Taxpayer Certainty and Disaster Relief Act - Residential Rental Property

The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (P.L. 116-200), signed into law by President Trump on December 27, 2020, allows a real property trade or business that elects out of the §163(j) business interest expense deduction limitation to depreciate residential rental property placed in service before 2018 over a 30-year ADS recovery period. Previously, a 30-year ADS period only applied to residential rental property placed in service after 2017, and a 40-year ADS period applied to residential rental property placed in service before 2018.

Note: A detailed discussion of what qualifies as a real property trade or business is outside the scope of this article.

Historical Background

The Tax Cuts and Jobs Act of 2017 imposed limitations on the business interest expense deduction for taxpayers with average annual gross receipts in excess of $25 million, effective for tax years beginning after 2017. A Real Property Trade or Business that was subject to this limitation could make an irrevocable election out of the limitation. The election had a negative impact on depreciation expense, and an analysis was required to determine if being able to take the full interest expense deduction outweighed the reduction in depreciation expense.

Once an irrevocable election was made, any nonresidential real property, residential rental property, and qualified improvement property held by the electing real property trade or business had to be depreciated using the less favorable Alternative Depreciation System (ADS) beginning in the year of the election. The 40-year ADS recovery period applied to residential property placed in service before 2018, and the 30-year ADS recovery period applied to residential property placed in service after 2017. The IRS issued favorable guidance that allowed electing taxpayers to make the switch to ADS in the election year with no need for amended returns or accounting method changes.

New Law Explained

The Taxpayer Certainty and Disaster Tax Relief Act of 2020 amends the TCJA to allow an electing real property trade or business that switched to ADS as a result of the election to depreciate residential rental property placed in service before 2018 using the 30-year ADS recovery period instead of the previously prescribed 40-year ADS recovery period. The reduced recovery period does not apply if the property was already being depreciated using ADS prior to the election. In other words, if a real property trade or business elected or was otherwise required to apply ADS to residential rental property placed in service before 2018, the 40-year ADS period for such property is not reduced to 30-years.

Issues and Unknowns

Many electing real property trade or businesses that made the irrevocable election in 2018 have now filed two tax returns using the 40-year ADS recovery period for residential rental property placed in service before 2018. Until the IRS issues further guidance, it is not known whether these taxpayers will have to amend prior returns to take advantage of the decreased recovery period, or if the IRS will apply the "change of use rules" and allow taxpayers to take a catch-up deduction on the 2020 tax return.

Conversely, some real property trade or businesses chose not to make the irrevocable election after analyzing interest expense vs. reduced depreciation expense. If the recovery period at the time of analysis was 30-year ADS instead of 40-year ADS, the election might have been made. It is possible the IRS will issue guidance that allows taxpayers to make a late election to address this issue.

If you have any questions or would like to discuss this further, contact your HLB Gross Collins, P.C. adviser or the author, Jonathan Milhalter.