The Tax Cuts and Jobs Act (TCJA) of 2017 is the most significant overhaul of the Internal Revenue Code1 (IRC) since the Tax Reform Act of 1986. Practitioners who were preparing tax returns back then likely remember the confusion surrounding parts of that law that were subject to interpretation. The best course of action was to wait, if possible, for clarification through technical corrections and guidance from the U.S. Treasury or the IRS. The Tax Reform Act contained 300 provisions and took over three years to implement. Astonishingly, 573 sections of the IRC were revised or added by the TCJA in less than one year. Considering how swiftly the TCJA was developed, there were bound to be areas needing clarification. This feature looks at a few that are affecting numerous taxpayers.
Proposed 163(j) Regulations
Section 163(j) of the TCJA places additional limitations on the deduction of business interest for taxpayers, replacing the old IRC Section 163(j). Generally speaking, if Section 163(j) applies, business interest expense is limited to the sum of the taxpayer’s business income for the year, 30% of the taxpayer’s adjusted taxable income for the year, and the taxpayer’s floor plan financing interest expense for the year. The limitation applies to all taxpayers unless they meet a gross receipts test, which requires average annual receipts of $25 million or less for the three previous years and the taxpayer cannot be considered a tax shelter. The new Section 163(j) applies to tax years beginning after Dec. 31, 2017.
The IRS released proposed regulations on Nov. 26, 2018, and corrected regulations on Dec. 28, 2018. They will be effective when finalized, but taxpayers may apply them to tax years beginning after 2017 if applied consistently. The proposed regulations are organized into 11 sections: proposed 1.163(j)-1 through -11. The proposals provide for the following:
- Common definitions
- General rules
- Ordering rules
- Rules applicable to C corporations, real estate investment trusts (REITs), regulated investment companies, consolidated group members, and tax-exempt organizations
- Rules governing the disallowed business interest expense carryforwards of C corporations
- Rules for applying the limitation to partnerships and S corporations
- Rules regarding the application foreign corporations and their shareholders
- Rules regarding the application foreign persons with effectively connected income
- Rules regarding elections for excepted trades or businesses as well as a safe harbor for certain REITs
- Rules to allocate expense and income between nonexcepted and excepted trades or businesses
- Certain transition rules relating to the application of the limitation
Proposed Section 1.163(j)-1(b) provides a broad and extensive definition of what is considered interest. The regulation states it is any amount paid, received, or accrued as compensation for the use or forbearance of money under terms of an instrument or contractual arrangement or that is treated as interest under the IRC or regulations. Also included in the definition of interest are certain amounts that are closely related to interest, such as substitute interest payments, debt issuance costs, loan commitment fees, and certain amounts that affect the economic costs of funds or yield of a borrowing or an interest-generating asset.
In determining a taxpayer’s adjusted taxable income, deductions for depreciation, amortization, and depletion are add-backs to taxable income for tax years beginning before Jan. 1, 2022, resulting in an increase in adjusted taxable income and a potential decrease in the business interest expense limitation. Proposed Section 1.163(j)-1(b)(iii) states that any depreciation, amortization, or depletion that is capitalized to inventory under Section 263A is not considered a depreciation, amortization, or depletion deduction for purposes of Section 163(j), thereby increasing the amount of interest expense subject to the limitation.
Real property and farming trades or businesses may make an irrevocable election out of the business interest expense deduction limitation. Proposed Section 1.163(j)-9 provides for this election by attaching a statement to a timely filed return. Electing out requires the business to use an alternative depreciation system (ADS) to depreciate property. Taxpayers need to know that, once made, this election is irrevocable. In addition, the regulations provide an anti-abuse rule, so real property rentals to commonly controlled businesses, such as self-rentals, are ineligible.
Proposed Sections 1.163(j)-5(b)(2) for C corporations and 1.163(j)-6(l)(5) for S corporations provide for disallowed interest to be carried forward and deducted in the order of the taxable years in which they arose, beginning with the earliest year. Limitations may apply in certain situations, such as the limitation under Section 382. For partnerships, Proposed Section 1.163(j)-6(g) provides that, to the extent a partnership has interest expense in excess of its limitation, the excess business interest expense is not carried forward by the partnership, but rather allocated to the partners in the same manner as nonseparately stated taxable income or loss.
Income Inclusion with Applicable Financial Statements and Advanced Payments
Taxpayers are required to recognize all income unless specifically excluded by law.2 Regulations under Section 451 govern the rules as to which taxable year an item is to be included in gross income. Under the cash method of accounting, an amount is includible in gross income when actually or constructively received. Under the accrual method of accounting, income is includible in gross income when all the events have occurred that fix the right to receive the income and the amount can be determined with reasonable accuracy (the all-events test).
