Section 163(j) and Real Estate: How High Interest Rates Create Hidden Tax Consequences
Originally published on February 3, 2026
“When rates go up, your interest expense goes up. Everyone expects that. But what people don’t expect is paying more taxes.” — Daniel Roccanti
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In this episode of Real Estate Industry Update, Daniel Roccanti and Kyle Paxton break down how today’s elevated interest rate environment creates unexpected tax consequences for real estate investors. The discussion focuses on Section 163(j) of the Tax Cuts and Jobs Act, debt structuring considerations and why tax modeling has become essential in acquisition underwriting.
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Full Transcript
[00:02] Daniel Roccanti: Welcome to the Real Estate Industry Update. I’m your host, Daniel Roccanti, here with Kyle Paxton. We’re going to talk about the hidden tax impact of today’s interest rate environment. If you’ve been paying any attention to the economy and interest rates, you’ve probably noticed that they’ve gone up a lot. So when rates go up, your interest expense goes up. Everyone expects that. But what people don’t expect is paying more taxes. So when your cash flow gets tighter, how can you pay more taxes?
[00:42] Kyle Paxton: Yeah, Daniel, this is an interesting conversation because like you said, you’re paying more interest. Inherently, that’s a bigger tax deduction, right? But there’s catches. I say that all the time with the IRS, there’s a catch everywhere. So today what we’re going through, we’re going to talk about Section 163(j), where and how that plays into high rate deals, how to model kind of acquisition feasibility when factoring in 163(j), and then the debt structure choices that decide where deductions land and how all of these factors tie into your tax picture. So let’s dive into it.
[01:08] Daniel Roccanti: Yeah. So let’s talk about why higher rates are more than just a debt service coverage ratio story. High point here is you got higher payments because basically interest has gone up, but there’s these tax limitations when it comes to business interest. The first one that we see that can be considered like a silent tax is this 163(j) business interest limitation. And this can be a surprise because it’s really about timing of deductibility which catches people off guard here. And then we’re also going to go into a few other areas about basis and at-risk loss limitations. And then debt terms, recourse, nonrecourse. Why does this matter when you’re trying to deduct all of this interest that you’re having from these higher interest payments and how it affects you and your investors? All right, I’ll dive into 163(j) here.
[02:06] Kyle Paxton: And this is something I say, it feels like in every one of these videos because I’m a big tax nerd, but back when the Tax Cuts and Jobs Act came out in 2018, I was eat, sleep 163(j). So well-versed in an area of the code that I enjoy talking about. It’s less fun in practice because it is kind of a negative implication here and limits deductibility, but it’s fine. So really how this functions is that 163(j) drives how much of your business interest as a taxpayer you can deduct in this year. Anything over that cap doesn’t vanish. It just carries forward indefinitely.
[02:44] Kyle Paxton: And so what this calculation looks like is it takes your business interest and compares it against what’s called your adjusted taxable income. And so the adjusted taxable income is taken with your bottom line net income in your business with some add-backs. And so the add-backs include depreciation and amortization, different buckets of interest to get to this adjusted taxable income number. And then 30% of that adjusted taxable income is what’s compared to your business interest expense to determine whether or not that interest expense is deductible.
[03:24] Kyle Paxton: And certain taxpayers are subject to this, which we’ll talk about in a minute. But at a high level, that’s the mechanics of this. And the idea here is just that what this looks like in practice is that you have sufficient adjusted taxable income to stomach this interest deduction. And that’s your business interest holistically. So that can be your bank interest. That’s interest on debt that the company has. This looks a lot of different buckets, but that’s the general mechanics of how this functions. So if your deal is highly leveraged, this is going to affect you the most.
