Reports from the Small Business Administration (SBA) indicate that the construction industry received the most significant share of the Paycheck Protection Program (PPP) loans. Assuming most of these loans are eligible for forgiveness, borrowers can utilize the short-term liquidity available through their PPP loans. Recent legislation, the President’s declaration of a federal disaster and existing tax law provide opportunities for construction and real estate companies impacted by the pandemic.
As the economic impacts of the current pandemic continue to unfold, our accounting professionals remain committed to working with you to navigate existing business and tax opportunities to strengthen your balance sheet. Below, we highlight some specific opportunities for impacted taxpayers.
Federally Declared Disaster Areas
When we think of a federally declared disaster area, what usually comes to mind may be a hurricane, tornado or other natural disasters. Now, we must think of a pandemic. There are existing tax laws in place to provide flexibility and potential benefits to taxpayers that are geographically located in a disaster area. As the whole country is currently deemed a disaster area, this applies specifically to U.S. contractors and real estate businesses.
Section 165(i): Tax Benefits for Contractors
Under Section 165(i), a taxpayer may elect to deduct a loss that occurred in a disaster area in the tax year immediately preceding the year in which the disaster occurred. Given the strength of the economy in 2019, many taxpayers have high 2019 taxable income. If these taxpayers have qualifying losses in 2020, the losses can be reported as if they occurred in 2019.
The amount of the loss that can be claimed must meet the following criteria:
- Loss reported must be net of any reimbursement from vendors, customers or insurance contracts,
- The taxpayer must establish a direct link of the incurred loss to COVID-19-related circumstances during 2020, and
- Loss must be evidenced by finalized transactions or contracts.
In general, economic losses or estimated losses for uncompleted transactions are not eligible. Impairment loss of intangible assets, such as goodwill from an acquisition, may qualify.
Examples of losses that could be eligible for reporting in 2019 are as follows:
- Completed construction contracts that incurred losses in 2020 due to the impact of the pandemic,
- Abandonment of leasehold improvements by a real estate tenant,
- Termination payments, lost deposits on products or services,
- Loss on the sale of real or personal property,
- Scrapped or unusable inventory.
CARES Act changes to treatment of Business Losses
As a result of the 2017 tax law changes (The Tax Cuts and Jobs Act, TCJA), loss deductions were limited for certain business owners. The recent CARES Act eliminated some of these limitations, allowing for contractors to potentially generate cash flow if they have unused losses.
Under the TCJA, excess business losses (defined as an otherwise deductible trade or loss in excess of $250,000 for single taxpayers and $500,000 for married filing jointly couples) were limited for taxpayers other than C Corporations for tax years 2018 through 2025. This limitation primarily impacted pass-through entities and their owners, such as LLCs, partnerships and S Corporations. This provision also required any excess business losses to be carried forward as a Net Operating Loss (NOL) in future tax years.
Under the CARES Act, this limitation is retroactively eliminated for tax years 2018 through 2020. Contractors who had excess business losses in 2018 or 2019 should look to those years and determine if an amendment to those returns would generate additional tax refunds given the elimination of this loss limitation.
Putting this change into perspective
As an example, a taxpayer in a 37% tax bracket with $100,000 of excess loss limitation in one of those tax years could generate a federal tax refund of $37,000. The ability to claim the loss in this example would depend on the taxpayer having other income to offset the additional loss. If there is not adequate income, then the loss would have to continue to be carried forward or potentially be carried back to prior tax years under another CARES Act change dealing with NOLs.
Limitations on NOL carrybacks and carryforwards were also eliminated for tax years 2018 to 2020. Loss carryovers were limited to 80% of taxable income under the TCJA, and this limitation was retroactively eliminated. Additionally, NOL carrybacks were eliminated under TCJA. Under the CARES Act, NOLs arising in tax years 2018 to 2020 can be carried back to the five tax years preceding the year of the loss. 2018 returns that have a loss can first be carried back to 2013, and then any unused loss not absorbed in 2013 would be carried back to years after 2013 where the loss could offset taxable income and generate tax refunds.
Contractors that file their returns on a completed contract method often incur tax losses where they experience significant growth in volume and have significant work in process at year-end. This accounting method impacts contractors that have average annual gross receipts under $26 million and $25 million in tax years 2019 and 2018, respectively.
Opportunity to generate liquidity in these difficult times can be found from traditional sources, such as shrinking your balance sheet and seeking additional investment from stakeholders. However, unique opportunities also exist in navigating the new and existing laws that are in place to provide relief to the construction and real estate industry. Please reach out to a Sikich construction and real estate professional to discuss your situation.