Section 451 was amended by Section 13221 of the TCJA regarding the rules associated with the timing of the recognition of income. Specifically, Section 451(b) was revised to require an accrual-method taxpayer who is subject to the all-events test for an item of gross income to recognize such income no later than the taxable year in which such income is taken into account as revenue in an applicable financial statement (AFS), or another financial statement under rules specified by the treasury secretary. Additionally, Section 451(c) was revised so that an accrual method taxpayer who receives an advanced payment during the tax year must either include the advance payment in gross income in the year received or elect to defer the inclusion of the payment in gross income to the taxable year following the year of receipt if the income is deferred for financial statement purposes.
In early September 2019, the Treasury released two sets of proposed regulations under Sections 451(b) and (c). One of the purposes for the revision of Section 451 was to codify the deferral method of accounting for advanced payments provided for by the IRS under Revenue Procedure (Rev. Proc.) 2004-34. Some of the important provisions of the proposed regulations include clarifying how the AFS income inclusion rules apply to accrual method taxpayers with an AFS, and explaining how the general rule for the all-events test applies to taxpayers with an AFS.
Proposed Section 1.451-3(b) provides that the AFS income inclusion rule generally applies to accrual method taxpayers with an AFS when the timing of the income inclusion of one or more items of income is determined using the all-events test. The proposed regulations also describe and clarify the definition of AFS under Section 451(b)(3). An AFS is a financial statement prepared according to generally accepted accounting principles (GAAP), certain financial statements prepared according to International Financial Reporting Standards (IFRS), and financial statements filed with certain regulatory or government bodies. Section 451(b)(1)(A)(ii) gives the treasury secretary the authority to specify other financial statements for purposes of Section 451(b)(1). Proposed Section 1.451-3(c)(1) provides that an AFS is consistent with the listing provided in Rev. Proc. 2004-34.
Proposed Section 1.451-8(b)(1) clarifies that the definition of advanced payment under the AFS and non-AFS deferral method is consistent with the definition of advanced payment in Rev. Proc. 2004-34, and provides a list of items excluded from the definition of advanced payment similar to Rev. Proc. 2004-34. Section 451 does not address how any adjustments to income for financial statement purposes are to be treated. Proposed Section 1.451-8(c)(3) and (d)(7) provide that a taxpayer who defers inclusion of all or a portion of an advanced payment must include the remainder of the advanced payment in gross income in the subsequent year, notwithstanding any write-down or adjustment for financial reporting purposes. This ensures that a financial statement write-down or adjustment to deferred income does not result in a permanent exclusion of income for federal income tax purposes.
Rev. Proc. 2019-37 was issued to provide procedures under Section 446 for taxpayers to obtain automatic consent of the IRS commissioner to change accounting methods to comply with the proposed regulations under Section 1.451-3 and 1.451-8, requiring Form 3115 to be filed. When Proposed Section 1.451-8 is finalized, it will render obsolete Rev. Proc. 2004-34, Rev. Proc. 2011-18, Rev. Proc. 2013-29, and Notice 2018-35.
Rental Real Estate Safe Harbor under Section 199A
With the enactment of the TCJA, Section 199A provides a deduction to noncorporate taxpayers of up to 20% of the taxpayer’s qualified business income from each of the taxpayer’s qualified trades or businesses. Section 199A(d) defines the term “qualified trade or business” as any trade or business other than specified service trades or businesses or the trade or business of performing services as an employee.3 The language in Section 199A and the legislative history contain no further definition of a trade or business.
As noted in the proposed regulations, Treasury and IRS agreed that Section 162(a) provides the most appropriate definition of a trade or business for purposes of Section 199A. The definition was further extended to rental activity where the property is rented to a trade or business conducted by the individual or a relevant pass-through entity (commonly referred to as self-rental), while not rising to the level of a trade or business for Section 162, would still qualify as a trade or business for purposes of Section 199A.4
In an attempt to clarify the uncertainty that remained regarding whether rental real estate activity was considered a trade or business under Section 199A, the IRS released a proposed safe harbor in January 2019 in Notice 2019-07, 2019-09, IRB 740, that coincided with the release of the final regulations for Section 199A. The IRS finalized the safe harbor with Rev. Proc. 2019-38, published Sept. 24, 2019.
Specifically, Rev. Proc. 2019-38 defines a rental real estate enterprise (RREE) as an interest in real property held for the production of rents, and may consist of an interest in a single property or interests in multiple properties held directly or through a disregarded entity. Each RREE meeting the safe harbor is treated as a separate trade or business for Section 199A purposes. For multiple properties to meet the definition of an RREE, the properties must be similar, such that only commercial properties can be part of an RREE with other commercial properties, and only residential properties can be part of an RREE with other residential properties.