[03:47] Kyle Paxton: Now thankfully, Congress did put in some exceptions to this rule. So you might not be subject to 163(j) if you meet some of the exceptions. The largest one is the small business exception. They put this in for a lot of things. Basically, if you’re considered a small business, there’s a lot of rules that just don’t apply to you, and this is one of them too. It’s basically to be considered a small business, your revenue needs to be about 30 million approximately, averaged over 3 years. If it’s that or less, then you’ll meet the small business exception and 163(j) doesn’t matter. Sign of relief for a lot of people. 30 million in revenue is still a lot of revenue for a lot of people. Most people are still going to be under it.
[04:38] Kyle Paxton: Now unfortunately, there’s one caveat that affects most real estate, especially funds and syndications, and that is there’s no exception if you’re a tax shelter. There’s a lot of rules with a tax shelter, but the most important one is that if you are allocating 35% or more of your losses to limited partners or investors in this case, passive investors, then you’re considered a tax shelter for tax purposes and you cannot meet the small business exemption and so you have to consider 163(j). So a lot of real estate funds and syndications that are investing in these things, even though they’re significantly maybe under 30 million in revenue, they’re considered a tax shelter and now they have to consider 163(j).
[05:14] Daniel Roccanti: You know, this is a classic problem in the fund space, right? Because you have these typically structured to where a piece of property is acquired, you have your batch of partners, you have one or a couple GPs and then a laundry list of LPs. And then when the property is placed in service, a cost segregation is done to accelerate depreciation and generate taxable losses for the GPs and the LPs. And so even if there’s not a loss economically on that deal, you’re filtering through a taxable loss driven by depreciation.
[06:00] Daniel Roccanti: And that’s where you can really get into this trap to where now you have to, we’ll dive into this a little more, but you get into this calculation on what’s the trade-off on, in this structure, my interest expense on the debt securing the property is no longer deductible or I have a trade-off to where I have to sacrifice some of the depreciation I’m taking. So this is a calculation we do quite frequently with our clients in the real estate space and it comes back to: is there a taxable loss in the entity? And again, in these initial years it’s prettyREIU frequent it occurs. And then is more than 35% of that loss allocated to the LPs?
[06:26] Daniel Roccanti: And Kyle and I did a video on 163(j). Go back watch our video if you want to get really more technical because it only focuses around this. But the nice thing is that we were really worried about the 163(j) because of the changes. Basically, they were going to make us keep depreciation to get to the adjusted taxable income. Thankfully, the One Big Beautiful Bill came in and changed that. It went back to more what an EBITDA is. So basically, we can add back depreciation before we get to that 30% limitation calculation.
[07:16] Daniel Roccanti: This helps out a lot, especially because real estate loves cost segs. They love front-loading their losses. So if we were going to have to include that whole depreciation deduction, now we have a whole different story. Thankfully, this is going to save a lot of the people in the real estate. I think they weren’t trying to hurt all these syndications and funds and everything. So I think they’re trying to come back to the table and be like, “All right, let’s think this through.” And yes, we don’t want to let people take these huge leverage deductions, but we don’t want to hurt the standard real estate industry that is just doing what it always does, which is leverages the real estate property and then provides a nice deduction, especially upfront to its investors.
[08:05] Daniel Roccanti: And so this really helps out, but it still needs to keep in mind because the math still might happen. There still might be a limitation and you should really be modeling this, calculating what the 163(j) is, especially as you’re underwriting the product, as you’re underwriting the real estate in your acquisition because you just don’t want to get surprised. Investors, they care about two things. One, are you giving them what they promised? Whatever you promised upfront, they want that. And then two, they want zero surprises. And if there are going to be surprises, they want to make sure that the fund manager is out in front of it, reacting to it, giving them the information as soon as possible.
[08:51] Daniel Roccanti: Most people understand that in this world, nothing’s 100% predictable, right? We want it as close as possible and we want to make sure when they are that there’s a good fund manager letting us know. And then what can they do about it?
