Guidance on CARES Act Section 163(j) Elections for Real Estate Businesses

On April 10, 2020, the Internal Revenue Service released Revenue Procedure 2020-22 (Revenue Procedure) providing guidance on certain elections with respect to the business interest expense deduction limitation under Section 163(j) of the Internal Revenue Code of 1986 (Code). 

As enacted by the Tax Cuts and Jobs Act (TCJA), Section 163(j) limited the deductibility of business interest to 30% of “adjusted taxable income” (ATI).  ATI generally tracks earnings before interest, taxes, depreciation and amortization or EBITDA.  The TCJA allows certain real property and farming businesses to elect out of the application of the Section 163(j) limitation (Exclusion Election), however any such electing real property and farming business is required to apply the “alternative depreciation system” and is thus ineligible to take bonus depreciation with respect to its property.  Any such election, once made, is irrevocable.  Thus, to determine whether to make an Exclusion Election, real estate and farming businesses would generally analyze whether the Section 163(j) limitation costs more or less than the cost of deferring depreciation deductions under the alternative depreciation system relative to bonus depreciation.  It is worth noting that, as originally enacted by the TCJA, “qualified improvement property” used in a real property business was not eligible for bonus depreciation whether or not the business had elected out of the Section 163(j) limitation due to a technical glitch.   

The Coronavirus Aid, Relief, and Economic Security Act (CARES Act) added Section 163(j)(10) to the Code which substitutes a 50% rather than 30% ATI limitation for tax years beginning in 2019 and 2020.  The CARES Act also included a technical correction to treat qualified improvement property as eligible for bonus depreciation.  These CARES Act changes alter the calculus regarding whether it made sense and makes sense moving forward for real estate and farming businesses to make an Exclusion Election. Thus, notwithstanding the fact that an Exclusion Election is irrevocable, the Revenue Procedure allows taxpayers to revoke an Exclusion Election if one was made or makes an Exclusion Election with respect to a prior tax year if one was never made, in each case, with retroactive effect to the prior applicable tax years.  Taxpayers should examine whether making or revoking an Exclusion Election produces tax savings including the potential to generate tax refunds for prior years.