November 29, 2022

Year-End Planning for Real Estate Owners and Operators

Year-End Planning for Real Estate Owners and Operators Year-End Tax Guide

More sustainable, “green” buildings are in increasing demand by tenants in the commercial real estate sector. As developers install energy-efficient systems to attract tenants, they should keep in mind the tax benefits to such buildings and improvements.

On August 16, 2022, President Joe Biden signed the Inflation Reduction Act, which will increase the Internal Revenue Code (IRC) Section 179D Energy-Efficient Commercial Building Deduction (179D) for property placed into service after December 31, 2022. The availability of the deduction will also expand to include real estate investment trusts (REITs) and designers of commercial buildings owned by tax-exempt entities (previously only government entities).

The changes to 179D will allow for an accelerated deduction of energy-efficient buildings and improvements. Reductions of 25% energy usage qualify for a base deduction equal to $0.50 per square foot. As the energy savings increase above 25%, the deduction increases on a sliding scale, capped at $1.00 per square foot for a 50% reduction. A bonus deduction is also available to companies that meet local prevailing wage and apprenticeship requirements. Prior to this change, only one deduction per building was permitted. The deduction can now be taken on commercial properties every three years.

This new provision may allow real estate owners to accelerate the deduction of energy-efficient buildings from the previous 39-year period.

2022 Marcum Year-End Tax Guide

Bonus Depreciation on Certain Property Begins to Phase Out

One of the biggest TCJA bonuses for property owners is the provision allowing 100% bonus depreciation on assets with a recovery period of 20 years or less. Examples of eligible property include vehicles, furniture, manufacturing equipment and heavy machinery. Most important for the commercial real estate industry, an asset class identified as “qualified improvement property” is also included. This means upgrades to a building’s interior, even after the building is placed into service, could qualify for this hefty deduction.

Eligible property placed into service prior to January 1, 2023, will still receive the full benefit. Property owners who are unable to close deals and bring their assets online will have to settle for an 80% deduction in 2023. Each year, the deduction is reduced by an additional 20% until it fully phases out in 2027.

Calculation of Business Interest Expense Limitation to Change

Another TCJA provision changing for tax years beginning January 1, 2022, is the calculation of Adjusted Taxable Income (ATI) as it relates to the Section 163(j) limitation on business interest expense. Prior to 2022, ATI was determined by adding back depreciation, amortization and depletion (DAD adjustment) to taxable income. For tax year 2022, the DAD adjustment will be eliminated. Since interest expense is limited to 30% of ATI, this will likely result in a lower interest expense deduction for real estate investors who are highly leveraged.

To illustrate the impact, assume a taxpayer has tentative taxable income of $1,000, $400 of depreciation expense and $700 of interest expense.

Energy Efficient Building
2021 Rules 2022 Rules
Tentative Taxable Income $1,000 $1,000
Addback – Depreciation $400 N/A
Adjusted Taxable Income $1,400 $1,000
30% of ATI (Allowable Interest Expense) $420 $300
Disallowed Interest Expense $280 $400

Small Business Exemption and RPTOB

While the rules for ATI are changing, both the small business exemption and real property trade or business election (RPTOB) remain intact. To claim the small business exemption for 2022, a taxpayer’s average annual gross receipts for the prior three years must be below $27 million (previously $26 million in 2021 and 2020). This is an annual test, and the taxpayer’s status may change from year to year.

If the taxpayer does not meet that exemption level, it may be eligible to make the one-time irrevocable RPTOB election. In order to make such election, the taxpayer must be a real property business. This election allows the taxpayer to deduct all interest expense. However, a real estate business that elects out using RPTOB must depreciate its assets using the alternative depreciation system (ADS) instead of the more commonly used general depreciation system (GDS). This results in slightly longer depreciation periods, as indicated in the following chart.

Type of Property GDS Life ADS Life Annual Depreciation Expense Reduction
Nonresidential Real Property 39 40 2.5%
Residential Real Property 27.5 30 9.091%
Qualified Improvement Property 15 20 Eligible for bonus depreciation under GDS but not ADS

Personal property such as furniture and fixtures is still eligible for bonus depreciation regardless of whether the RPTOB election is in place.

Any business interest expense not allowed as a deduction for any tax year may be carried forward indefinitely and treated as business interest expense paid or accrued in the succeeding tax year, with certain restrictions.

There are many changes on the horizon for taxpayers invested in real estate. Each of the items highlighted above impact the others and should be carefully considered as the year comes to a close.

2022 Marcum Year-End Tax Guide