[09:20] Kyle Paxton: Absolutely. So in talking about kind of where these surprises come from, right? So like we said, one thing 163(j) pops up for the syndications, tax shelters, or often referred to as syndications in the real estate space. Daniel touched on the importance of modeling. This can change year to year and especially over the last couple years where this was started by the Tax Cuts and Jobs Act and as some of the provisions started phasing out, the rules changed and so that had negative implications for real estate entities backward looking. And then forward looking here with the One Big Beautiful Bill kind of boost to 163(j) that gives us some more wiggle room.
[09:42] Kyle Paxton: It’s still really important that we’re modeling what our taxable income looks like year over year and if there’s any scenarios where we fall into this trap and then if so, what can we do to mitigate that? So four common triggers that tend to kind of drive this or drive change in that year-over-year analysis is: do you have interest-only debt at high rates? See that an issue frequently here. Do you have a value-add plan where NOI ramps up later? Are you doing a refi deal where interest rate expense spikes but the cash proceeds aren’t driving taxable income? And then the other issue is with how this functions within partnerships is that the disallowed interest actually flows down to the partner level.
[10:34] Kyle Paxton: So having a good grasp on how that interest is flowing to the partner level and when it gets released is important in mitigating those surprises and communicating that. Now the individual partner has this carryover that flows down to their personal tax return in a pass-through entity that they have to track going forward. How do you track it and what scenarios cause the release of that carryover? So those are big kind of drivers in this year-over-year change and something that we really look at in this area.
[10:54] Kyle Paxton: So if you’re highly leveraged, if your NOI is low, these are just common triggers of hey, I need to think about 163(j) because your adjusted taxable income when we’re computing that is going to decide if I can take this. I don’t ever lose it, but it might be carried over in future years when then we got to run the calculation again.
[11:18] Daniel Roccanti: So basically when your cash flow is feeling tight because interest is a real expense. I have to pay this interest, but then what my investors are getting on their K-1 is going to be different than their expectations. One way to get around this is basically modeling what we were saying in the surprise. So if you can basically model what you think it will be out, then that’s going to help your investors have an expectation of, hey, there’s going to be a 163(j) limitation. We already know, but we build it out to avoid surprises.
[11:40] Daniel Roccanti: And so this helps your investors with their expectation. And it’s built into your rate of return so that your investors already understand, hey, we are going to get a return. It just might be spread out over a longer time and might not be as front-loaded at the beginning, but you’re still probably getting a pretty big deduction if you’re doing the cost segregations, front-loading expenses. So it all needs to be added into your model.
[12:09] Kyle Paxton: Absolutely. So in looking at kind of strategies to mitigate this, Daniel touched on modeling. Looking at kind of bucket B of strategy here is what’s called the Real Property Trade or Business election. So here’s what I mentioned before. We kind of have the opportunity to opt out of the 163(j) regime. As with the IRS, if there’s something that’s too good to be true, it probably is, right? So there’s catches.
[12:34] Kyle Paxton: And so the catch in this instance is that if you elect out of 163(j), so let me take a step back, quick example here. We have a new multifamily property that is placed into service. There’s a taxable loss driven by depreciation from a cost segregation. We’ll just say 50% of the loss is allocated to limited partners. And let me clarify, limited partners isn’t a limited partner by the technical legal definition. It is individuals who are passive in the activity and not part of the day-to-day management. So there is kind of a terminology definition snafu there.
[13:21] Kyle Paxton: But the idea here is you can elect out of 163(j) and then your interest is deductible in full without being subject to this test. The catch is that you have to switch to ADS as your method of depreciation on certain classes of assets within the property. And generally ADS is slower than the standard MACRS method of depreciation. So part of this calculus that we do is sitting down and saying, okay, is the benefit of being able to deduct all the interest expense now more beneficial than kind of the slowdown of the depreciation, or more beneficial if we were able to take the MACRS depreciation?
[14:08] Kyle Paxton: Really taking a look at that: is the ability to deduct our interest now worth slowing down our depreciation expense? And many times it is. Once you make that election, you’re in it. It’s a one-time election and carries forward. So we often see that occur in the first year an entity is started and the property’s placed into service.
