Real Estate Businesses: How Much Interest Expense Can You Deduct? – Real Estate

The deduction limit for business interest expense can have a big
impact on a real estate firm’s tax bill and the limit is even
more stringent starting in 2022. If your firm has significant
interest expense, it is important to: (1) Determine whether the
deduction limit applies to you; (2) Assess the limit’s impact
on your tax liability; and (3) Evaluate the costs and benefits of
opting out.

Related Read: Treasury Department Proposes Regulations on
Business Interest Expense Limitation

Background

The Tax Cuts and Jobs Act of 2017 amended Internal Revenue Code
Section 163(j) to impose a limit on deductions of business interest
expense, with an exception for “small businesses” (see
below). For tax years beginning after December 31, 2017, Section
163(j) provides that a taxpayer’s deduction of business
interest expense in a given tax year cannot exceed the sum of:

• The taxpayer’s business interest income (which does not
  include investment income);




• 30% of the taxpayer’s adjusted taxable income (ATI);
  and




• The taxpayer’s floor plan financing interest.

Disallowed interest expense may be carried forward indefinitely
to succeeding tax years.

Floor plan financing is typically used by auto dealers and
certain other retailers. So, for real estate firms, deductions are
generally limited to their business interest income, if any, plus
30% of ATI. ATI means taxable income, computed without regard
to:

• Nonbusiness income, gain, deduction or loss;




• Business interest income or expense;




• Net operating loss deductions;




• The qualified business income deduction; and




• Depreciation, amortization or depletion (for tax years
  beginning before 2022).

To provide businesses with temporary relief during the COVID-19
pandemic, the CARES Act of 2020 increased the deduction limit to
50% of ATI for 2019 and 2020 and allowed businesses to calculate
the 2020 limit based on their 2019 ATI. Now, however, the limit is
back to 30% of ATI. In addition, for tax years beginning after
2021, businesses may no longer add back depreciation, amortization
and depletion in computing ATI. As a result, many real estate firms
will see their interest deductions reduced this year, some for the
first time.

Related Read: CARES Act Issues Facing Real Estate
Clients

Does the Limit Apply to You?

Section 163(j) contains an exception for “small
businesses,” defined as businesses, other than tax shelters,
with average annual gross receipts for the preceding three years of
$25 million or less. This threshold is adjusted annually for
inflation and currently stands at $27 million. Keep in mind that to
determine whether your firm qualifies as a small business, you may
need to aggregate your gross receipts with certain related
businesses.

Even if your firm’s gross receipts are below the threshold,
it is disqualified from claiming the small business exception if it
is considered a tax shelter. A tax shelter includes a partnership
or other pass-through entity if more than 35% of its losses during
the tax year are allocable to limited partners or “limited
entrepreneurs” (owners who do not actively participate in
management). If your firm meets this definition, there may be
strategies you can use to avoid tax shelter status, such as
reducing the amount of losses allocated to limited partners or
limited entrepreneurs, or having those owners actively participate
in the management of the firm.

Should you opt-out?

If you are ineligible for the small business exception, you can
still avoid the business interest limit by filing an election to
opt-out. This option is available to real property businesses,
which include development, redevelopment, construction,
reconstruction, acquisition, conversion, rental, operation,
management, leasing and brokerage businesses. However, opting out
comes at a cost; once you make the election, which is irrevocable,
you must use the alternative depreciation system (ADS) for
nonresidential real property, residential rental property and
qualified improvement property. Depreciation periods are longer
under ADS, which results in lower depreciation deductions. Also,
qualified improvement property loses its eligibility for bonus
depreciation.

Whether opting out is the right choice depends on your
firm’s particular tax circumstances. You will need to weigh the
benefits of fully deducting business interest against the cost of
lower depreciation deductions.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.