One significant element of the Tax Cuts and Jobs Act of 2017 (“TCJA”) was the new limit on deductibility of business interest expense. The IRS has since published proposed regulations, which taxpayers can rely on as they await the release of final regulations. However, these proposed regulations provide complex rules and procedures dealing with interest expense incurred by consolidated groups, partnerships and partners, S corporations and controlled foreign corporations. This exclusive Property Matters - article will guide you in navigating changes in the real estate industry related to the business interest expense limitation. The proposed regulations provide a much broader and encompassing definition of interest than previous interpretations of the term for tax purposes.
For tax years beginning after 2017, the TCJA amended Section 163(j) of the Internal Revenue Code to limit the deduction for business interest incurred by both corporate and noncorporate taxpayers to the sum of:
- Business interest income for the taxable year,
- 30% of the taxpayer's Adjusted Taxable Income (a new defined term) for the tax year, and
- the taxpayer's floor plan financing interest paid by vehicle dealers for the tax year.
The limit applies to all taxpayers with business interest expense, except those with average annual gross receipts of $25 million or less, adjusted annually for inflation, and certain businesses like real estate that elect to exempt themselves. The regulations also include rules governing when related entities must be aggregated for purposes of the small business gross receipts exception.
The amended rules allow for the indefinite carryforward of any business interest not deducted because of the limit.
The new definition of "interest"
The proposed regulations define “interest” as, “any amount paid or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement, including a series of transactions.” The definition also includes amounts treated as interest under other tax code provisions or tax regulations. For example, original issue discount and accrued market discount fall under this definition.
The far-reaching definition incorporates certain items not previously treated as interest such as guaranteed payments by a partnership for the use of capital. The definition includes as interest certain amounts that are closely related to interest and affect the economic yield or cost of funds in a transaction involving interest. This definition maintains regardless of whether the amounts are compensation for the use or forbearance of money on a standalone basis. Examples include substitute interest payments, certain debt issuance costs and certain commitment fees.
Amounts associated with time-value components that weren’t previously treated as interest would now be deemed interest. A swap transaction with significant nonperiodic payments, for instance, would be treated as two separate transactions — an on-market, level payment swap and a loan.
The IRS acknowledges that, in some cases, certain items could be tested under the business interest limit that aren’t treated as interest under other tax law provisions. For example, an amount that was previously fully deductible as a business expense under Section 162 could now be tested as a business interest expense subject to limitation.
This will likely make it more difficult to negotiate financing deals with lenders that are structured to increase the borrower’s deductible costs and reduce its costs subject to limit. For example, in the past, a business might negotiate a lower interest rate in exchange for a higher loan commitment fee that it could fully deduct. Now; however, that fee could be considered interest expense. The impact will be greater as a company takes on more debt or interest rates edge higher.
The real estate exemption
The ability to elect out of the application of these rules applies to a broadly defined group of real estate activities including:
- Development or redevelopment
- Construction or reconstruction
The election is made for each eligible real estate trade or business by attaching a statement to a timely filed federal tax return. Once made, the election is irrevocable.
In order to qualify for the election, the real estate trade or business you operate must depreciate its nonresidential real property, residential rental property and qualified improvement property using the Alternative Depreciation System (“ADS”). Interestingly, personal property (i.e. furniture, fixtures, etc.) are not required to be depreciated under ADS meaning those assets will still qualify for bonus depreciation. Until recently, it was not clear if this provision applied to property placed in service before 2018 or how to make an election changing the depreciable life if it did.
On Christmas Eve, the IRS released a Revenue Procedure clarifying how to make the ADS election and what property is affected:
- The election is not treated as a change in accounting method so there is no need to file a Form 3115, recompute previously taken depreciation, or recapture prior bonus depreciation;
- ADS treatment applies to "old" and newly acquired nonresidential rental, residential real or Qualified Improvement Property. The election will be treated as a change in use. The adjusted depreciable basis of the affected property as of the beginning of the year of change is depreciated over the remaining portion of the new, longer recovery period as of the beginning of the year change.
- The shorter 30-year ADS life for residential real property applies only to property placed-in-service after 12/31/17. Residential real property placed in service prior to 1/1/18 is depreciated using the 40-year ADS life in effect when the property was placed in service; and,
- The ADS election does not apply to any other types of property meaning that equipment, furniture, fixtures and other personal and short-lived property may still be covered using accelerated or bonus depreciation methods as appropriate.
Please feel free to contact your Friedman LLP tax professional to discuss this new deduction limitation, how it may affect your business and what alternatives are available to you.