United States: COVID-19 - Changing the past - CARES Act depreciation method and interest deduction opportunities

In brief

On 27 March 2020, Congress passed the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") to grant retroactive tax benefits to businesses by modifying certain provisions of the Tax Cuts and Jobs Act of 2017 (TCJA).

To enable businesses, particularly partnerships, to benefit from these changes, the IRS has issued the following three revenue procedures: 

  • Depreciation deductions under Rev. Proc. 2020-25: On 17 April 2020, the IRS issued Rev. Proc. 2020-25 to allow a taxpayer to change its method of accounting automatically to take into account the new 15-year tax life, or deduct 100% depreciation (bonus depreciation) in the first year, with respect to a qualified improvement property (QIP) placed in service in tax year 2018, 2019, or 2020. This new change may avoid the need for a cumbersome amended return process. 

Generally, QIP is an improvement made to the interior portion of a nonresidential building that is not attributable to the enlargement of a building, any elevator or escalator, and the internal structural framework of the building. The TCJA simplified the definition of QIP, but failed to designate a 15-year recovery period for QIP, thus unintentionally disqualifying it from being property eligible for bonus depreciation. The CARES Act included a retroactive technical correction to address this error, and Rev. Proc. 2020-25 provides the various options for taxpayers to depreciate QIP over a 15-year period or to take QIP as bonus depreciation within the first year in which the QIP is placed in service in tax year 2018, 2019, or 2020.     

Additionally, the Revenue Procedure allows taxpayers to revoke or withdraw, or file late, certain other depreciation elections. Taxpayers should reconsider their recent depreciation elections, especially if they have placed any QIP in service in the past few years, to see which option now available is most beneficial in light of their particular circumstances.

  • Interest deductions under Rev. Proc. 2020-22: On 10 April 2020, the IRS issued Rev. Proc. 2020-22 setting forth the procedures for a real property trade or business to withdraw a previous section 163(j)(7) election out of the interest deduction limitation regime. Taxpayers may wish to reconsider their election out given that the election prevents them from electing newly eligible bonus depreciation for QIP, and especially given the temporarily higher 50% limitations for section 163(j) enacted as part of the CARES Act for tax years 2019 and 2020.
  • Amending BBA partnership returns under Rev. Proc. 2020-23: On 8 April 2020, the IRS issued Rev. Proc. 2020-23 to permit a partnership ("BBA partnership") subject to the unified partnership audit rules in the Bipartisan Budget Act of 2015 (BBA) to amend its partnership return for tax year 2018 or 2019 in lieu of filing an administrative adjustment request (AAR). This is important because not only are the procedures under the BBA rules more cumbersome but they also do not otherwise provide a mechanism for refunds. 

Changes to depreciation deductions and QIP

To take into account the new 15-year recovery period for a QIP or to claim the recently permitted bonus depreciation with respect to a QIP constitutes a change in accounting method, which would normally require consent from the IRS Commissioner. The late elections available under Rev. Proc. 2020-25 are also considered changes in method of accounting. However, if certain requirements are satisfied, Rev. Proc. 2020-25 provides automatic consent to make these changes.

Procedure to make retroactive changes with respect to QIP

Under Rev. Proc. 2020-25, a taxpayer can in certain circumstances make a retroactive change to account for the new 15-year recovery period, or take the bonus depreciation deduction, with respect to a QIP that has been placed in service by a taxpayer after 31 December 2017 for tax year 2018, 2019, or 2020. To make these changes a taxpayer can either (1) file an amended federal income tax return for the year when the QIP was placed in service or (2) file a Form 3115, Application for Change in Accounting Method, with the taxpayer’s timely filed federal income tax return.

If a taxpayer decides to amend the federal income tax return in order to make the change, the filing of the amended return must be done on or before 15 October 2021 but in no event later than the applicable statute of limitations. A BBA partnership must instead follow the time frame to file its amended Form 1065 as set forth in Rev. Proc. 2020-23, and may also file an AAR in certain circumstances.

Alternatively, under Rev. Proc. 2020-25, a taxpayer generally can file a Form 3115 for a property that was placed in service after 31 December 2017, if the taxpayer adopted the method of accounting for two consecutive tax years preceding the change, and the taxpayer owned the QIP at the beginning of the year of change (the two year rule). However, Rev. Proc. 2020-25 provides an exception to allow a taxpayer who only applied such an impermissible method in the prior year (e.g., 2018) to change the method of accounting via Form 3115 in an immediately subsequent year (e.g., in 2019) (one-year QIP rule). Regardless of which rule applies, because the IRS considers this a change from an impermissible method to a permissible method, the additional depreciation is computed as a section 481(a) 'catch-up adjustment' that is included in the return as a reduction to taxable income for the year of change.

