Before the close of 2020, Congress and the IRS brought about changes to the application of the business interest expense deduction limitation rules with regard to taxpayers who wish to make a real property trade or business (RPTOB) election, which may benefit owners and operators of qualified residential living facilities.
Section 163(j) generally limits the amount of a taxpayer’s business interest expense that can be deducted each year. The term “business interest” means any interest that is properly allocable to a “trade or business,” which could include an electing RPTOB. The term “trade or business” has not been separately defined for purposes of Section 163(j); however, it has been defined for purposes of the passive activity loss rules under Section 469(c)(7)(C) as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.
In general, a taxpayer engaged in a trade or business that manages or operates a “qualified residential living facility” may elect to be treated as an RPTOB solely for the purpose of applying the interest expense rules under Section 163(j). Taxpayers who make an RPTOB election to avoid being subject to the business interest deduction limitation under Section 163(j) must use the alternative depreciation system (ADS) to compute depreciation expense for property described in Section 168(g)(8), which includes residential rental property.
In Notice 2020-59, issued on July 28, 2020, the IRS and Treasury proposed a revenue procedure providing a safe harbor for purposes of determining whether a taxpayer meets the definition of a qualified residential living facility and is therefore eligible to make the RPTOB election. Following review of comments submitted in response to Notice 2020-59, the Treasury Department and IRS published Revenue Procedure 2021-9 on December 29, 2020. Rev. Proc. 2021-9 modifies the proposed safe harbor under Notice 2020-59 to make it more broadly applicable and less administratively burdensome.
Additionally, the emergency coronavirus relief package signed into law on December 27, 2020, contains a taxpayer-favorable provision that modifies the recovery period applicable to residential rental property (including retirement care facilities) placed in service before January 1, 2018 for taxpayers making the RPTOB election.
Modifications to the RPTOB Safe Harbor Under Rev. Proc. 2021
Under Rev. Proc. 2021-9, a residential living facility will be eligible to make the RPTOB election providing the facility:
- Consists of multiple rental dwelling units within one or more buildings or structures that generally serve as primary residences on a permanent or semi-permanent basis to individual customers or patients;
- Provides supplemental assistive, nursing, or other routine medical services; and
- Has an average period of customer or patient use of individual rental dwelling units of 30 days or more.
Alternatively, if the residential living facility qualifies as residential rental property under Section 168(e)(2)(A), it will be treated as an RPTOB for purposes of the revenue procedure. Thus, in response to comments submitted to the Treasury Department and the IRS, Rev. Proc. 2021-9 modified the proposed safe harbor published in Notice 2020-59 in several important ways, including the following.
- The definition of a qualified residential living facility has been modified to reduce the required average period of customer or patient use from 90 to 30 days. Further, the average period of use may be determined by reference to either the number of days paid for by Medicare or Medicaid, or the number of days under a formal contract or other written agreement.
This modification is a welcome change from the proposed safe harbor contained in Notice 2020-59. Medicare and Medicaid frequently cover patient stays of less than 90 days. Consequently, reducing the required number of days of use and allowing for determination with reference to days paid by Medicare or Medicaid should allow a greater number of facilities to qualify under the safe harbor.
- Rev. Proc. 2021-9 provides an alternative test for purposes of determining whether a taxpayer meets certain requirements of the definition of a qualified residential living facility. Under this alternative test, if a taxpayer operates or manages residential living facilities that qualify as residential rental property for depreciation purposes, then the facility will be considered a qualified residential living facility for purposes of Section 163(j).
The administrative burden on taxpayers should be significantly reduced by allowing reliance on separate determinations made for depreciation purposes. Taxpayers will not be required to consider two distinct tests.
- Rev. Proc. 2021-9 clarifies that the determination of whether a facility meets the definition of a qualified residential living facility must be determined on an annual basis.
