Business Interest Limitation and the Tax Cuts and Jobs Act - Part II

Posted on Tue, Jun 05, 2018 ©2021 Drucker & Scaccetti


As promised last week, we're back at it analyzing the Business Interest Limitation in Section 163(j) of the Tax Cuts and Jobs Act ("TCJA").  In Part I, we learned the general rules, what companies it applies to, and who may elect out.  Today, we're going to look at how the section affects real estate and pass-through entities.


Real Estate is Even Trickier


The Business Interest Limitation allows real estate companies to elect out of the limiting interest expenses under the "certain trade or business exception."   It might seem like a simple decision electing to ignore this section of the tax code but, as the saying goes, ‘nothing in life is free.’‘


There are several considerations when talking to your tax advisor about whether to elect out of the business interest limitation.  First, the election is irrevocable.  Once you make the election, you will always be bound by it, even if it becomes disadvantageous.  Second, any business that has elected out is required to depreciate its assets using the less-favorable Alternative Depreciation System (“ADS”) methods rather than the current Modified Accelerated Cost Recovery System (“MACRS”) method (this requirement only applies to assets with a life of 10 years or greater).  The ADS method is much slower and, most importantly, it does not allow for first-year bonus depreciation.


Assuming Congress fixes this drafting error, electing out of the business interest limitation will require depreciating affected property over a few decades rather than getting 100% bonus depreciation in year one.  Furthermore, the IRS has not yet provided guidance on what the election will entail, and it is possible that the ADS method will have to be applied to a business's existing property.  In short, if you’re a business that can potentially elect out of the business interest limitation, talk to your tax advisor.


Application to Pass-Through Entities


The business interest limitation’s application to pass-through entities is confusing and in need of guidance from the IRS.  While the business interest limitation is calculated at the entity level, any “excess business interest” (disallowed interest expense) is passed through to the partner/member and carried forward by the partner until they have excess business income from the pass-through entity (excess business income is calculated by using a complicated ratio of adjusted taxable income). 


When a partner is allocated excess business income, they must then calculate the business interest limitation to determine how much excess business interest may be deducted.  If a partner still has excess business income after calculating how much excess business interest is deductible, they can apply the excess income to the deduction limitation for other business interest expense such as a Schedule C business.  This makes it important for pass-throughs subject to section 163(j) (and potentially all pass-throughs) to put a footnote on their K-1s allocating excess business income to their owners if the IRS does not redraft Schedule K and K-1 to include line items for the applicable information needed.  Again, the application of this code section to pass-through entities is very complicated, and the IRS's guidance will be needed to fully grasp the business interest limitation’s effect on pass-through entity owners.


If your business is potentially subject to this limitation or you are in a business that can potentially elect out of the limitation, you should talk to your tax advisor.  The Tax Warriors® at Drucker & Scaccetti have decades of experience with the most complex parts of the tax code.  If you need help with any of the subjects discussed here or in Part I of this two-part series, call on us to help you plan for your business.


Topics: real estate, Pass-through entities, TCJA, business interest expense, Business Interest Expense Limitation, ADS, MACRS

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