Tax Considerations for Real Estate Investors: New Limitation on Interest Expense Deductions

How the Interest Expense Deduction Affects Real Estate Investors

Under the Tax Cuts and Jobs Act, “TCJA,” one of the revenue generators was new IRC code section 163(j) which limits the ability of a business to deduct its interest expense effective for tax years beginning after December 31, 2017.

Under this new law, the deduction for interest expense is limited to 30% of adjusted taxable income. Any interest expense disallowed for a taxable year is carried forward to the next taxable year.

What Is Adjusted Taxable Income?

Adjusted taxable income is basically defined as income before interest, depreciation and amortization deductions. However, the depreciation and amortization expense adjustments are only available for tax years beginning before January 1, 2022. Therefore, the new interest limitation could especially impact real estate companies, as interest is typically one of the industry’s largest business deductions, other than depreciation expense.

What Are the Exceptions to the New Interest Limitations?

The good news is there are several exceptions to the new interest limitations.

Small Business Exception. The first exception, which will benefit small businesses, is that any business with average annual receipts of $25 million or less for the prior three taxable years is not subject to this limitation.

However, if there are commonly controlled businesses, the receipts of all the related businesses must be aggregated to determine if the exception is met. It should also be noted that tax shelters are not eligible for this small business exception. A tax shelter is defined as a partnership or S corporation if more than 35% of the losses of the entity for the taxable year are allocated to limited partners or limited entrepreneurs. Since many small real estate businesses have limited partners, they might qualify as a tax shelter and therefore not be eligible for this exception.

Electing Real Property Trade or Business Exception. If a real estate company does not meet the small business exception, the second exception is the electing real property trade or business exception. A real estate trade or business includes property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. If a business meets once of these definitions, it can make an irrevocable election to avoid the interest limitation rules.

However, there is a trade off, the business must depreciate its nonresidential real property, residential rental property and qualified improvement property under the “alternative depreciation system (ADS).”

Qualified Improvement Property (QIP). However, for qualified improvement property the impact of this election could be much greater. QIP is defined as any improvement made to the interior portion of a nonresidential building after it was placed in service. Congressional intent was that QIP would have a 15-year useful life and it would also be eligible for bonus depreciation. However due to an error in the TCJA, QIP is currently considered 39-year property. If the law is corrected, making the election to avoid the interest limitation would significantly lower the amount of depreciation that would normally be allowed for QIP in the initial year due to the disallowance of bonus depreciation. Additionally, the useful life for QIP would be 20 years rather 15 years under ADS depreciation.

For real estate businesses electing the real property trade or business exception to avoid the interest limitation: it was clear that newly acquired property would be subject to ADS depreciation, but guidance was needed on what the impact would be, if any, on previously owned property.

Revenue Procedure 2019-8

Revenue Procedure 2019-8 was recently issued to address this question. The revenue procedure makes it clear that the electing real property trade or business is required to change the depreciation on existing property to the ADS method. To accomplish this, rather than recalculate depreciation on the impacted assets from the date placed in service, instead the business will take the remaining tax basis in the asset and depreciate it straight-line over the remaining ADS life. This is good news to taxpayers as they will not have to recapture previously deducted bonus depreciation. One item to note under the revenue procedure is that the ADS life of pre-2018 residential property is 40 years rather than the 30-year ADS life for property placed in service after 2017.

Since the election is irrevocable, careful consideration of a taxpayer’s current and future expected tax situation is needed. Companies may reconsider how they finance their real estate operations and as interest rates rise, the impact of the limitation could be more expensive. Since depreciation and amortization expense is not included in adjusted taxable income for the interest limitation through 2021, it is possible that some real estate businesses will not be subject to the limitation until 2022. To discuss how this new law might impact your real estate business, please contact a member of the Construction and Real Estate Services team or your Sikich tax advisor.