The Real Estate Election Out of the Section 163(j) Business Interest Limitation
By Rachel Lawent, Supervisor, Tax & Business Services
Introduction
As a result of the Tax Cuts and Jobs Act (TCJA), businesses incurring interest expense face a new limitation in tax years beginning after December 31, 2017, that restricts the amount of interest expense that can deducted. Real estate investors with business debt, such as a mortgage, may find themselves affected by this new restriction and no longer able to deduct full interest costs. This article explains the limitations and how real estate investors may be able to avoid them.
The Real Property Election
The new section 163(j) of the Internal Revenue Code stipulates that the maximum amount that may be deducted for interest expense is the sum of 30% of the taxpayer’s adjusted taxable Income, plus total business interest income, plus floor plan financing interest expense. Adjusted taxable income is defined as taxable income with certain items added back, including interest expense, depreciation, amortization, and depletion. Business interest income consists of interest received in the ordinary course of business, such as from customer receivables, and does not include interest from an investment such as a savings account. Floor plan financing is a type of loan used by dealers to purchase vehicles held for sale or lease.
For example, assume that in 2018 taxpayer X has $400,000 of taxable income, $200,000 of depreciation and amortization, and $400,000 of business interest expense (none of which is floor plan financing interest). X’s net interest expense is $400,000 and its adjusted taxable income is $1,000,000 (400k+400k+200k). The maximum interest expense deduction is $1,000,000 x 30%, or $300,000. Therefore, $100,000 of the interest expense is not deductible and is carried forward to the 2019 tax return.
If a business opts to be an electing real property trade or business, there will be no limitation on the amount of business interest expense it may deduct. However, the tradeoff is that in making this election the business is required to use the Alternative Depreciation System (ADS) on certain depreciable assets. The existing assets placed in service in previous years, as well as new assets placed in service in the year of election or future years, are subject to this requirement. The asset classes that fall under this requirement are residential real property, nonresidential real property, and qualified improvement property. If the business has other classes of depreciable property, such as furniture, fixtures, equipment, or other tangible personal property, these assets are not required to be depreciated under the ADS system. For nonresidential real property, a switch from general depreciation to ADS would mean depreciating over a 40-year life instead of a 39-year life. For residential rental property, the life is 30 years (compared to 27.5), but only for property placed in service on or after January 1, 2018. For property placed in service before that date, the ADS life is 40 years. Assets with longer lives will take a bite out of depreciation expense. Also, taxpayers cannot claim 100% bonus depreciation on any assets depreciated under the ADS method.
Due to this tradeoff, a business eligible to make this election must analyze the amount of interest expense that exceeds the limitation (if any) in comparison to the decrease in depreciation expense that would result from using ADS instead of the General Depreciation System. This difference will vary in significance from business to business.
In the absence of this election, the new limitation applies to most businesses, regardless of whether they are structured as corporations, partnerships, or sole proprietorships. However, there are several types of businesses that are exempt from the requirement, such as small businesses with average gross receipts less than $25 million over the prior three years. In addition, to be recognized as a small business, a taxpayer must not be a tax shelter, which is defined as a business where more than 35% of losses are allocated to owners who are not active in the business. For purposes of determining the $25 million threshold, the gross receipts of commonly controlled businesses must be combined. Businesses that do not meet the definition of a small business should consider the real property trade or business election.
Planning Considerations
Once made, the 163(j) real property election is irrevocable. Thus, businesses must consider whether the election will provide sufficient benefit over the long term even if it is clear that it provides a more beneficial result on the current year tax return. If the overall benefit is unclear, it may be worthwhile to delay considering the election until a future year. Beginning with the 2022 tax year, depreciation, amortization, and depletion will no longer be added back to arrive at adjusted taxable income, which will result in a lower allowable interest expense amount for businesses that have these expenses. For some businesses, the election may be more of a no-brainer at that time.
Conclusion
The election out of section 163(j) can be a beneficial choice for real estate businesses that have a significant amount of interest expense and qualify to make the election, as it will allow taxpayers potentially to deduct more expenses than they would be able to deduct otherwise. For assistance with navigating the 163(j) interest limitation and the real property trade or business election, please contact your Marcum tax professional.
