Changes to the 163(j) Interest Expense Limitation for the Real Estate Industry
By Harrison Lindsay, Withum
Internal Revenue Code (“IRC”) Section 163(j) limits the amount of business interest expense certain businesses can deduct. Changes to the rules will further limit the amount of business interest expense that can be deducted for companies where the interest expense limitations apply. With interest rates on the rise because of recent inflation, this business interest expense disallowance could be painful for taxpayers, especially ones that will have larger amounts disallowed.
For businesses where the business interest expense limitation applies, the amount of business interest expense allowable for deduction typically cannot exceed 30 percent of the taxpayer’s Adjusted Taxable Income (ATI). In years prior to 2022, one of the components used to calculate the ATI of a taxpayer was an add-back of the taxpayer’s deductions allowable for depreciation, amortization, or depletion, per the IRC. However, in tax years starting in 2022, these add-backs are no longer used to calculate the ATI of the taxpayer. This, in effect, reduces ATI, which would result in a smaller allowable interest expense deduction after applying the 30% limitation.
There is a provision in the tax code for certain real estate businesses to elect out of this interest limitation and be able to take the full amount of business interest expense incurred during their tax year. The real estate businesses that qualify to make this election include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business, per the IRC. However, by making this election, taxpayers will have to convert certain classes of fixed assets (Residential Rental Property, Nonresidential Real Property, and Qualified Improvement Property) to the Alternative Depreciation System (ADS) and would no longer be able to depreciate these assets using the standard MACRS method and certain property would no longer be eligible for bonus depreciation.
Withum can assist with making the election with the IRS, conversion of fixed asset depreciation to the allowable ADS method and answer any questions. Withum also provides cost segregation services to clients who may want to help mitigate the decelerated depreciation that occurs with the election out of 163(j).
Withum provides many other offerings in real-estate focused advisory, audit, and tax services. For additional information or inquiries, please reach out to a member of the Real Estate Services Team.
Harrison Lindsay, CPA is a Tax Supervisor at Withum.