[14:32] Daniel Roccanti: Yeah. And Kyle makes a good point here. The Real Property Trade or Business election. Do we opt in? Do we opt out of this? Really needs to be built into your model before you even buy the real estate. Hey, what do I need to consider here? Do I care more about taking the interest expense now and slowing down depreciation, or do I care more about taking depreciation upfront which might slow my interest deductions? A lot of times these work together. Sometimes you might have to worry about both, but you need to consider it especially for these larger deals that you’re doing that are highly leveraged.
[14:58] Daniel Roccanti: Really need to build this out so you understand when you’re structuring your financing. Think about the taxes in mind. Not only do I need to make money, but I really need to understand what the tax concept is because a lot of your investors are getting sold, “Hey, you’re going to get losses. You’re going to get losses.” A lot of what people’s selling point is, especially losses upfront first year, first or second year, significant losses. And so you want to make sure that your goal isn’t always to maximize every deduction at all costs. It’s more about expectations and then avoiding accidental tax distributions when your cash is already tight.
[15:51] Daniel Roccanti: By modeling this out, you can already get an idea of, okay, this is what cash I’m going to need. These are the deductions I’m going to have, and this is when maybe phantom income is going to happen to our investors. And we need to think about, hey, do we need to make tax distributions? Are we going to have the cash to do that? Which takes us to the underwriting side here. How do you actually model feasibility in cash flow after tax for acquisitions and refinances?
[16:15] Kyle Paxton: And so looking at that, most models we kind of stop at cash flow before tax, right? But in the current interest rate environment and with these rules in play, you definitely have to factor in the tax component of this. I often say don’t let the tax drive the economics. This is a big exception to that because this can be a significant part of this conversation and it’s an area of big surprise with the tax shelter syndication area. These are areas the IRS scrutinizes. They don’t like taxable losses, right? And so these returns tend to have maybe another set of eyes on them or something that increases the risk a little bit.
[16:58] Kyle Paxton: So having a good grasp on these rules is good from just the compliance standpoint, but also of course avoiding the surprises. So when we’re looking at the tax cash flow overlay and looking at the cash flow and tax implications, we really want to look at what are the core inputs here. We talked about taxable income estimate by year. Daniel and I just recorded a video talking about generating dashboards where we get information more in real time. Super helpful in this space.
[17:18] Kyle Paxton: Then we look at, okay, estimating our tax distributions based on the partnership agreement. How is cash going to be flowing out? And then looking at our after-tax DSCR and or the tax distributions coverage ratio and really just looking at what is the cash available for distributions divided by the expected tax distributions. And so kind of looking at those core outputs helps in building our model and making sure we have a good grasp on the cash flow side of this conversation.
[17:46] Daniel Roccanti: Yeah. And I really like the after-tax debt service coverage ratio. It’s really a tax distribution coverage ratio. The same way you are doing KPIs for, hey, can I service my debt? Do I have the cash to service my debt? Same for, do I have the cash to service my distributions? You want to make sure that when you’re in the underwriting process here that you’re thinking about that.
[18:21] Daniel Roccanti: And you should be thinking about a lot of the other things like a checklist kind of. We’ve mentioned existing elections at the entity level going back to, all right, if I’m doing the 163(j), am I electing out of it by doing the Real Property Trade or Business election? What about the carryforwards? Am I going to have any carryforwards? That should be built into your modeling here and understanding that I won’t be getting that deduction.
[18:53] Daniel Roccanti: Again, back to depreciation, how is that going to affect it? Am I going to do a cost seg? Am I going to elect to do ADS and I don’t have that significant depreciation? It’s going to be spread out. And then always need to be doing planned capex. What’s the timeline? When are my repairs and my improvements going to come in? How is that going to affect my cash flow? If I know, if I have it modeled out that I’m going to have a huge capex in a couple of years, my investors are expecting it. I can plan for it. My cash flow and everything can plan for it.