In addition, mixed-use property may either be treated as a single RREE or can be bifurcated into separate commercial and residential interests. A mixed-use property is a single building that combines commercial and residential units. If the mixed-use property is treated as a single RREE, it may not be treated as part of the same enterprise as other residential, commercial, or mixed-use property.
The safe harbor must be determined on an annual basis, and the RREE must meet four general requirements:
- Separate books and records must be maintained to reflect income and expenses for each RREE. If the RREE contains multiple properties, income and expense statements must be maintained and then can be consolidated.
- For RREEs that have existed for fewer than four years, 250 or more hours of rental services must be performed per year. If the RREE has existed for more than four years, then in any of the three of five consecutive years that end with the taxable year, 250 or more hours of rental services must be performed. Rental services include (but are not limited to) advertising to rent or lease real estate; negotiating and executing leases; verifying information contained in prospective tenant applications; collection of rent; daily operation, maintenance, and repair of the property, including purchase of material and supplies; management of the real estate; and supervision of employees and independent contractors. Specifically excluded are financial or investment management activities, procuring property, reviewing financial statements, improving property, or travel to and from real estate.
- The taxpayer must maintain contemporaneous records, including time reports, logs, and similar documents for all services performed; description of all services performed; dates on which such services were performed; and who performed the services. Note that this requirement does not apply to tax years beginning before Jan. 1, 2020.
- The taxpayer must attach a statement to a timely filed original return for each taxable year in which the taxpayer relies on the safe harbor. A single statement is acceptable for multiple properties and should include the required information separately. The statement must have a description of the properties (including address and rental category) included in the RREE, a description of any properties acquired and disposed of during the year, and a representation that the requirements of the revenue procedure have been satisfied.
Certain notable rental real estate arrangements are not eligible for the safe harbor. Such arrangements include real estate used by the taxpayer as a residence under Section 280A(d); triple net leases where the lease agreement requires the tenant to pay taxes, fees, insurance, and maintenance activities for the property in addition to rent and utilities; real estate rented to a trade or business conducted by a taxpayer or relevant pass-through entity; and the entire rental real estate interest if any portion of the interest is treated as a specified service trade or business under Treasury Regulation Section 1.199A-5(c)(2).
Late Election or Revocation of Election under Section 168(k)
The TCJA also made significant changes to Section 168(k), commonly referred to as bonus depreciation. In general, Section 13201 of the TCJA increases the bonus depreciation percentage from 50% to 100% of qualified property, and eligibility for bonus depreciation expands to include certain used depreciable property. Additionally, the 100% bonus depreciation applies for assets acquired after Sept. 27, 2017, through the 2022 tax year. These amendments generally apply retroactively to property placed in service after Sept. 27, 2017. Additionally, Section 168(k)(10) was added to Section 168(k), allowing taxpayers to elect to deduct 50%, rather than 100%, bonus depreciation for qualified property acquired by the taxpayer after Sept. 27, 2017.
Under Section 168(k)(7), a taxpayer can elect not to deduct bonus depreciation for all qualified property that is in the same class of property and placed in service by the taxpayer in the same taxable year. Similarly, this election is revocable only with the IRS commissioner’s consent, and such election is required by the due date, including extensions, of the federal tax return for which the election applies.
Under Section 168(k)(10), a taxpayer may elect to deduct 50%, rather than 100%, of bonus depreciation for qualified property acquired by the taxpayer after Sept. 27, 2017, for the taxable year that includes Sept. 28, 2017. This new election essentially allows taxpayers to continue to take the 50% bonus depreciation for the 2017 tax year for property that would have been eligible for the 100% bonus depreciation.
Treasury issued proposed regulations for Section 168(k) on Aug. 8, 2018. In response, taxpayers requested relief to make late elections under Section 168(k)(7) or (10) because some taxpayers had already filed their tax returns before the regulations were issued, and others did not have sufficient time to understand the proposed regulations and fully contemplate the consequences of making such elections.
Rev. Proc. 2019-33 was issued July 31, 2019, and set the procedures for making late elections or revocations under Section 168(k)(5), (7), or (10) for certain property acquired after Sept. 27, 2017, and placed in service during the tax year that includes Sept. 28, 2017.5 Therefore, a taxpayer can file a late election or revocation of an election for the 2016 or 2017 tax year (depending on year-end). Taxpayers can make late elections or revocations of elections under Section 168(k)(5), (7), or (10) using two alternatives: The taxpayer may file an amended return prior to the taxpayer filing its federal tax return for the first taxable year succeeding the 2016 or 2017 tax year, or, alternatively, the taxpayer may file Form 3115 with the taxpayer’s timely filed federal tax return for the first, second, or third taxable year succeeding the 2016 or 2017 tax year.
