Navigating Interest Rates, Depreciation, & Tax Changes: A Real Estate Year-End Overview

Real estate owners and operators are experiencing increased headwinds across all real estate asset classes as they face changes to various tax rules, adjust to the post-COVID real estate market, and deal with the current interest rate environment. In these dynamic times, it remains important to stay current on the latest developments in the industry to make the best decisions as an owner or operator in the field.

Interest rates have steadily increased since the pandemic (with the average home mortgage rates recently rising to levels not seen over the prior two decades). This has caused disruptions in the real estate industry as borrowers look to secure affordable financing. With this shift, real estate investors have had to recalculate their expected returns and change the decision-making process when moving forward with new deals. Along with interest rate changes, investors have tax impacts to consider: the Tax Cuts and Jobs Act (“TCJA”) has phase-outs and expirations, which will continue to require attention in year-end planning.

BUSINESS INTEREST EXPENSE LIMITATION CALCULATION CHANGE REMAINS

For tax year 2023, the business interest expense limitation remains at 30% of Adjusted Taxable Income (“ATI”). In 2022 and prior, ATI allowed for addbacks of depreciation and amortization expenses. However, those addbacks ended and are still not on the docket to be reinstated for the tax year 2023. Directionally, this is unfavorable for real estate investors since these lower ATI (more real estate ventures are likely to be caught by interest expense limitations). It also reduces the interest expense deduction allowable. This impact was felt in the tax year 2022 and, absent any legislation, will continue during the 2023 tax year. Any unused interest expense can be carried forward to future years, which offers some positive spin to make up for the current year’s tax implication.

Some real estate ventures may be able to clear this interest limitation issue by electing to be treated as a Real Property Trade or Business (“RPTOB”), but this also comes at a cost. As a result, electing entities are required to move certain assets to longer depreciable lives (i.e., less depreciation expense). Taxpayers potentially subject to the interest expense limitation in 2023 should consult with their tax advisors to study the cost-benefit of electing RPTOB status.

PHASE OUT ON BONUS DEPRECIATION FOR CERTAIN PROPERTY

In tax years 2022 and prior, the TCJA allowed for 100% bonus depreciation for property owners with assets with a recovery period of 20 years or less. This included heavy machinery, manufacturing equipment, vehicles, and furniture. Also, improvements to real property labeled “qualified improvement property” were included, resulting in a sizeable upfront deduction for these capital expenditures. In 2023 and going forward, the deduction decreases. For tax year 2023, this allowable deduction is 80%. In 2024, it will drop further to 60% and continue from there. Taxpayers will benefit from cost segregation more than ever, which allows them to properly assign assets to their class life. This allows for higher deductions when assets are designated to lower-class lives based on their appropriate qualification because additional assets qualify for bonus depreciation.

EXCESS BUSINESS LOSS RULES

Noncorporate taxpayers cannot deduct excess business losses for post-pandemic tax years ending December 31, 2020, and before January 1, 2029. They must treat them as net operating losses (NOLs) that carry over to future years. Taxpayers need to pay attention to this limitation when reviewing their overall tax plan. For tax year 2023, excess business losses are limited to $578,000 for joint tax returns ($289,000 for single). Any unused losses can be carried forward, but this limitation does deal a significant blow to many taxpayers who enjoyed increased losses during the pandemic years.

INTEREST RATE ENVIRONMENT

Over the past few years, interest rates have soared. The days of enjoying 2% to 3% interest rates have passed for now, and real estate owners must be agile in the marketplace. It is crucial to evaluate the tax situation for each deal in addition to all other factors, as returns on investment have become a different calculation for each taxpayer. The loan-to-value (“LTV”) ratio, or mortgage compared to appraised value, is incredibly important to pay attention to in each deal and ongoing deals. With higher interest rates, real estate appraised values have decreased; therefore, the LTV has declined on properties. This impacts the overall value of the property and the feasibility of any given deal. Real estate owners and operators should be aware of exit strategies: cancellation of debt, a “deed in lieu” transaction, or taking advantage of the insolvency exclusion. An insolvency exclusion is enacted when a discharged debt is excluded from gross income if the discharge occurs when the taxpayer is insolvent. Insolvency is defined as an excess of the taxpayer’s liabilities over assets.

QUALIFIED OPPORTUNITY FUNDS

Taxpayers that have invested in Qualified Opportunity Funds (“QOFs”) need to consider the rules impacting deferred gains on the transactions carefully. These unique investments allow taxpayers to defer gains through December 31, 2026, with taxes generally paid in April 2027 for those with extensions. The holding period on these investments is anywhere between 7 and 10 years for those invested in QOFs, and the overall economic environment has shifted since they were first introduced. Real estate owners or investors may consider refinancing QOF construction loans and finding fixed debt options as interest rates continue to rise. This can help predict returns and keep stable cash flows throughout the investment and when investors exit. This year presents many challenges and unique changes for taxpayers in the real estate industry. Challenges and disruptions to an existing real estate venture may prove to be an opportunity for existing or potentially new investors if navigated strategically. These considerations should be carefully analyzed to determine the best planning strategy for each taxpayer’s situation.