[19:21] Daniel Roccanti: And then last but not least is always your exit strategy. Anytime you get into a deal, know what your exit is. Whether it’s 5 years, 7 years, 10 years, 12 years. You really need to be planning out from beginning to the end. When you’re doing kind of the underwriting here, when you’re in acquisition, I need to know what my exit strategy is. Meet that expectation by basically going from beginning to the end and providing a timeline and what to expect to all your investors.
[19:49] Kyle Paxton: Absolutely, Daniel. And then I want to take a moment to just emphasize, if you’re in a refinance conversation, that is a sign to stop and talk to your tax advisor, right? Because a lot of times refinances, I have these conversations all the time. “Oh, we refied, interest expense changed.” It’s a lot deeper than that in this space. Rate resets change, which obviously changes your annual interest expense, but also changes your entire taxable income profile.
[20:12] Kyle Paxton: And there’s some things like the small one, but that can drive big implications, is that with the refi, you have costs associated with the refi, right? Those costs are amortized over the length of the debt. And so that changes your taxable income that we’re talking about. And then we talked about too in that specific example, amortization is added back for purposes of the adjusted taxable income. But the point I’m trying to demonstrate here is just that these events have a change on your bottom line taxable income, have a change on that interest expense, and how these things interplay is an important thing to be ahead of to mitigate those surprises.
[21:01] Daniel Roccanti: Yeah. Hopefully you’re already including refinancing in your beginning model in the underwriting process. You’ve already modeled, okay, we’re going to refi. But reality is it’s hard to predict what the future will be like in 5, 10 years when you got a refi. So we want to make sure that, okay, once we’re doing a refi, we’re coming up, we know what the actual numbers are. Let’s update our model.
[21:24] Daniel Roccanti: Because most likely now my interest expense has gone up. How is that affecting me? I know we’re just replacing old debt, but tax-wise it’s not that clean. We need to really be talking about basically, okay, how is this going to affect our taxable income, our losses, and what gets allocated to our investors. So it’s just important that when you’re refinancing because the environment changes quickly. And anyone who’s doing funds and deals know that right now refinancing is way more complicated.
[21:47] Daniel Roccanti: Before you might be able to do a little bit more traditional refinancing with the bank. Now banks are tightening up a lot. They might not even be willing to lend you all the money. So now you’re going to have to layer your debt. You have to bring in some mezzanine debt, which is going to be higher, maybe even shorter terms onto your traditional debt. Was that factored into it? It might not have been if you were able to use a more traditional model when you first were able to acquire your property.
[22:28] Daniel Roccanti: So let’s talk, Kyle. Let’s talk a little bit about debt structuring. What gets overlooked a lot in debt structuring is recourse and nonrecourse. Probably to the average taxpayer, you don’t really think about how my debt is actually structured actually affects me for tax purposes. And what that means is in a lot of these deals, you get this thing called basis or at-risk. And what kind of debt affects that?
[22:53] Daniel Roccanti: And there’s a couple different kinds of debt. One is recourse. Recourse debt means that I’m as an investor or I’m as an owner partner, it is guaranteeing some of this debt. I bear some of the economic risk. So basically, if this debt, I’m going to lose something because I have to pay this back no matter what. Then there’s nonrecourse, which basically just means that I’m really not at risk. This is a lot of times like credit card debt, things like that. If I can’t pay it back or something, no one’s going to come after me basically. There’s not really an economic risk.
[23:44] Kyle Paxton: To be clear, you’re talking about you personally, right? So the company credit card debt, now they’re not coming after Daniel Roccanti related to that.
[24:05] Daniel Roccanti: Right, they could still come after at the entity level, things like that, but they’re not going to come after me personally. And so then last but not least, the one that gets used all the time in real estate is qualified nonrecourse. And this just is basically debt that is collateralized by real property. So when you go and you buy that apartment complex building, usually you’re getting the loan that is collateralized by the property itself.
