Simplifying Deduction Limitations of Business Interest Expense

The Tax Cuts and Jobs Act (TCJA) of 2017 brought significant changes to Internal Revenue Code Section 163(j) of the Internal Revenue Code, which previously applied only to certain interest paid or accrued by corporations.

The TCJA expanded the scope of Section 163(j), and further amendments were made by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in 2020. Final regulations under Section 163(j) were issued by the Treasury Department and the IRS in September 2020 and January 2021.

What is the Section 163(j) limitation?

Taxpayers can generally deduct interest expense paid or accrued during the taxable year. However, if the Section 163(j) limitation applies, the deductible business interest expense in a taxable year cannot exceed the sum of:

• The taxpayer's business interest income for the taxable year;
• Thirty percent of the taxpayer's adjusted taxable income (ATI) for the taxable year; and
• The taxpayer's floor plan financing interest expense for the taxable year.

Under the CARES Act, a different percentage (50%) of ATI applied for the 2019 and 2020 taxable years. Initially, the calculation of ATI included an add-back for depreciation and amortization, making ATI like EBITDA (earnings before interest, taxes, depreciation, and amortization). However, the add-back of depreciation and amortization expired for tax years beginning after December 31, 2021. This change resulted in many taxpayers facing limited or higher interest deduction limitations, which unfortunately led to significant tax liabilities for highly leveraged taxpayers.

Who is affected by the Section 163(j) limitation?

For taxable years beginning after December 31, 2017, the limitation applies to all taxpayers who have business interest expense, other than certain small businesses that meet the gross receipts test in Section 448(c). A business meets the gross receipts test of Section 448(c) when it is not a tax shelter (as defined in Section 448(d)(3)) and has average annual gross receipts of $25 million or less in the previous three years ($31 million for the 2025 tax year after applying with annual inflationary adjustments to the thresholds).

Partnerships and excess business interest expense

The Section 163(j) limitation is applied at the partnership level. Business interest expense that may be deducted upon application of the Section 163(j) limitation is considered in determining the non-separately stated taxable income or loss of the partnership.

Any business interest expense of the partnership that is disallowed upon application of the Section 163(j) limitation is allocated to each partner in the same manner as the non-separately stated taxable income or loss of the partnership. This amount is called excess business interest expense. A partner carries forward its share of EBIE. In a succeeding taxable year, a partner may treat its EBIE as business interest expense paid or accrued by the partner to the extent the partner is allocated excess taxable income or excess business interest income from the same partnership.

Electing real property trade or business

A taxpayer with an eligible real property trade or business may elect not to apply the Section 163(j) limitation by following the procedures outlined in Treasury Regulations §1.163(j)-9. Once made, an election is generally irrevocable and binding on the trade or business for all succeeding years.

There is a cost of electing out of the Section 163(j) limitation: by electing out, the following categories of assets that you hold in the electing real property trade or business must be depreciated over longer lives using the alternative depreciation system (ADS) and are not eligible for a bonus depreciation deduction under Section 168(k):

• Nonresidential real property (39-year life becomes 40 years)
• Residential rental property (27.5-year life becomes 30 years)
• Qualified improvement property (15-year life becomes 20 years)

Carryforward of disallowed business interest expense

The amount of business interest expense disallowed as a deduction in the current year under Section 163(j) is carried forward to the next taxable. Your disallowed business interest expense carryforward may be limited in the next taxable year if the Section 163(j) limitation continue to apply.

How CLA can help

Understanding the limitations on the deduction of business interest expense under Section 163(j) is crucial for real estate businesses aiming to enhance financial outcomes. The Section 163(j) limitation has posed significant challenges for companies as they manage cash flow amidst elevated interest rates and increased tax liabilities.

These challenges also present opportunities to add value through strategic tax planning and discussions. CLA's real estate industry tax team can help you by:

• Modeling the effect of the Section 163(j) limitation
• Using a cost segregation to identify 5- and 7-year property eligible for bonus depreciation for electing real property business
• Using a repair study to identify real property improvements that can be immediately expensed even if your business is not eligible for bonus depreciation