Tax reform, also known as the Tax Cuts and Jobs Act (TCJA), was enacted at the end of 2017, resulting in considerable changes to the federal tax code—including a new limitation on the business interest deduction.
Business-Interest Deduction Limitation
Business interest expense was generally deductible under the previous law. Beginning in 2018, however, the business interest deduction may be limited to the sum of the following:
- A taxpayer's business interest income for the tax year
- Thirty percent of the taxpayer's adjusted taxable income for the tax year—but not less than zero
Adjusted taxable income is defined as taxable income adjusted in the following ways:
- Disregards any income, gain, deduction, or loss that isn't properly allocable to a trade or business
- Includes any business interest income
- Adds back any deduction allowable for depreciation, amortization, or depletion during tax years beginning before January 1, 2022
It’s worth noting after January 1, 2022, it may be increasingly difficult to deduct interest due to the new limitation.
These rules don’t apply to taxpayers with average annual gross receipts of less than $25 million for the three-tax-year period ending with the prior tax year.
Carryover of Disallowed Interest
Generally, any business interest that isn't deductible in the current year because of the limitation is treated as business interest incurred in the following tax year. This excess may be carried forward indefinitely.
The general carryforward rule for disallowed interest expense doesn't apply at the partnership level, but rather applies to any business interest that isn’t deductible by a partnership because the limitation is allocated to its partners. The partners may then deduct the interest against future excess business income from the partnership that gave rise to the interest deduction.
A partner's adjusted basis in a partnership is reduced by the amount of excess business interest allocated to the partner—even if there’s no resulting tax deduction. This means a partner's deduction in a future year for interest carried forward doesn't reduce the partner's basis at the time of the deduction.
If a partner disposes of a partnership interest, his or her basis is increased immediately before the disposition by any excess business interest that hasn’t yet been deducted.
The rules for S corporations operate similarly to those for partnerships. However, rather than passing through excess interest to each shareholder to track, the corporation maintains excess interest for future deductions.
Special Real Estate Election
A provision of the law allows certain real estate companies to be treated as an electing real property trade or business and avoid these limitations. This provision seemingly intends to recognize the higher leverage required to acquire real property and the implications to an entity’s adjusted taxable income.
As defined by the new law, a real property trade or business is broadly defined to include the following:
- Real property development or redevelopment
- Real property construction, reconstruction, acquisition, or conversion
- Rental, operation, management, leasing, or brokerage of real property
If a real property trade or business makes the election to opt out of the limitation rules, it must depreciate its real property over the alternative depreciation system (ADS) life. The ADS life for nonresidential property is 40 years rather than 39 years while the ADS life for residential property is 30 years instead of 27.5 years.
Further Guidance Needed
Further guidance is needed in a variety of situations, some of which are addressed below.
It’s unclear in tiered structures whether excess business interest or income should be reported at every level—including the ultimate taxpayer—or if it must stop one level above the partnership that incurs the debt.
It’s unknown whether an election out of the rules can be applied to the upper tiers of a multiple-tiered entity if debt exists in more than one tier and the operating entity is a real property trade or business.
If upper-tier entities are unable to separately elect out or benefit from a bottom tier’s election, it’s possible upper tiers won’t be able to deduct any interest expense.
The law doesn’t address how to deal with businesses that have significant real estate holdings joined with other business activities.
The law doesn’t provide guidance for how depreciating existing assets will need to be addressed. The application may apply only to new assets placed in service, but if it’s deemed applicable for existing assets as well, there are two possible options:
- Change to the ADS system following an accounting method change that requires excess depreciation recapture over four years
- Use a cutoff method and depreciate the net-tax basis over the remaining ADS life
These new rules represent a significant change from historical law and place a compliance burden on taxpayers that need to calculate any limitation and carryforward items. This work is compounded by the minimal amount of available guidance, making it unclear whether opting out of the rules makes sense—or is even available—for eligible taxpayers.
We’re Here to Help
For more information on how your company may be affected by the new business-interest deduction limitations, contact your Moss Adams professional. You can also visit our dedicated tax reform page to learn more.