The deduction limit for business interest expense can have a big impact on a real estate firm's tax bill and the limit is even more stringent starting in 2022. If your firm has significant interest expense, it is important to: (1) Determine whether the deduction limit applies to you; (2) Assess the limit's impact on your tax liability; and (3) Evaluate the costs and benefits of opting out.
The Tax Cuts and Jobs Act of 2017 amended Internal Revenue Code Section 163(j) to impose a limit on deductions of business interest expense, with an exception for "small businesses" (see below). For tax years beginning after December 31, 2017, Section 163(j) provides that a taxpayer's deduction of business interest expense in a given tax year cannot exceed the sum of:
- The taxpayer's business interest income (which does not include investment income);
- 30% of the taxpayer's adjusted taxable income (ATI); and
- The taxpayer's floor plan financing interest.
Disallowed interest expense may be carried forward indefinitely to succeeding tax years.
Floor plan financing is typically used by auto dealers and certain other retailers. So, for real estate firms, deductions are generally limited to their business interest income, if any, plus 30% of ATI. ATI means taxable income, computed without regard to:
- Nonbusiness income, gain, deduction or loss;
- Business interest income or expense;
- Net operating loss deductions;
- The qualified business income deduction; and
- Depreciation, amortization or depletion (for tax years beginning before 2022).
To provide businesses with temporary relief during the COVID-19 pandemic, the CARES Act of 2020 increased the deduction limit to 50% of ATI for 2019 and 2020 and allowed businesses to calculate the 2020 limit based on their 2019 ATI. Now, however, the limit is back to 30% of ATI. In addition, for tax years beginning after 2021, businesses may no longer add back depreciation, amortization and depletion in computing ATI. As a result, many real estate firms will see their interest deductions reduced this year, some for the first time.
Related Read: CARES Act Issues Facing Real Estate Clients
Does the Limit Apply to You?
Section 163(j) contains an exception for "small businesses," defined as businesses, other than tax shelters, with average annual gross receipts for the preceding three years of $25 million or less. This threshold is adjusted annually for inflation and currently stands at $27 million. Keep in mind that to determine whether your firm qualifies as a small business, you may need to aggregate your gross receipts with certain related businesses.
Even if your firm's gross receipts are below the threshold, it is disqualified from claiming the small business exception if it is considered a tax shelter. A tax shelter includes a partnership or other pass-through entity if more than 35% of its losses during the tax year are allocable to limited partners or "limited entrepreneurs" (owners who do not actively participate in management). If your firm meets this definition, there may be strategies you can use to avoid tax shelter status, such as reducing the amount of losses allocated to limited partners or limited entrepreneurs, or having those owners actively participate in the management of the firm.
Should you opt-out?
If you are ineligible for the small business exception, you can still avoid the business interest limit by filing an election to opt-out. This option is available to real property businesses, which include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing and brokerage businesses. However, opting out comes at a cost; once you make the election, which is irrevocable, you must use the alternative depreciation system (ADS) for nonresidential real property, residential rental property and qualified improvement property. Depreciation periods are longer under ADS, which results in lower depreciation deductions. Also, qualified improvement property loses its eligibility for bonus depreciation.
Whether opting out is the right choice depends on your firm's particular tax circumstances. You will need to weigh the benefits of fully deducting business interest against the cost of lower depreciation deductions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.