Exactly one year ago in December 2017, a sweeping overhaul of the tax code was enacted by Congress via the Tax Cuts and Jobs Act. What many taxpayers welcomed as a holiday gift, especially those in the real estate industry, has turned out to be one of those childhood “a-gift-within-a-gift” nested present gags that our parents always found hilarious at the expense of our frustration and disappointment. We tore through box after box to finally arrive at the holy grail holding what we thought was the newest video game console we’d been wishing for, only to open it up and find the outdated prior year model. Similarly, “the gift that keeps on giving”, otherwise known as the TCJA, continues to be unwrapped by tax practitioners and taxpayers only to discover new layers of complexity, issues, and confusion. One of these “layers” is Section 163(j) which governs the amount of business interest that can be deducted by taxpayers.
General Rules
In general, Section 163(j) limits the amount of business interest expense a taxpayer can deduct in the current taxable year to the sum of:
- The taxpayer’s business interest income
- 30% of the taxpayer’s adjusted taxable income (ATI); and
- The taxpayer’s floor plan financing interest expense
The limitation applies to all taxpayers except certain small businesses, other than tax shelters, with average gross receipts of $25 million or less. The limitation also does not apply to trades or businesses of providing services as an employee, electing real property businesses, electing farming businesses, and certain regulated utility businesses. Any disallowed interest is considered paid in the following tax year and may be carried forward indefinitely. The general rules seem simple on the surface but as we unravel the rules surrounding the highlighted terms above, we are led down a rabbit hole filled with complexities and issues, some of which the IRS has attempted to address through 300+ pages of Proposed Regulations and Revenue Rulings.
Taxpayer Affected
All taxpayers with business interest expense are subject to the interest limitation (before meeting any exception), including pass-throughs, corporations, and even individual taxpayers.
Defining Interest
Under Prop. Reg. 1.163(j)-1(b)(20), interest is expanded and defined to include “any amount paid or accrued as compensation for the use or forbearance of money under the terms of an instrument or contractual arrangement,…”. The proposed regulations provide about twenty different examples of what constitutes interest including original issue discount, qualified stated interest, acquisition discounts, and amounts treated as interest under a Section 467 rental agreement, to name a few.
One exception is investment interest expense which the proposed regulations exclude from the definition of interest BUT gets recharacterized for C-corporations as includible business interest and expense. In cases where partnerships have investment income and expenses AND has a C-corporation partner, the partnership has to disclose that partner’s allocable share of investment interest income and expense. This represents just one of the many disclosures pass-through entities will now have to disclose for Section 163(j) purposes to partners and shareholders.
Determining Adjusted Taxable Income (ATI)
A major component of the interest limitation calculation is a new concept termed adjusted taxable income (ATI) which in basic terms is EBITDA through the year 2021 and EBIT for the years thereafter. Upon closer inspection of Section 163(j)(8), ATI is taxable income without regard to the following:
- items not properly allocable to a trade or business
- business interest expense and business interest income
- net operating loss deductions
- deductions for qualified business income under section 199A
- depreciation, amortization, and depletion (only through the year 2022)
- depreciation recapture upon sale of business property
Partner-level adjustments such as Section 743(b) adjustments are disregarded by the partnership when calculating its ATI. Instead, these partner-level adjustments are taken into account at the partner level in determining its own limitation.
The businesses interest limitation and ATI calculation are applied at the partnership level. As a result, any interest deduction limited (i.e. excess business interest expense) at the partnership level must be allocated to partners. Excess business interest expense is then treated as paid or accrued by the partner to the extent the partner is allocated “excess taxable income” (ETI), which is ATI in excess of the amount the partnership needs to deduct its own interest.
| ETI = ATI X 30% of ATI – (Business Interest Expense – Floor Plan Financing Interest – Bus. Interest Income) |
| 30% of ATI |
Any deductible interest expense, excess business interest expense, and excess taxable income are all required to be allocated to partners as non-separately stated items. The proposed regulations provide an 11-step 20+ page allocation process to allocate these items to partners.
Exception – Small Businesses
The Section 163(j) interest expense limitation does not apply to certain small businesses (other than a tax shelter) that meet the $25M gross receipts test i.e. average annual gross receipts for the 3 preceding years do not exceed $25M. Small businesses are required to aggregate gross receipts of businesses in the same control group, if any. For purposes of Section 163(j), control groups can be a parent-subsidiary control group or a brother-sister control group. These control group rules apply to corporations, S-corporations, and partnerships. For brother-sister control groups, familial attribution rules also apply. Therefore, on an entity by entity basis, real estate partnerships may be under the $25M gross receipts exception but if the real estate is tiered and or closely held, the entity may easily exceed the $25M after aggregation.
An otherwise small business classified as a “tax shelter” is not eligible for the gross receipts exception. In the context of partnerships, a “syndicate” is considered a tax shelter if the pass-through entity allocates more than 35% of its losses to limited partners or limited entrepreneurs (not active in management or day to day operations). Designation of “tax shelter” may change from one year to the next. If a real estate entity is deemed a “tax shelter” it can still elect out of the interest limitation rules via the “electing real property trade or business” rules, although the election would be binding for future years.
Exception – Electing Real Property Trade or Business
A real property trade or business that does not satisfy the $25M gross receipts exception is eligible to elect out of the Section 163(j) business interest deduction limitation. A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. The proposed rules define real property to include land, buildings, and other inherently permanent structures that are permanently affixed to land, and exclude other items that serve an active function and may be permanently affixed to real property (like machinery).
The drawback of electing out is the entity must irrevocably switch to the Alternative Depreciation System (ADS). ADS lengthens the depreciable period of improvement property from 15 to 20 years, residential real estate buildings from 27.5 to 30 years, and commercial real estate buildings from 39 to 40 years. Recently released Rev. Proc. 2019-08 clarifies the switch to ADS affects assets placed in service before AND after December 31, 2017. For assets placed in service before 12/31/17, the conversion to ADS will be through a “change-in-use” under Section 168(i)(5) and in accordance with Reg. 1.168(i)(4(d), instead of a change in accounting method requiring a Form 3115.
A change in use in this case would require electing real estate businesses to determine the depreciable basis of assets as of 1/1/18 and calculate depreciation on that depreciable basis over the years still remaining as if the assets were placed in service using ADS recovery periods.
Issues Awaiting (A New Year’s) Resolution
While the proposed regulations and revenue procedures have addressed, and in some cases complicated, many of the existing issues and questions surrounding Section 163(j), there are still issues that have yet to be addressed. The proposed regulations have reserved discussing the impact Section 163(j) will have on partnership mergers and divisions, self-charged interest on loans between partners and partnerships, and tiered partnerships. As we await further guidance on these topics, businesses should be aware of the traps and complexities of Section 163(j) and how to prepare for them. For further discussion on the impact of Section 163(j) and planning opportunities, contact a member of Withum’s Real Estate Services Group by filling out the form below.
Author:Andy Dilone, CPA, MST, Real Estate Services Team Member |[email protected]
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