While many of the owners of skilled nursing facilities have been closely monitoring whether they will be able to receive the 20% pass-through deduction under Section 199A, there is another potential significant limitation under the new tax law related to the ability to deduct interest expense incurred that should also be considered. If skilled nursing facilities plan to utilize the real property trade or business election to avoid the new interest expense limitation rule, they may need to reevaluate their position.
Background of Interest Expense Limitation Rule
Prior to the Tax Cuts and Jobs Act of 2017, the interest expense limitation rule applied to a very narrow group of businesses. The interest expense limitation only applied where the interest was either payable to a foreign related party or guaranteed by a foreign related party. Under the old rules, only related party interest was limited when an entity had a debt to equity ratio of 1.5 or more. In addition, the interest had to exceed 50% of adjusted taxable income.
However, under the new interest expense limitation rule, the number of businesses affected is much more expansive. The new interest expense limitation rule applies to both related and unrelated interest expense, there is no debt to equity ratio that needs to be exceeded before the limitation is applied, and interest will start to be disallowed when it exceeds 30% of adjusted taxable income.
Effective for taxable years beginning after December 31, 2017, a business interest deduction for the taxable year cannot exceed business interest income of such taxpayer for such taxable year and 30% of adjusted taxable income of such taxpayer. In other words, a business entity is allowed to deduct net interest expense up to 30% of adjusted taxable income. The definition of adjusted taxable income for purposes of the limitation is generally taxable income before income tax, depreciation, and amortization (EBITDA) for taxable years before January 1, 2022. However, starting in the 2022 taxable year the limitation becomes even more restrictive as adjusted taxable income no longer allows a depreciation and amortization addback, and is instead based on taxable income before income tax (EBIT).
The interest expense limitation rule occurs at the taxpayer level. Therefore, the limitation is applied at the level of each partnership or S Corporation. Currently, no aggregation rules exist for partnerships or S Corporations. However, the IRS has provided clarification that for a group of affiliated C Corporations, the limitation will apply at the consolidated tax return filing level (Notice 2018-28).
For example, assume a partnership has preliminary taxable loss of approximately $100,000. The same partnership has net interest expense of $500,000, and depreciation expense of $600,000. The following interest expense limitation would apply:
Note that the cash impact assumes the taxpayer can otherwise use the losses generated.
Significance to Skilled Nursing Facilities
Many skilled nursing facilities separate their operating structure from their property. There are many non-tax reasons for an Operating Company/Property Company structure, including liability and reporting requirements. In order to acquire and develop nursing homes, the Property Company often acquires third party debt and incurs significant interest expense. In general, the Property Company receives a rental revenue stream from the Operating Company. This can lead to either a marginal or a negative net income stream.
As the new interest expense limitation rules are applied at an entity by entity level basis, the Property Company will have a significant amount of interest expense with a high likelihood of minimal EBITDA (or EBIT for tax years starting in 2022) causing paid interest expense to be non-deductible for tax purposes.
Exceptions for Interest Expense Limitation Rule
There are two major exceptions in which the interest expense limitation rule will not apply. The first exception is provided for small businesses (IRC §163(j)(3)). The interest expense limitation rule does not apply if a taxpayer has average annual gross receipts for the 3-taxable-year period ending with the prior taxable year that do not exceed $25,000,000. However, for purposes of determining whether the small business exception is met a taxpayer must follow aggregation rules. As the Operating Company and Property Company often have similar ownership, the gross receipts of both the property and operating company most often need to be combined when determining whether the $25,000,000 gross receipts test is met which often causes the small business exception not to be viable.
The second exception to avoid the interest expense limitation rule applies to business that can qualify as a real property trade or business and choose to make an irrevocable election (IRC §163(j)(7)(B)). The interest expense limitation rule defines a real property trade or business by referencing the definition included in the passive activity loss rules, Section 469. Under Section 469(c)(7)(C), the term real property trade or business means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Because the definition of a real property trade or business is linked to Section 469, the only guidance that currently exists regarding the definition is based on the Treasury Regulations under Section 469. The Treasury Regulations specifically state that an activity is not a rental activity if extraordinary personal services are provided by or on behalf of the owner of the property in connection with making the property available to customers. Extraordinary personal services are provided in connection with making property available for customer use only if: (1) they are performed by individuals; and (2) the customers' use of the property is incidental to their receipt of such services. These requirements are met, for example, in the case of a hospital with in-patients, since the use of the hospital's boarding facilities is incidental to the receipt of medical services from the hospital staff. Similarly, the requirements are met by a school with student dormitories, since the use of the dormitories is incidental to the receipt of personal services from the school's teaching staff. Thus, neither of those two businesses involves a rental activity either in whole or in part (Treas. Reg. §1.469-1T(e)(3)).
Provided the ownership structure of the Operating Company and Property Company are similar, if skilled nursing facilities are required to follow the Treasury Regulations under §469 it raises the concern that the Property Company will not be able to conclude they are involved in rental activities. Using the Section 469 regulations, the IRS could argue that extraordinary personal services are provided on behalf of the owner in relation to the rental because of the related party ownership of the Property and Operating Company. If both the small business exception and the real property trade or business election are unavailable, then the interest expense limitation rule must be applied at the entity level. This could cause skilled nursing facilities that utilize an Operating Company and leveraged Property Company structure to be disallowed paid interest expense for tax purposes, and potentially even cause a business that generates a loss to create taxable income for the owner.
We are working closely with our clients and the New York State Health Facilities Association (NYSHFA) to advocate that a Property Company involved in a skilled nursing facility Operating Company/Property Company structure should be able to make a real property trade or business election, and therefore avoid the interest expense limitation rule. In addition, The Bonadio Group has been exploring potential planning opportunities if the interest expense limitation rule applies. We highly encourage other affected parties to reach out to The Bonadio Group or NYSHFA directly to find out ways they can help support this effort.