Many of us have been anxiously awaiting tax legislation change under the Biden administration to correct and mitigate several tax codes. But in order to move forward, there is value in looking back with regard to the business interest deduction limitation.
The Tax Cuts and Jobs Act (TCJA) of 2017 revised Section 163(j) by imposing a limitation on the deduction for business interest expense for years beginning after December 31, 2017. Section 163(j) limits business interest payments for taxpayers with gross receipts under a specific threshold ($27 million for 2022).
To determine the amount of deductible business interest expense permitted, a calculation is required, the result of which cannot exceed the sum of:
- The taxpayer’s business interest income,
- 30 percent of the taxpayer’s adjusted taxable income (ATI), and
- the taxpayer’s floor plan financing interest.
During the COVID-19 pandemic, Congress provided temporary relief from the negative impact of the business interest limitation. Thanks to the CARES Act, taxpayers were able to elect to use 50 percent of their ATI limitation for 2019 and 2020 (rather than the normal 30 percent) and to use their 2019 ATI to compute their 2020 business interest limitation. This enabled many businesses to deduct their full business interest expense.
In 2022, the business interest limitation returned to the 30 percent of ATI limitation with added pain points – depreciation, amortization, and depletion can no longer be added back in the calculation of ATI. As a result, more taxpayers will be limited in their business interest deduction, even if they were not previously subject to the limitation.
Pursuant to the TCJA of 2017, there are two business interest limitation opportunities – one of which is of particular importance to the real estate industry:
- Small Business Limitation: Certain businesses are eligible for a “small business exception” to Section 163(j). To qualify, the business’ gross receipts must be less than the gross receipts threshold amounts, and the business cannot be a “tax shelter,” per the IRS definition.
- Election Out: Certain real estate businesses may consider making a one-time irrevocable election to opt out of the Section 163(j) limitation. However, these taxpayers would then be required to use the Alternative Deprecation System (ADS) for certain categories of assets, which has longer depreciation periods and lower annual depreciation deductions than under the regular depreciation rules. Further, the affected assets are not eligible for a bonus depreciation deduction.
Real property businesses that elect out of the Section 163(j) limitation must depreciate their current and future residential rental property, nonresidential real property, and qualified improvement property using ADS, which means there is a slightly longer depreciation period for residential and nonresidential properties. Other asset classes — such as land improvements, five-year, and seven-year property — will continue to be depreciated under the regular depreciation rules and can be eligible for bonus depreciation.
For reference, the depreciable periods under the regular depreciation rules as compared to ADS are as follows:
- Nonresidential real property – Depreciable period changes from 39-year life to 40-year life
- Qualified improvement property – No longer eligible for bonus depreciation under ADS and depreciable life extended from 15 years to 20 years
- Residential real property – Depreciable life changes from 27.5 years to 30 years
It is important to compare the projected business interest limitation to the longer depreciation period to determine whether the real property business election is right for your business. It is also important to note that this analysis would have been done in previous years, but the result may be very different under the new rules effective for the 2022 tax years.
Please contact us to discuss the opportunities that may exist for your real estate business under this, and other, tax provisions.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.