Planning to manage the QIP and business interest expense changes

The Coronavirus Aid, Relief, and Economic Security (CARES) Act made several changes to the Tax Cuts and Jobs Act (TCJA) intended to help taxpayers through the current economic crisis. The CARES Act corrected the TCJA’s infamous “retail glitch” affecting qualified improvement property (QIP), changing its depreciable life to 15 years from 39 years, thus making QIP eligible for bonus depreciation. This change is retroactive to 2018. The legislation also temporarily relaxed the rules on the deduction for business interest expense. The TCJA included limitations on the deduction for business interest expense that, subject to some exceptions, generally limited business interest deductions to 30% of adjusted taxable income (ATI). The CARES Act eased the restriction to 50% of ATI for 2019 and 2020, except for partnerships (see additional discussion below), where the 50% ATI allowance is only for 2020 returns. For some taxpayers, these changes are interrelated due to the exceptions under the business interest expense limitation rules for real property businesses.

First, let’s take a look at the changes.

Business interest expense limitation

Under the TCJA, taxpayers’ business interest deductions (IRC section 163(j)) are limited to 30% of ATI, plus business interest income, unless an exception applies. Exceptions include:

• Small taxpayers, generally with less than $26 million of gross receipts; however, aggregation and tax-shelter rules apply in determining eligibility for this exception
• Taxpayers with interest expense relating to floor plan financing
• Electing real property trades or businesses

For electing real property businesses as well as taxpayers with floor plan financing, the trade-off for not being subject to the business interest expense limitation is that they must use longer depreciable lives under the alternative depreciation system (ADS) for real property assets. In addition to having longer depreciable lives, assets depreciated using ADS are not eligible for bonus depreciation.

ATI is similar to earnings before interest, depreciation and amortization (EBIDA) — the two are not technically the same, but thinking of ATI as EBIDA is a good shortcut — and is calculated as follows:

Taxable income, adjusted by

• Taking out items of income or loss not allocable to a trade or business
• Adding back any net operating losses (NOLs), section 199A deductions
• Taking out any business interest income
• Adding back depreciation, amortization or depletion, for tax years beginning before Jan. 1, 2022

This last item is especially helpful. If you are able to take advantage of the QIP change, the additional bonus depreciation deduction will not lower your ATI for purposes of determining the business interest expense limitation. However, if you utilized the floor plan financing exception or were an electing real property business, QIP is not eligible for bonus. If you want to take advantage of the QIP changes, you will not be able to use the floor plan financing exception or you will have to revoke the 163(j) real property business election and, therefore, you will be subject to the business interest limitation rules.

Any interest expense limited under this computation carries forward indefinitely. The CARES Act:

1. Increases the allowable interest deduction to 50% of ATI from 30% for 2019 and 2020 returns.
2. Allows taxpayer to use 2019 ATI for 2020 returns. For most taxpayers, this is expected to allow a higher interest deduction.
3. Lets taxpayers choose to elect out of each of these 50% ATI changes.
4. Applies the 50% ATI limitation change to only 2020 returns for partnerships. For partnerships that have interest deductions limited (excess business interest expense) in 2019, partners can deduct 50% of their allocable share of the 2019 excess business interest expense on their 2020 return. Each individual partner can elect to opt out of the additional deduction on their 2020 return. However, only the partnership can decide whether to utilize the 2019 ATI and 50% ATI options on the partnership’s 2020 return. Individual partners cannot make those elections.

Considerations related to these changes:

• If you have already filed a 2019 return and had business interest expense limitations, you may want to amend it to take advantage of the increased ATI limit.
• If you were an electing real property trade or business and had QIP placed in service in 2018 and/or 2019, you may want to amend to revoke that election and possibly subject yourself to the business interest expense limitation in order to claim bonus on the QIP.
• Taxpayers with floor plan financing face the same choice if they have QIP placed in service in 2018 and/or 2019. Study and model scenarios, and possibly amend to claim QIP and potentially forgo interest expense deductions.
• If you believe tax rates will be increasing in coming years to help pay for the economic stimulus, run calculations to decide whether a deferred interest deduction would be more beneficial in the future. On the other hand, if the increased deductions could lead to, or increase a net operating loss, you may be able to carry these losses back and achieve a more immediate tax benefit and at pre-TCJA rates.

QIP – The retail glitch

Due to a drafting error in the TCJA, QIP placed in service after Dec. 31, 2017, was not eligible for bonus depreciation — this was known as the “retail glitch.” Congress intended for QIP to be bonus-eligible; however, the TCJA did not specifically include a 15-year recovery period for QIP. Therefore, after the tax reform dust settled, QIP was nonresidential real property with a recovery period of 39 years, not eligible for bonus. All of this changed with the passage of the CARES Act, which amended the Internal Revenue Code (IRC) to define QIP as 15-year property. Consequently, QIP is now eligible for bonus depreciation. These changes are retroactive to 2018, i.e., to the passage of the TCJA.

Prior to the CARES Act, real property trades or businesses that elected out of the 163(j) business interest expense limitation had to depreciate QIP, residential real property and nonresidential real property over longer recovery periods, and QIP was not eligible for bonus.

Before the technical correction, this was not a big deal because QIP was not eligible for bonus, so many taxpayers made the election.

Now, however, these taxpayers have to consider the retroactive nature of the change — if QIP had been eligible for bonus in the first place, maybe taxpayers would have postponed the election or not made it at all.

How to take advantage of the QIP changes? If, and that can be a big “if,” the business interest limitation rules do not affect your situation, there are multiple choices. Assuming the QIP was placed in service in 2018:

• If you have not yet filed your 2019 return, you can amend your 2018 return and claim the deduction. For pass-through entities, this will also entail amending shareholder or partner returns as the case may be to take advantage of the increased deduction. Generally, the deadline to amend returns for these changes is Oct. 15, 2021. It is critical to note that if you are a partnership subject to the centralized partnership audit regime (CPAR), the deadline to amend the return to claim this deduction is before Sept. 30, 2020.
• Alternatively, you can file for an accounting method change on Form 3115 with either your 2019 return or your 2020 return, if you have already filed your 2019 return. This eliminates the need for an amended return, but may delay the benefit of the deduction.
• As noted above, partnerships subject to CPAR must amend their returns before Sept. 30, 2020. In general, these partnerships cannot file amended returns, although, due to the retroactive nature of the CARES Act changes, the Treasury Department provided limited relief to these partnerships through this date. Partnerships can also file what is known as an administrative adjustment request (AAR) to claim the additional deduction. The AAR process eliminates the need to file amended returns; however, AARs are subject to complex rules. Further, depending on individual partners’ tax positions, there is the potential that some tax benefits from a depreciation adjustment could be permanently lost using this approach. The technicalities are beyond the scope of this article, but you should thoroughly review the AAR rules with your tax advisor if you are interested.

On the other hand, if the business interest limitation rules do affect your situation and you have previously made a qualified real property trade or business election, you’ll need to decide whether it is to your advantage to revoke the election and claim bonus. To revoke a previous election, you must amend the return for the year of election and all subsequent years. 

As part of this process, you will need to recalculate the interest deduction since the business will no longer be exempt from the business interest limitation rules once the election is revoked. 

Integrating the potential results from these changes with your tax position is critical to determine your maximum benefit. Determinations will need to be made as to whether the additional deductions can create NOL carrybacks, refunds in prior years or are best utilized as carryforward losses. There is no one best practice as each taxpayer’s circumstance is different. The bottom line is model, model, model.

View more insights from our guide to tax planning during and after COVID-19

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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.