Leveraged manufacturers and health care providers are looking for a way around the 2017 tax overhaul’s limit on debt interest payment write-offs. One potential option: calling themselves real estate.
That might entail stretching the definition of a “real property trade or business,” a category of companies that can elect out of the restriction on deductions of interest expenses, which the law capped at 30 percent of adjusted taxable income under amended tax code Section 163(j). They would avoid both the limit on interest deductions and what could be a tedious compliance process, at the cost of losing out on the law’s coveted full expensing provision.
Owners of skilled nursing facilities are pushing for the Internal Revenue Service to allow for a different route, counting them as real property trades or businesses if they lease property to another entity owned by the same parent company. If the businesses are forking over interest payments greater than 30 percent of their earnings before interest, taxes, depreciation, and amortization (EBITDA) are taken out of the equation, their debt is going to become more expensive, as it will no longer be fully deductible.
The proposed regulations (REG-106089-18) include an example of a “luxury hotel” which, along with its owner, qualifies for the election as a “real property trade or business.” Owners of golf courses, timeshare businesses, and rooftop spaces could all comfortably use the example to apply the real property category to themselves as well, said Mark Van Deusen, a principal at Deloitte Tax LLP in Washington.
Others want the rules changed to broaden the scope of what the IRS will consider real estate, and therefore eligible to elect out.
Public commenters have sent four similarly worded comments on the IRS’ proposed rules requesting that an entity that leases property to a skilled nursing facility, assisted living community, or similar facility be given the option to opt out as a real property trade or business, even if both lessee and lessor share a common owner. A fifth suggests that “nursing home operations should be entitled to the same relief other business owners are realizing from the Tax Act.”
The American Health Care Association, a leading skilled nursing and assisted living facility trade group, said it was working on its own requests for the proposed rules, ahead of their finalization. When asked whether the organization directed members to send comment letters requesting that property lessors to skilled nursing facilities get the real property trade or business election, a spokesperson declined to comment further.
For doctors’ offices, manufacturers, and a wide array of brick-and-mortar businesses, the structure described in the nursing facility letters is fairly common, and in some cases the lessor and lessee are within the same business, said Andrea Mouw, a principal at Eide Bailly LLP in Minneapolis.
But the package of proposed regulations, issued Nov. 26, contains an anti-abuse rule that would bar companies containing entities that lease at least 80 percent of their property to other entities with the same owner from qualifying for the real property trade or business election, calling such practices “inappropriate.”
“It’s kind of a raw deal for those people that were already structured that way,” Mouw said. On the flip side, she added, such structures could become a means of abuse, absent the rule: A company could try to set up a real estate entity, buy a property, and lease it to its main operating business, and even attach all their debt to the real estate entity—and then deduct all the interest it pays.
Aggregation or Abuse?
It’s unclear whether the IRS will change the anti-abuse rule or provide exceptions as officials iron out the final version of the regulations. The IRS didn’t immediately respond to a request for comment. A Treasury spokesperson said the department will consider comments as it works on finalizing the rules after the comment period ends in Feb. 26.
Final regulations (REG-107892-18) for another provision of the tax overhaul—the 20 percent write-off for pass-through businesses, such as partnerships and S corporations—allowed businesses to aggregate their related entities. Without the ability to do so, they could have been almost completely shut out of that deduction, under new Section 199A, because of how a phased-in limit based on their wages and capital functions.
The debt interest deduction regulations do include an aggregation rule, but only for purposes of the tax law provision’s exception for small businesses, meaning those with $25 million or less in annual gross receipts over the last three years. That is, they can’t say that multiple related entities in a family of businesses that might each individually earn less than $25 million are exempt from the new interest write-off limit.
Distinguishing between abusers exploiting a loophole the code and businesses structured this way for years prior to the tax overhaul isn’t an insurmountable obstacle, Van Deusen said. The IRS could require that those companies show that they’re organized that way for a reason other than tax avoidance, he said.
“I think it’s completely understandable that Treasury and the IRS, as they say in the preamble, didn’t want people to engage in non-economic transactions,” he said. Still, he added, “What is the abuse of putting them in two separate entities?”
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(Updates with response from Treasury spokesperson.)