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As interest rates continue to remain high, commercial real estate companies may benefit from re-evaluating their tax responsibilities and strategies in light of these higher costs. Read on for a summary of two key tax topics to explore – interest rate caps and the Section 163(j) interest expense limitation – and what borrowers should discuss with their tax advisors now.
Interest rate cap
In today’s interest rate environment, it is common for real estate companies to protect their mortgage financing with an interest rate cap, or for lenders to require one. An interest rate cap is a derivative offered by a third-party financial institution to pay interest that would be payable by the borrower over the strike rate or the interest rate at which the cap provider begins to make payments to the cap purchaser. To avoid exposure to rising interest rates on a floating rate loan, the taxpayer-borrower enters into a cap agreement and pays an upfront fee for the rate cap protection. If the loan is paid off early, the cap is typically terminated. In shifting interest rate environments, many taxpayers find that their rate caps are in-the-money and receive a payout, which creates taxable income.
With sustained higher interest rates, the relevance of interest rate cap transactions will likely continue throughout 2023 and beyond. Borrowers, however, should be aware of the tax implications associated with these derivatives. For federal income tax purposes, an interest rate cap is a notional principal contract (NPC) and is subject to the tax rules in the Internal Revenue Code (IRC) and NPC treasury regulations (IRC Section 446 and Treas. Reg. Sections 1.446-3 and 1.446-4, respectively). Under these rules, payments to purchase a cap are taken into account over the term of the NPC “in a manner that reflects the economic substance of the contract,” which generally involves amortizing the premium. Purchasers that receive periodic payments at intervals of one year or less must also “recognize the ratable daily portion of a periodic payment for the taxable year to which that portion relates” as ordinary income.
Termination payments are recognized in the year the “contract is extinguished, assigned, or exchanged.” The character of that payment depends on whether the NPC is a capital asset in the hands of the taxpayer. However, per Treas. Reg. Section 1.1221-2(b), a capital asset does not include property that is part of a qualified hedging transaction or properly identified as a hedging transaction, including an interest rate cap transaction that the “taxpayer enters into in the normal course of the taxpayer’s trade or business primarily . . . to manage risk of interest rate . . . with respect to borrowings made.” Therefore, in the case of many financing situations where a real estate company enters into a cap agreement to manage interest rate changes with respect to a commercial property loan, the character of that gain or loss on the termination payment will be ordinary.Section 163(j): Interest expense limitation
Due to higher interest rates and higher interest expense amounts, another renewed tax consideration is the business interest expense limitation, also known as the IRC Section 163(j) limitation. As a result of the tax law changes made by the 2017 Tax Cuts and Jobs Act (TCJA), the amount of a taxpayer’s deductible business interest expense in a tax year cannot exceed the sum of (1) the taxpayer’s business interest income; (2) 30% of the taxpayer’s adjusted taxable income (ATI); and (3) the taxpayer’s floor plan financing interest expense.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily relaxed the Section 163(j) limitations, but that relief has now ended. Those changes only applied to taxable years beginning in 2019 and 2020.
In addition, beginning in 2022, deductions for depreciation, amortization, or depletion are not added back to taxable income for purposes of computing ATI pursuant to IRC Section 163(j)(8)(A)(v). Accordingly, the interest expense limitation is more restrictive than before, and more taxpayers will be subject to the limitation.
While certain small business taxpayers that have an average annual gross receipts of $25 million or less in the previous three years are exempt from this limitation, taxpayers can fall into tax shelter rules from losses that are allocated to limited partners and become ineligible for the exemption. (See IRC sections 448(d)(3), 461(i)(3)(B), and 1256(e)(3)(B).) The average gross receipts test is adjusted for inflation. For 2023, the inflation-adjusted gross receipts amount is $29 million. In some cases, tax planning can help avoid the tax shelter status.
However, for real estate businesses that either are too large or cannot avoid the tax shelter status, the taxpayer should consider making an opt-out election as a real property trade or business if there is considerable business interest expense. Section 163(j)(7)(B) of the IRC refers to electing real property trade or business as any trade or business described in IRC Section 469(c)(7)(C), which includes “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, lease, or brokerage trade or business.” While the election is irrevocable and causes certain real estate assets – such as nonresidential real property, residential rental property, and qualified improvement property – to be depreciated using the longer alternative depreciation system (ADS) method (with no bonus depreciation permitted), the tax benefit of taking the interest expense deduction may outweigh the loss in depreciation deductions.Takeaways: What should you do about these caps?
If you are a CRE borrower:
1) Speak to your tax advisor about interest rate cap transactions for proper tax treatment. Be sure to keep proper records and documentation of the cap terms.
2) Discuss whether the Section 163(j) business interest expense limitation cap applies in the current tax year. If eligible as a real property trade or business, consider the tax benefit and cost of making an election to opt out of the interest expense limitation rules.
Higher interest rates have consequential and complicated tax implications for CRE borrowers. Please discuss these important issues with your advisor.
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Naya Pearlman
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Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.