Among the many questions around tax reform, one question those in real estate might be asking is whether or not all business interest will be deductible. The answer to this question is likely, “yes.” However, under tax reform, starting in 2018, your interest expense may be limited to 30% of adjusted taxable income.
Through December 31, 2021, adjusted taxable income is basically earnings before interest, depreciation and amortization (EBIDA). Starting in 2022, adjusted taxable income is earnings before interest, but you do not get to add back depreciation and amortization.
Putting it into Practice
Let’s assume you put a building into service in 2018. Due to large depreciation deductions, your taxable income is a $4 million loss, which includes interest expense of $1 million and depreciation of $6.5 million. Your adjusted taxable income for 2018 would be $3.5 million as follows:
Taxable income(loss) ($4,000,000)
Add back interest expense $1,000,000
Add back depreciation $6,500,000
Adjusted taxable income $3,500,000
Thirty percent of your adjusted taxable income is $1,050,000, which is greater than your business interest of $1,000,000. There is no limitation on your interest deduction for 2018.
Looking ahead, starting in 2022, you do not get to add back your depreciation and amortization expense in calculating your adjusted taxable income. Assuming the same facts as above, you would have adjusted taxable income of a $3 million loss and, therefore, you may not be able to deduct your $1 million in interest expense during 2022.
These rules could be detrimental to those operating in the real estate industry; fortunately, there are some carve outs to the application of the interest limitation.
First, there is an exemption for certain small businesses. Small businesses are generally businesses where the average annual gross receipts is less than $25 million. The small business exemption does not apply to tax shelters. A tax shelter can include a partnership where more than 35% of losses during the tax year are allocated to limited partners. The tax shelter rules can be confusing, so make sure to reach out to your CPA to see if these rules apply to you.
Second, there is also an exception for electing real property trades or businesses. These businesses can make an irrevocable election to be excluded from the business interest limitation rules. If a real property trade or business makes the election to opt out of these rules, they must depreciate their property over the ADS (alternative depreciation system) life, which is generally slightly longer than the depreciable life usually used. For instance, the ADS life for non-residential property is 40 years, versus 39 years generally used. The ADS life for residential property is 30 years for property placed in service after December 31, 2017, versus 27.5 years generally used.
If you do not meet one of the exceptions noted above and your interest deduction is limited, you are able to carry forward the disallowed interest indefinitely until used.
As with much of tax reform, there are a lot of unanswered questions, which will hopefully be clarified by the IRS over the coming months. Here are some questions that come to the top of my mind when thinking about these rules:
- How will we make the election to opt out of the rules for real property trades or businesses?
- When making the election for taxpayers who have buildings placed in service in prior years, how will we change the life of the property to conform with the ADS life? Is a method change required?
- What happens to the carryover of disallowed interest when a partner transfers interest?
These new rules are complex. At Clark Nuber we are staying on top of tax reform and how it affects our clients. If you would like to learn more about the business interest limitation rules, feel free to reach out to Amber Busch.
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