The Hidden Tax Impacts of High Interest Rates on Real Estate Investments

Higher interest payments are only part of the story when rates climb. During a recent Real Estate Industry Update, Daniel Roccanti and Kyle Paxton from James Moore & Company explored the hidden tax impacts of high interest rates that catch many real estate investors off guard. This discussion highlighted how Section 163(j) of the Tax Cuts and Jobs Act creates timing limitations on interest deductions that can significantly affect syndications, funds and highly leveraged deals.

“When rates go up, your interest expense goes up. Everyone expects that. But what people don’t expect is paying more taxes,” Roccanti explained. “So when your cash flow gets tighter, how can you pay more taxes?”

Understanding Section 163(j) and Business Interest Limitations

The Section 163(j) limitation determines how much business interest a taxpayer can deduct in a given year. Paxton described the mechanics: the calculation compares your business interest expense against 30% of your adjusted taxable income. Any interest expense exceeding that cap carries forward indefinitely rather than disappearing entirely.

“If your deal is highly leveraged, this is going to affect you the most,” Paxton noted. The adjusted taxable income figure starts with your bottom line net income and includes add-backs for depreciation and amortization.

Congress did create exceptions to this rule. The most significant is the small business exception, which applies to businesses averaging approximately $30 million or less in revenue over three years. However, there’s a critical caveat that affects most real estate syndications.

The Tax Shelter Classification Problem

“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,” Paxton explained. If an entity allocates 35% or more of its losses to limited partners or passive investors, it becomes classified as a tax shelter for tax purposes and cannot qualify for the small business exemption.

This creates a common problem in the fund space. As Paxton described, “These are typically structured to where a piece of property is acquired, you have your batch of partners… 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.”

Even deals significantly under $30 million in revenue often fall into this category, requiring careful consideration of 163(j) implications.

Common Triggers That Create Tax Surprises

Several scenarios frequently drive 163(j) limitations for real estate investors. Paxton identified four common triggers: 

• Interest-only debt at high rates
• Value-add plans where NOI ramps up later
• Refinance deals where interest expense spikes but cash proceeds don’t drive taxable income
• The way disallowed interest flows down to the partner level in partnerships

“If you’re highly leveraged, if your NOI is low, these are just common triggers of hey I need to think about 163(j),” Paxton said.

The Real Property Trade or Business Election

One strategy to mitigate 163(j) limitations involves electing out of the regime entirely through the Real Property Trade or Business election. However, this comes with trade-offs.

“The catch in this instance is that if you elect out of 163(j)… you have to switch to ADS as your method of depreciation on certain classes of assets within the property,” Paxton explained. Since ADS depreciation is generally slower than standard MACRS depreciation, investors must weigh whether deducting all interest now justifies slowing down depreciation expense.

Roccanti emphasized that this decision should be built into your model before purchasing real estate. “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?”

Why Tax Modeling Is Essential in Today’s Environment

Both hosts stressed the importance of incorporating tax assumptions into acquisition underwriting. Most models stop at cash flow before tax, but current interest rates and these rules demand a more comprehensive approach.

Roccanti highlighted what investors care about most: “One, are you giving them what they promised?… 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.”

Paxton recommended tracking several core inputs including taxable income estimates by year, tax distribution estimates based on partnership agreements and what he called an “after-tax DSCR” or tax distribution coverage ratio. This measures cash available for distributions divided by expected tax distributions.

Refinancing Requires Immediate Attention

Refinancing events deserve particular scrutiny. “If you’re in a refinance conversation, that is a sign to stop and talk to your tax advisor,” Paxton advised. Rate resets change not just annual interest expense but the entire taxable income profile. Costs associated with refinancing are amortized over the length of the debt, further affecting calculations.

How Debt Structure Affects Who Benefits

Beyond timing of deductions, debt structure determines which investors can actually use the tax benefits. Roccanti explained the differences between recourse debt (where owners bear economic risk), nonrecourse debt (no personal liability) and qualified nonrecourse debt (collateralized by real property).

“Recourse and qualified nonrecourse, I’m at risk. Nonrecourse debt, I’m not at risk,” Roccanti summarized. This classification directly affects basis and at-risk limitations that determine whether losses are usable.

Plan Ahead to Protect Your Investors and Your Deal

The key takeaway from this discussion is clear. As Paxton stated, “163(j) decides when the deal gets the interest deduction. Debt structure decides who actually gets the benefit.”

Higher rates make interest deductibility a modeling issue that belongs at the front of every acquisition analysis. By understanding these rules and building them into your underwriting process, you can set realistic expectations with investors and avoid the surprises that damage trust and deal economics.

Check out the full Real Estate Industry Update video to hear Daniel Roccanti and Kyle Paxton discuss these topics in greater detail.