For more than a year, owners of real estate businesses have debated whether it’s beneficial, or not, to elect out of the proposed rules for interest expense limitations under section 163(j) of the Tax Cuts & Jobs Act (“TCJA”).
Under this provision, a taxpayer may not deduct business interest expense for the tax year that exceeds the sum of:
- the taxpayer's business income for the tax year,
- 30% of the taxpayer's ATI for the tax year (but no less than zero) and
- the taxpayer's floor plan financing interest expense for the tax year.
Taxpayers may indefinitely carry forward business interest expense not allowed as a deduction for any tax year. That amount of disallowed interest expense is treated as business interest paid or accrued in the subsequent year. The amount of a partnership’s interest expense that is disallowed as a deduction at the partnership level – its “excess business interest expense” – is not carried forward by the partnership. Instead, it is allocated to the partners.
Companies that seek to preserve the deductibility of their interest expense can elect out of the business interest expense limitations in Section 163(j), but at a cost.
Real estate businesses that choose to elect out of the interest expense limitation thereby forgo their historically enhanced depreciation method, and must switch to alternative depreciation. Additionally, they can no longer take advantage of bonus depreciation—recently boosted under TCJA to 100 percent.
Modeling scenarios to take full advantage of the new tax law is an adventure. Seldom is a single model sufficient in capturing the myriad changes to the Internal Revenue Code (“the Code.”)
When Congress amended section 168(k), lawmakers forgot to give the new Qualified Investment Property (“QIP”) a 15-year life, so QIP remained subject to a 39-year life under the old rules. For highly leveraged commercial real estate businesses, the QIP issue matters. Whether Congress ultimately fixes its oversight could affect the answer as to whether real estate businesses should elect out of the interest limits. Most practitioners who are gearing up to file 2018 returns are taking the position that this will be corrected. Therefore businesses must exercise care in deciding to permanently elect out of section 163(j) and give up bonus depreciation down the road.
Residential rental property, which is less likely to have capitalized tenant improvements, is affected differently by the election. Typically, since the release of the Tangible Property Regulations (“TPR”) in 2013, more additions to residential property were able to be deducted as repairs. Even if improvements were capitalized, most were tangible personal property, depreciated over five or seven years. Such assets are not affected by the real property trade or business election and remain eligible for bonus depreciation. The more significant impact of the election on residential rental property is that the depreciable life may be extended to 40 years from 27 1/2.
The analysis needs to be holistic in considering other changes introduced by the TCJA, even at the individual level. If a taxpayer elected out of section 163(j) to take advantage of bonus depreciation, that deduction could create a big loss that is subject to the new business loss limitation rules in section 461(l). The TCJA caps excess business losses at $500,000 for joint filers ($250,000 for single filers).
Lastly, the section 163(j) rules generally apply to taxpayers with an average of at least $25 million of annual gross receipts over the three preceding years. This requires analysis to determine by way of aggregation when entities share common controlling interest of 80%.
If you think this automatically excludes your entity, think again!
Taxpayers could be subject to these limits if they fall under the definition of a tax shelter. Smaller taxpayers (with less than $25M in average gross receipts) may fall under a subset of the tax shelter definition known as a syndicate. A syndicate is defined in the Code as a pass-through entity wherein at least 35% of losses are allocable to limited partners or limited entrepreneurs.