Tax Reform and Business Interest Expense Limitations: What Real Estate Businesses Need to Know
Originally published on March 9, 2020
Updated on October 31st, 2023
The Tax Cuts and Jobs Act (TCJA) of 2017 brought with it significant changes to the limitations on business interest deduction. Also known as the IRC 163(j) limitation, this change is of high importance to real estate businesses, which often rely on leverage to maintain operations and control their tax burden.
Prior to the TCJA, real estate businesses were unlikely to run up against deductibility issues. Today, it’s a growing concern. The change in approach is meant to curb the practice of business owners taking a very small equity stake in a business and relying on large interest expense deductions to offset owed taxes.
Old vs. new interpretation of business interest expense limitations
Under the old rules, business interest expense was generally fully deductible, limited only in unique cases involving related or foreign parties. Under TCJA legislation, deductions for business interest expense are much more limited, not exceeding the sum total of:
- The business interest income of the taxpayer;
- 30% of the adjusted taxable income of the taxpayer; and,
- The floor plan financing interest of the taxpayer.*
* – Floor plan financing is a revolving line of credit that allows the borrower to obtain financing for retail goods. This is most common in the auto dealership industry and is generally not seen in the real estate industry.
While these new guidelines cap deductions, any disallowed interest is considered paid in the following tax year and may be carried forward indefinitely.
This new legislation does not apply to small businesses with less than $25M in average gross receipts (inflation-adjusted to $26 million for tax years beginning in 2019) over the prior three-year period. It should be noted these provisions include aggregation rules that prevent related party taxpayers from circumventing the $25 million threshold for the business interest expense limitations by using either parent/child or brother/sister entities.
Real estate businesses and investors need to pay attention
Since business interest expense is now subject to limitations, larger real estate businesses exceeding $25 million in average gross receipts are likely to see a shift in their accounting. Let’s look at an example:
- XYZ Real Estate Holdings has $4,000,000 in adjusted taxable income, $2,000 in business interest income and $2,000,000 in business interest expense, with three-year average receipts of $33 million.
- In total, XYZ Real Estate Holdings can deduct up to $1,202,000 in business interest expense this year.
- The remaining $798,000 of its original $2 million business interest expense will be deducted in future years.
Examples like this similarly affect tax shelters, which must apply these provisions regardless of the average annual gross receipts.. Generally, a tax shelter includes an entity of which more than 35% of its interest is owned by limited partners or limited entrepreneurs (persons who have an interest in the enterprise and who do not actively participate in managing the enterprise).
Consider a partnership that owns a commercial rental property with a hefty mortgage and has a loss for 2018. There are has four partners, and each owns 25%. One partner is active in the business and the other three are passive investors. This partnership could be subject to the interest expense limitation rules of 163(j) regardless of its gross receipts because more than 35% of the losses are allocated to limited entrepreneurs.
Deduction rules for other flow-through entity structures have even more nuances. Both S corporations and partnerships must first calculate and apply the business interest limitation at the entity level. For S corporations, any disallowed business interest expenses remain at the S corporation level and are not passed through to shareholders. Any disallowed business interest expense at the partnership level will be passed through to the entity’s partners adding complexity to the partners’ personal income tax returns.
Electing to become a real property trade or business
There is an exemption to the new rules for business interest expense limitation. Companies can make an irrevocable election to be treated as a real property business—exclusive to real estate investment/holding companies and agricultural operations. Once elected, the real property trade or business is required to use the alternative depreciation system (ADS) to depreciate any of its non-residential real property, residential real property and qualified improvement property. The ADS requires these real property assets to be depreciated over a longer life than is required under the Modified Accelerated Cost Recovery System (MACRS) method of depreciation that is typically used.
Companies deciding whether to become a real property trade or business should run a cost-benefit analysis against both options, as well as a forward-looking analysis to determine the best course of action.
If you need help determining the right course of action for your real estate business, or you want to learn more about how the new limitations on business interest deduction may affect you, contact the real estate CPAs at James Moore.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
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