Impact on Real Estate
The Tax Cuts and Jobs Act modified many provisions; affecting various industries in numerous ways. One such modification to 163(j) limits the amount of interest expense that can be deducted on tax returns. With many real estate entities being highly leveraged, interest expense can be a major deduction relied upon come tax time. This limitation has generated numerous conversations amongst real estate entities on potential options – making a real estate entity election or even restructuring.
In general, the new rule only allows the current expensing of business interest to the extent that it does not exceed the sum of the following:
- The business interest of the taxpayer
- 30 percent of the adjusted taxable income for such year, and
- The floor plan financing interest for such year
Adjusted taxable income means the taxable income of the taxpayer computed without regard to any of the following:
- Business interest or business interest income
- Any net operating loss deduction
- Any deduction allowed under section 199A, and
- Any deduction allowable for depreciation, amortization, or depletion (only applicable for years beginning before January 1, 2022)
For a business operated as a Partnership or S Corporation the above limitations will be calculated at the entity level prior to allocating the taxable income to the owners on the IRS Form K-1.
Any business interest that is disallowed due to these rules will be treated as business interest paid or accrued in the succeeding taxable year. The amounts carried over will continue to be subject to the general rule until it can be deducted. The carryover amounts do not expire.
The new law provides some exemptions to the requirement to follow these rules including electing to be considered a Real Property Trade or Business. Many entities are considering making this election if they are highly leveraged but it is important to know the risk vs. the reward:
- An irrevocable election to be considered a Real Property Trade or Business means interest won’t be limited under 163(j) but depreciation will need to be claimed using the slower ADS recovery periods for long-lived property. Not just for that year, the depreciation will need to utilize ADS for future additions as well. If the entity is substantially growing its portfolio, this could result in outweighing the benefit of claiming the interest expense.
- With irrevocable elections, changing your mind down the road becomes quite challenging. Also to consider is that since the laws are so new, any potential technical corrections – either favorable or unfavorable – could have an impact on the decision you would like to make. Does waiting a year to make this election make sense to see if any modifications that could impact your decision are made?
- How much interest would actually be limited with 163(j)? Other limitations were put in place or continue to be relevant that may impact the final tax position; making the impact of 163(j) less crucial. It’s important to consider all potential scenarios before making a final decision.
To illustrate these confusing rules let’s look at an example:
Taxpayer has net income of $1,000,000. In determining that income the taxpayer deducted $800,000 of business interest, $210,000 of depreciation and received $10,000 of business interest income.
In this scenario the Adjusted Taxable Income would be the $1,000,000 of net income plus the $800,000 of interest plus the $210,000 of depreciation less the $10,000 of interest income, for a total of $2,000,000. Therefore, the taxpayer would be allowed to deduct $610,000 of interest expense for the current year (30% of $2,000,000 plus $10,000). The current year taxable income would be $1,190,000 and $190,000 of disallowed interest expense would be treated as a deduction in the next taxable year subject to the same calculation to determine deductibility.
Look to Lurie for future information on the Tax Cut & Jobs Act of 2018 (TCJA). To view our updates on TCJA you can check out our website at: www.luriellp.com/news or follow us on social media @LurieLLP.
If you have any questions or would like additional information on how this change could affect you or your business please contact your Lurie advisor.