Late ADS, no-bonus-depreciation, or 50% deduction election

Rev. Proc. 2020-25 provides the procedures to file late an election to depreciate a property under the alternative depreciation system ("ADS election"), to take no bonus depreciation deduction or to take a 50%, instead of 100%, additional first year depreciation for certain qualified property in certain circumstances. In particular, certain late elections require that a taxpayer must have, on or before 17 April 2020, timely filed its federal income tax return or Form 1065 for the year in which such depreciable property was placed in service.

There are two options for making these late elections: either on an amended prior year return or on a Form 3115 reporting a change in accounting method in the current tax year. The amended federal income tax return for the year in which the property was placed in service must be filed on or before 15 October 2021 but in no event later than the applicable statute of limitations. Rev. Proc. 2020-23 separately determines the time frame to file amended returns for BBA partnerships, which may also file an AAR.

With respect to the Form 3115 option, one single form should be filed for all elections and can be submitted with a taxpayer’s original federal income tax return filed either (1) in a taxpayer’s first or second tax year succeeding the tax year in which the taxpayer placed the property in service; or (2) on or after 17 April 2020, but on or before 15 October 2021. Additionally, a section 481(a) adjustment must be made within this time frame, and the Form 3115 must provide a single net section 481(a) adjustment for all such changes.

Rev. Proc. 2020-25 also provides the option for eligible taxpayers to revoke or withdraw these elections with respect to qualified property. The procedures are generally conducted in the same manner and within the same time frames as provided with respect to filing late elections. However, the revocation of an ADS election can only be made via an amended return or AAR, as applicable.

Relaxation of the interest deduction limitation

The TCJA included a new regime generally limiting a taxpayer’s business interest deduction to the sum of business interest income and 30% of the taxpayer’s adjusted taxable income (ATI). Real property trades or businesses are allowed to elect out of this limitation under section 163(j)(7) but at the cost of foregoing bonus depreciation and using the longer ADS tax depreciation lives. The CARES Act increased the interest limitation from 30% to 50% with respect to ATI for tax years 2019 and 2020, and provides an optional election to use a potentially higher 2019 ATI in determining the applicable limitation for 2020.

Withdrawal of an electing real property trade or business election

Rev. Proc. 2020-22 allows a real estate business to withdraw its election to be excluded from the section 163(j) interest limitation rules. To make such withdrawal, a taxpayer can timely file an amended federal income tax return or an AAR, as applicable, for the tax year in which the election was made along with a properly completed withdrawal statement.

The amended return must be filed on or before 15 October 2021, but in no event later than the applicable statute of limitations on assessment. A BBA partnership must file its amended return within the time frame provided in Rev. Proc. 2020-23, or may withdraw this election by filing a timely AAR. Whichever method is used, the taxpayer must include the adjustment to taxable income and tax liability in the amended return or AAR. The same procedure must also be followed for any affected succeeding tax years.

In deciding whether to withdraw this election in light of the higher interest limitations, real estate businesses should also consider the benefits of shorter depreciation lives and potential bonus depreciation available absent the section 163(j)(7) election. This tax benefit may be enhanced further with respect to a taxpayer’s particular circumstances by the temporary repeal of the section 461(l) limitation on excess business losses and the temporary allowance of carryback and the carryforward of net operating losses. The potential benefits for past, present, and future tax years should be carefully modeled.

Special rules for partnerships

The CARES Act provides special interest limitation rules for partnerships and their partners. See Prior Alert, "CARES Act Tax Provisions Impacting the Real Estate Industry." Rev. Proc. 2020-22 also sets forth the time and manner for a partner to make or revoke an election with respect to excess business interest expense. Partnerships and partners should carefully consider the implications of the different options taking into account the special rules applicable to partnerships.

Filing amended partnership returns

The IRS issued Rev. Proc. 2020-23 to allow a partnership to amend its federal income tax return, thus affording its partners the possibility of receiving tax refunds, which otherwise does not exist under the BBA rules. The relief is limited to BBA partnerships that filed a Form 1065 and furnished schedules to their partners for the 2018 or 2019 tax year prior to the issuance of this revenue procedure. An eligible BBA partnership can amend its 2018 or 2019 tax return by filing electronically or by mailing an amended partnership return as follows: (1) the amended return box is checked on the Form 1065; (2) Filed Pursuant to Rev. Proc. 2020-23 is written on top of that form; and (3) corresponding amended Schedule K-1s are furnished to partners.

How to move forward

These revenue procedures should be assessed and analyzed together based on a taxpayer’s particular circumstances. For example, taxpayers with significant QIP are more likely to benefit from revoking a section 163(j)(7) election. Additionally, taxpayers should consider the impact of the different options available to change past elections as provided in the various IRS guidance, along with the timelines and manner set forth by the IRS for taking advantage of these changes. These decisions affect several tax years—past, present, and future.

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