of action related to the business interest expense limitation under IRC section 163(j) and the ADS related to residential rental property investments has been complicated by recent legislation and IRS action or inaction. The Tax Cuts and Jobs Act of 2017 (TCJA) changed the ADS recovery period for residential real property from 40 years to 30 years. The TCJA, however, didn't address property that had already been placed in service prior to 2018. The law in effect created two buckets: residential rental property placed in service before tax reform (40-year recovery period) and residential rental property placed in service after tax reform (30-year recovery period).  

The Consolidated Appropriations Act, 2021 changed the ADS recovery period for residential rental property placed in service prior to 2018 from 40 years to 30 years. This change is retroactive to tax years beginning after Dec. 31, 2017 – this means that taxpayers that made the real property trade or business election in 2018 or 2019 must change the recovery period to 30 years for their pre-2018 property.

The IRS has not yet issued formal guidance on this subject and has given no indication that they intend to do so. However, based on informal remarks at a recent tax conference, the IRS has indicated that taxpayers should rely on existing guidance under Rev. Proc. 2019-08, and treat this situation as a change in method of accounting due to a change in use of MACRS property. Based on this commentary, eligible taxpayers should file a Form 3115 Application for Change in Accounting Method to catch up depreciation for pre-2018 property, and to place their residential rental property on the new 30-year ADS recovery period.

Taxpayers that are making the real property trade or business election on their 2020 return should use 30-year ADS for all residential rental property on their timely filed original return. New property should be placed in service using 30-year ADS. Depreciation on existing property should be recomputed under the change in use rules at Reg. §1.168(i)-4. If the 2020 tax return was extended and has already been filed using MACRS or the wrong ADS period, taxpayers should file a superseding return by extended due date.

Taxpayers should consider the following:

• Quantify the additional depreciation deductions generated by filing a Form 3115 to catch up depreciation for pre-2018 residential rental property.
• Determine if the additional losses are more beneficial to the taxpayer in 2020 or 2021. Taxpayers should consider upcoming changes in tax law that may impact this decision, such as:
  - 2020 NOLs can be carried back five years, while 2021 NOLs can only be carried forward and are subject to a limitation of 80% of taxable income.
  - Individual taxpayers are not subject to the IRC Sec. 461(l) excess business loss limitation in 2020, which will be in effect for tax years 2021 to 2026.
• Reminder: A method change cannot be made on an amended return, only on an original or a superseding return.

Stimulus payments

The ARP provides $1,400 direct payments to qualifying taxpayers. The IRS is using 2019 adjusted gross income (AGI) to determine if an individual qualifies for the payments. An individual with an AGI of up to $75,000 would receive the full $1,400 check; a couple filing jointly with an AGI of up to $150,000 would receive $2,800 ($1,400 per eligible person). A head-of-household filer with an AGI of up to $112,500 would receive the full $1,400 check.

If your 2019 AGI does not qualify you to receive a stimulus check, but your 2020 AGI does, the IRS will consider 2020 tax return data filed by Aug. 15, 2021 (90 days after the filing deadline of May 17, 2021) to determine eligibility for an ARP stimulus payment.

Protective refund claims

Certain individual taxpayers have until April 15 to file a protective refund claim that may be relevant depending on how the Supreme Court rules in California v. Texas later this spring or early summer. The case, brought by a group of Republican state attorneys general and two individuals, challenges the constitutionality of the ACA’s individual mandate, especially in the wake of the 2017 TCJA, which reduced the tax penalty for not having health insurance to zero.

It is possible that the Supreme Court will rule that all or a portion of the ACA is unconstitutional, making taxes and fees under ACA unconstitutional. The 3.8% Net Investment Income Tax and Additional Medicare Tax are two of the ACA taxes that could be affected by the Supreme Court’s decision. If the taxes are ruled unconstitutional, taxpayers may be eligible for a refund for taxes already paid.

Individual taxpayers who filed on time have three years to file a protective refund claim. For individual taxpayers who filed their 2017 taxes by April 15, 2018, the statute of limitations for filing a protective refund claim is April 15, 2021. Taxpayers should consider the following:

• Step one: figure out when you filed your 2017 return
• Step two: quantify Net Investment Income Tax and Additional Medicare Tax paid
• Step three: decide if filing a protective refund claim is the right thing to do

Get help as needed

Decisions especially relating to the ADS changes and protective refund claims are complicated because the laws and rules have changed several times in a short period. In the case of a protective refund claim, the upcoming decision by the Supreme Court may also qualify eligible taxpayers for a refund for taxes paid in past years. If you have any hesitation as to what the right decision is, consult your tax advisor, but pay attention to the calendar.  

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.