[24:27] Daniel Roccanti: And so even though it’s considered nonrecourse because they can’t come after you personally, they can come after the real property and they will take that back from you basically. And so that gets to get added on when you’re doing your basis and you’re at-risk. And so you’re still at risk because you can lose something. So it’s important when you’re looking at this: recourse and qualified nonrecourse, I’m at risk. Nonrecourse debt, I’m not at risk.
[24:45] Kyle Paxton: And like Daniel said, so that’s the classic structure of these deals, right? You have a property secured by qualified nonrecourse debt. It gets allocated to all of the partners. The operating agreement spells out how loss is allocated against that debt across all the partners. And so that’s what’s driving that cost segregation, large depreciation deduction loss, which is triggering the tax shelter syndication rules and bringing the 163(j) into play here.
[25:09] Kyle Paxton: So that’s how from a tax world all that ties together. And then bringing it back just to kind of higher rates and 163(j), again we talked about how higher interest increases the size of the potential deduction, but that debt structure influences whether the losses are actually usable with the basis conversation. And the big one that gets all people all the time in these deals is how the economic risk is distributed among partners.
[25:38] Kyle Paxton: So you have the GPs, the LPs, what’s been communicated to them. Like Daniel said, a lot of time we have those big promises in year one, large taxable loss. Is that actually going to happen to LP number 100 based on how the debt’s being allocated? So that’s a very important consideration as we go through this. And then certainly the investor communications around this.
[26:03] Kyle Paxton: A lot of times I find that taxpayers who enter these deals, that LP number 100 has no real estate background, doesn’t understand these concepts, and so they’re just told that they’re going to invest money and get a loss. And then when that doesn’t happen, it causes a massive communication breakdown and loss of trust. So in practical takeaways here from a structuring standpoint, making sure we align that debt structure with the investor profile, guarantee willingness, who is actually willing to put themselves on the line for this debt and make it recourse.
[26:42] Kyle Paxton: A lot of times that’s required by banks in certain loan packages. So does that person exist? And then what does that impact to everyone else included in the deal? And then of course kind of holding period of the investment. What does that look like? And then the accidental complexity is just the guarantees that don’t align with what’s outlined in the partnership agreement and drives the tax allocations don’t align with what’s been delivered upfront. And then just making sure that expectations throughout the whole process align. So those are big considerations and making sure that how the debt’s structured aligns with the deal economics and the models.
[27:04] Daniel Roccanti: Yeah. And so closing here, the 163(j), this decides when the deal gets the interest deduction. Debt structure decides who actually gets the benefit.
[27:24] Kyle Paxton: Bada boom, bada bing. That’s a line right there.
[27:27] Daniel Roccanti: Well, let’s wrap up here. I’ll dive into a couple quick takeaways. One, higher rates make interest deductibility a modeling issue, right? This should be front of mind in modeling. This is the one time where I’m violating my rule of not letting the tax drive the economic decision-making.
[27:44] Kyle Paxton: And then 163(j) is a timing problem and it can be a significant timing problem. So just making sure you’re aware of that. When can I deduct this interest? Are there any additional steps I need to do to get this interest deduction and do those additional steps make sense? And then making sure that the debt structure aligns with what our intentions are in terms of who can use these tax results all factor into this process. And those are the big takeaways of our conversation here.
[28:09] Daniel Roccanti: Yep. So if you’re underwriting a deal this month, just join us next time for our next video.
[28:14] Kyle Paxton: Appreciate you all.
[28:16] Narrator: To learn more about James Moore and Company’s real estate accounting and business solutions, go to jmco.com and don’t forget to subscribe to our Real Estate Industry Update series to receive updates when new videos are released. If you’d like to be a guest or if there’s a topic you’d like to see covered on a future episode, contact us through our website or email us at info@jmco.com. You can also follow us on social media for more news as the landscape of real estate continues to evolve.
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