Under “new” section 163(j), enacted as part of the Tax Cut & Jobs Act (TCJA), the deductibility of interest expense is now limited to the sum of (1) business interest income, (2) 30% of adjusted taxable income (ATI) and (3) floor plan financing interest for tax years beginning after December 31, 2017. Certain activities are excluded from being a trade or business, specifically an electing real property trade of business (ERPTB). The trade-off for electing out of the 163(j) limitations is that the ERPTB must use the alternative depreciation system (ADS) to depreciate residential rental, nonresidential real and qualified improvement property. In essence, the effect of the election is to slow down the depreciation timetable.
For Marks Paneth’s real estate clients, there were questions on how to treat “existing property” (i.e., property placed in service prior to the 2018 tax year) for purposes of electing out of the 163(j) interest expense limitation. Let’s see if we can provide some clarity.
On December 26, 2018, the IRS released Rev. Proc. 2019-08, which clarified some of the issues for those who will elect to be treated as an ERPTB for purposes of the 163(j) interest expense limitation. For those not wanting to wade through the language, here is a synopsis:
1. An ERPTB will also be required to depreciate property placed in service prior to 2018 using ADS.
2. It is important to note that the switch to ADS for existing assets for an ERPTB is not a change in accounting method. Thus, no Form 3115 (Application for Change in Accounting Method) will be required and there is no section 481(a) adjustment for previously claimed depreciation taken in excess of ADS depreciation.
3. The ERPTB will recover the remaining undepreciated basis of existing/pre-2018 assets using ADS over the ADS recovery period that remains at the beginning of 2018. For this purpose, an ADS Life means one that was determined prior to 2018 (40 years for commercial and residential). For example, if a residential rental building (27.5 year life) was placed in service in January 2010, starting in 2018 the adjusted basis of the building will be depreciated over 32 years remaining. (40 year ADS life less 8 years depreciation already taken.)
4. If the residential rental or non-residential real property was fully depreciated before 2018, no switch to ADS is required because there is no undepreciated basis to recover using ADS even though the 40-year ADS recovery period has not expired.
5. Another important point with respect to existing assets where bonus depreciation was taken: you do not need to recalculate depreciation on those assets using ADS.
Conclusion and Next Steps: For now, a prospective approach to the election can be made. Taxpayers do not have to go back and re-figure historic depreciation taken in excess of ADS nor do they have to make adjustments for all the bonus depreciation taken in prior years. Yes, new depreciation will need to be calculated on the net tax basis of existing assets, but for taxpayers not willing to forgo their interest expense deduction this is a small administrative price to pay.