Business Interest Limitation Relief: Electing Real Property Trade or Business
The Tax Cuts and Jobs Act of 2017 (TCJA) amended Internal Revenue Code Sec. 163(j) to include new rules that potentially limit the ability to deduct business interest expense.
These new rules are in effect for tax years beginning after December 31, 2017. With limited exception, this potential limitation applies to all taxpayers. In general, a taxpayer’s business interest expense is now limited to the sum of (1) business interest income, (2) 30% of Adjusted Taxable Income (ATI), and (3) the taxpayer’s floor plan financing interest.
For most taxpayers, ATI is calculated by taking taxable income before any limitations imposed under Sec. 163(j), and adding back business interest expense, depreciation expense, and amortization expense. There are several other adjustments that are beyond the scope of this article. We examined in greater detail these calculations in a previous volume of For The Record. For tax years beginning after 2021, depreciation and amortization expense are not added back in the calculation of ATI. This will increase the potential for a business interest limitation under Sec. 163(j). To the extent business interest expense is limited, a carryover is permitted to future years. Any carryover amount is subject to the same potential limitations described above.
Exception for Electing Real Property Trade or Business
Fortunately, there is a potential exception to Sec. 163(j) that benefits Real Property Trades or Businesses (RPTB) known as an electing RPTB. An electing RPTB is any trade or business described in Sec. 469(c)(7)(C) that makes a binding election under Sec. 163(j)(7)(B). Section 469(c)(7)(C) includes real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. This definition includes trades or businesses that involve operating or managing a lodging facility.
The election under Sec. 163(j)(7)(B) to be an electing RPTB that is excluded from the business interest limitation is made by attaching a statement to the taxpayer’s timely filed original income tax return, including extensions. A taxpayer can incorporate multiple trade or business elections on a single statement. This election is irrevocable and applies to the tax year in which it is made and all subsequent tax years. An election made by a partnership doesn’t apply to trades or businesses conducted by a partner outside the partnership. This election terminates if the taxpayer no longer participates in the electing trade or business. In order to terminate, the taxpayer must sell or transfer substantially all the assets of the electing trade or business to a non-related party. IRS has included anti-abuse rules that prevent a taxpayer from attempting to terminate the election through a transfer with the intent of re-acquiring the assets in a similar trade or business.
An electing RPTB is required to use the alternative depreciation system (ADS) to depreciate its non-residential real property, residential rental property and qualified improvement property. Under ADS, assets are depreciated straight-line over a longer recovery period than the general depreciation system (GDS). Currently, the ADS recovery period for non-residential real property is 40 years as compared to 39 years under GDS and the ADS recovery period for residential rental property is 30 years as compared to 27.5 years under GDS. Any newly acquired property that is required to be depreciated under the ADS system is not eligible for the bonus depreciation deduction under Sec. 168(k).
The change to ADS is considered a change in use as described in Sec. 168(i)(5) and not a change in accounting method. For property placed in service before the election year, the remaining tax basis in the asset is depreciated straight-line over the remaining life of the asset as if it had originally been placed in service with the longer ADS life. For existing property, the additional first-year bonus depreciation deduction allowable under Sec. 168(k) for that property is not recalculated.
IRS has included anti-abuse rules preventing certain RPTBs from taking advantage of this exception. A trade or business isn’t eligible to be an electing RPTB if at least 80% of the real property’s fair market value is leased to a trade or business under common control. Common control occurs when 50% of the direct and indirect ownership interests in both trades or businesses are held by related parties as described in Sec. 267(b) and Sec. 707(b). These anti-abuse rules do not apply to real estate investment trusts (REITs) that lease qualified lodging facilities and qualified health care properties to a taxable REIT subsidiary.
Example: Newly Acquired Property
A taxpayer operates a single rental real estate business. The taxpayer placed a commercial office building into service on January 1, 2018 that has a cost basis of $6,500,000. In 2018, the taxpayer has taxable income of $50,000, which includes business interest expense of $150,000 and GDS depreciation expense of $159,965. Under Sec. 163(j) limitations, the business interest expense for 2018 is limited to only $107,990, making the taxpayer’s taxable income for 2018 $92,010.
If the taxpayer elects to be an electing RPTB in 2018, the business interest expense would no longer be limited. However, the depreciation expense for the year would be slightly lower since the building must be depreciated using ADS. The ADS depreciation expense for the year is $155,740. In this situation, the taxpayer’s taxable income for 2018 is $54,225.
By making the election, the taxpayer can reduce taxable income by $37,785.
The Takeaway
The TCJA significantly complicated the business interest limitation. Taxpayers who have RPTBs with business interest limitations should consult with their tax advisors about the benefits of making this election.
