Why Real Estate Entities Should Consider Interest Rate Swaps and Caps to Hedge Against Rate Volatility

Since March 2022, the Federal Reserve has raised interest rates by more than 500 basis points, and the future of those rates is uncertain at best — making it difficult for commercial real estate businesses to plan for future projects. In addition, Fitch Ratings has estimated that around 23% of existing commercial mortgage-backed securities and agency loans will be maturing through the end of 2023.

Whether you are looking to finance new deals or refinance current properties, rising interest rates may cause significant tax issues in the immediate future. Interest rate swaps and caps could provide an excellent option to hedge against uncertain rates. To take full advantage, it’s important to fully understand the tax implications of each alternative and possible business interest limitations under IRC Section 163(j).

How Do Rate Caps and Swaps Work?

Interest rate caps and interest rate swaps allow you to trade in a variable interest rate for a fixed rate or limit how high your variable interest rate can rise. Here’s how they work.

Interest Rate Caps

Interest rate caps allow a borrower to set an upper limit on a variable interest rate agreement. The borrower will pay an interest rate premium upfront (nonperiodic payment) and then will pay the current interest rate (periodic payment). If the interest rate goes above a predetermined strike rate, the borrower will be reimbursed for the difference.

Interest Rate Swaps

An interest rate swap is an agreement between two different parties to exchange one stream of interest payments for another over a specified time period. Two main types of interest rate swaps are “fixed to floating” and “floating to fixed.”

What are the Key Tax Considerations for Interest Rate Caps and Swaps?

Interest rate caps and swaps are considered notional principal contracts (NPCs) and as such are subject to complex rules for federal income tax purposes. The three types of payments associated with these strategies include periodic payments, nonperiodic payments and termination payments:

• Periodic payments. These are payable at intervals of one year or less during the entire term of the contract. Taxpayers recognize payments ratably, on a daily basis, in the year to which the payment relates. The character of the income is generally ordinary.
• Termination payments. These are made to terminate, extinguish or assign all or a portion of the remaining rights and obligations of any party under the agreement. Parties receiving termination payments recognize them in the year they are terminated, extinguished or assigned. The character of these payments depends on whether the contract is considered a capital asset in the hands of the taxpayer. A capital asset does not include property that is part of a qualified hedging transaction entered into in the ordinary course of the taxpayer’s business; therefore, for real estate businesses a termination payment will likely be characterized as ordinary income.
• Nonperiodic payments. These include any payments that are not a periodic payment or a termination payment. Nonperiodic payments are recognized over the contract term in a manner reflecting the economic substance of the contract as ordinary income or expense.

Additional Tax Considerations for Caps and Swaps Under IRC Section 163(J)

As interest rates rise, another concern for highly leveraged real estate projects will be possible business interest limitations under IRC Section 163(j), which was implemented by the Tax Cuts and Jobs Act (TCJA).

Beginning in 2022, the interest limitation calculation has become more restrictive as depreciation and amortization are no longer added back. This is coupled with increasing interest expense, which may cause taxpayers who may have not been subject in prior years to be subject to this limitation for the first time. Certain small business taxpayers with average annual gross receipts of $27 million (for 2022 and $29 million for 2023) or less in the previous three years are exempt from these limitations; however, a taxpayer considered a tax shelter would remain subject to Sec. 163(j) limitations.

If your real estate business is subject to these limitations, consider making the Real Property Trade or Business Election. This election is generally irrevocable and requires you to depreciate residential, nonresidential and qualified improvement property under the alternative depreciation system (ADS), which has longer depreciation periods. No bonus depreciation is permitted on qualified improvement property. However, bonus depreciation decreases to 80% beginning January 1, 2023, and will continue to decrease by 20% until completely phased out for property placed in service after December 31, 2026. Real estate businesses will need to analyze and determine whether they are subject to these limitations and if it makes sense to make the Real Property Trade or Business election, in addition to understanding the tax implications of their decisions.

Learn more about interest limitations and bonus depreciation changes for tax years beginning January 1, 2022.

During a time of economic uncertainty and interest rate volatility, interest rate caps and swaps can help your real estate business manage interest rate risk as you plan for new development or required refinancing. However, it is still important to be diligent and proactive with your tax planning to avoid the pitfalls of limitations placed on interest expense.

Contact Krista Zuchowski at kzuchowski@cohencpa.com, Donna Weaver at dweaver@cohencpa.com or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.