Under general rules, once a taxpayer makes the RPTOB election, the election remains in effect for subsequent years. Taxpayers relying on this safe harbor cannot depart from these rules as there is a continuing requirement to evaluate qualification on an annual basis. To the extent a taxpayer fails to meet the safe harbor requirements, it may become subject to the business interest deduction limitations under Section 163(j). Unless otherwise provided in future guidance, this would not appear to constitute an accounting method change.
Important Considerations to Apply the Safe Harbor Under Rev. Proc. 2021-9
Qualifying taxpayers may rely on the safe harbor contained in Rev. Proc. 2021-9 for tax years beginning after December 31, 2017. Further, if a taxpayer relies on the safe harbor, the taxpayer must use the ADS of Section 168(g) to depreciate the property described in Section 168(g)(8), as discussed above.
The changes under Rev. Proc. 2021-9 could open the door for taxpayers who qualify in a previous year (i.e., 2018 and 2019) as a result of the new rules to amend prior returns (for example, taxpayers who now qualify for the RPTOB election using the 30-day threshold average use instead of the 90-day average).
For purposes of applying the safe harbor, for any taxable year subsequent to the taxable year in which a taxpayer relies on the safe harbor to make the RPTOB election in which a taxpayer does not satisfy the safe harbor requirements, the taxpayer is deemed to have ceased to engage in the electing RPTOB (i.e., the taxpayer will likely be subject to the business interest expense limitations of Section 163(j)). However, for any subsequent taxable year in which a taxpayer satisfies the safe harbor requirements after a deemed cessation of the electing trade or business, the taxpayer’s initial election will be automatically reinstated.
To qualify to rely on this safe harbor, a taxpayer must retain books and records to substantiate that all of the above requirements are met each year. Taxpayers are not eligible to rely on the safe harbor in this revenue procedure if a principal purpose of an arrangement or transaction is to avoid Section 163(j) and its regulations in its entirety, and in a manner that is contrary to the purpose of Rev. Proc. 2021-9.
Modification to the Recovery Period Under the December 2020 Stimulus Package
The December 27, 2020 emergency coronavirus relief package provides an additional change related to the RPTOB election with respect to taxpayers who own residential rental property. Prior to the amendment, taxpayers making the RPTOB election were required to use an ADS recovery period of 40 years with respect to residential rental property placed in service before January 1, 2018. The bill retroactively modifies the recovery period for all residential rental property to 30 years for taxable years beginning after December 31, 2017, therefore allowing taxpayers to recover depreciation deductions from residential rental property sooner.
 The rental dwelling units of a residential living facility serve as primary residences on a “permanent or semi-permanent basis” to customers or patients whose use of the units is generally long-term (30 days or more) in nature, even though some customers or patients may arrive at the residential living facility with significantly shortened life expectancies due to advanced age or terminal medical conditions, and some customers or patients otherwise may be expected to periodically reside away from the residential living facility, such as at the primary residence of a spouse or other relative, for short periods of time.
 “Supplemental assistive, nursing, or other routine medical services” are personal and professional services that are customarily and routinely provided to individual residential customers or patients of nursing homes, assisted living facilities, memory care residences, continuing care retirement communities, skilled nursing facilities or similar facilities, as needed, on a day-to-day basis. Such services generally do not include surgical, radiological or other intensive or specialized medical services that are usually provided only in emergency or short-term in-patient or out-patient hospital or surgical settings.
 The “average period of customer or patient use” is determined by dividing: (i) the sum of the total number of days in the taxable year that each customer or patient resides in a rental dwelling unit of the residential living facility, which may be determined by reference to a rental contract or other formal written lease agreement, or by the number of days paid for by Medicare or Medicaid, by (ii) the total number of individual residential customers or patients who reside in all of the rental dwelling units of the facility for the taxable year.
This article reflects our views at the time this article was written and should be used as reference only. We recommend that you talk to your Warren Averett advisor, or another business advisor, for the most current information or for guidance specific to your organization.