Rev. Proc. 2019-33 additionally provides that late elections or revocation under Section 168(k)(5), (7), and (10) will be treated as a change in method of accounting. Treasury and the IRS were concerned about the potential administrative burden of filing amended tax returns. The change in the method of accounting treatment will require a Section 481(a) adjustment, and is only applicable for the first three tax years following the tax year that included Sept. 28, 2017. Taxpayers making such a change in method of accounting must use the automatic change procedures in Rev. Proc. 2015-13, or its successor, to receive automatic consent from the IRS commissioner.
At this point, it is unlikely taxpayers will be choosing the amended return option considering the deadline for extended 2018 calendar year tax returns has passed. Therefore, taxpayers will want to identify whether the change in accounting method and Section 481(a) adjustment for such depreciation presents a more tax-efficient strategy than their current position.
On Oct. 9, 2019, the IRS published Revenue Ruling 2019-24, providing guidance on cryptocurrency for the first time since 2014, when it classified all virtual currencies as property.6 Cryptocurrency (Bitcoin, for example) is a type of virtual currency that securely records digital transactions on a distributed ledger. The guidance comes at a time when auditors have increasingly focused on cryptocurrency investments. In summer 2019, the IRS sent out over 10,000 letters to taxpayers who had virtual currency transactions and who potentially failed to report income or did not report the transactions properly. In addition to the revenue ruling, the IRS released a question and answer document that covers areas such as receiving virtual currency as compensation and the calculation of gain on the sale or exchange of cryptocurrency.
There are two key concepts within the revenue ruling. First, a “hard fork” occurs when a cryptocurrency on a distributed ledger undergoes a protocol change, resulting in a permanent diversion from the legacy or existing distributed ledger, and may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy-distributed ledger.
Additionally, an “airdrop” is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. A hard fork followed by an airdrop results in the distribution of units of new cryptocurrency to addresses containing legacy cryptocurrency. As the Revenue Ruling notes, an airdrop does not always follow a hard fork. Cryptocurrency received from an airdrop is generally received on the date and time it is recorded on the distributed ledger.
In the ruling, the IRS differentiated two fact patterns. In the first scenario, the distributed ledger of a specific cryptocurrency held by a taxpayer experienced a hard fork, resulting in the creation of a new cryptocurrency. The new cryptocurrency was not part of an airdrop, or otherwise, transfer to an account controlled by the taxpayer. The IRS ruled a taxpayer does not have gross income under Section 61 because of a hard fork of cryptocurrency the taxpayer owns, as long as the taxpayer does not receive the new property.
In the second scenario, the distributed ledger of a specific cryptocurrency held by the taxpayer again experienced a hard fork, resulting in the creation of a new cryptocurrency. On the same date, the new cryptocurrency is part of an airdrop to the taxpayer’s distributed ledger address, and the taxpayer then had the ability to dispose of the new cryptocurrency (and thus had dominion and control). The amount included in income is the fair market value of the cryptocurrency when received. The IRS ruled that because the taxpayer received the new cryptocurrency through the hard fork and airdrop, the taxpayer has an accession to wealth under Section 61, and has ordinary income in the year in which the new cryptocurrency was received. Once the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency is acquired, the taxpayer is treated as receiving the cryptocurrency at that time.
Taxpayers holding cryptocurrencies will need to carefully maintain records documenting receipts, sales, exchanges, or other dispositions of virtual currency, as well as the fair market value of the virtual currency to ensure proper compliance with the tax laws as the IRS continues to ramp up enforcement over cryptocurrencies.
1 References to “Section” relate to the Internal Revenue Code of 1986, as amended by the Tax Cuts and Jobs Act and the Treasury Regulations promulgated thereunder.
2 Section 61 and Reg. Treas. Reg. Section 1.61-1.
3 Section 199A(d).
4 Treas. Reg. Section 1.199A-1(b)(14).
5 Note that Section 168(k)(5) was also referenced in the Rev. Proc. 2019-33, but is not being discussed here.
6 Notice 2014-21.
Edward A. Kollar, CPA, EA, CSEP, is firm director with Baker Tilly Virchow Krause LLP in Wilkes-Barre. He can be reached at firstname.lastname@example.org.
Tim Cotter, CPA, JD, is a senior manager with Baker Tilly Virchow Krause LLP in Wilkes-Barre. He can be reached at email@example.com.