The tax legislation known as the Tax Cuts and Jobs Act (the Act) places a new limit on the amount of interest expense businesses can deduct on their tax returns. This new limit will punish over-leveraged companies and discourage companies from becoming too leveraged.
Starting in 2018, businesses can only deduct interest based upon a formula contained within the act.
Business Interest Deduction
Under the new tax law, a business’s net interest expense deduction is limited to 30 percent of EBITDA (Earnings before Income Taxes, Depreciation, and Amortization). Beginning in 2022 the net interest expense deduction limitation is 30 percent of EBIT (Earnings before Income Taxes).
Businesses with average annual gross receipts of $25 million or less for the prior three years are exempt from this provision. The amount of business interest not allowed as a deduction for any taxable year is treated as business interest paid or accrued in the succeeding taxable year. Business interest may be carried forward indefinitely, subject to certain restrictions.
Real Estate Exception
Real estate is both illiquid and capital intensive, making leverage and the ability to deduct interest important to the industry. A real property trade or business can elect out of the net interest expense deduction limitations if they use the Alternative Depreciation System (ADS) to depreciate business-related real property.
Taxpayers electing to use the real estate exception to the interest limit must depreciate real property under longer recovery periods prescribed by ADS. Those recovery periods are 40 years for nonresidential property, 30 years for residential rental property, and 20 years for qualified interior improvements. This is compared to recovery periods of 39 years for nonresidential property, 27.5 years for residential rental property, and 15 years for qualified interior improvements.
Application to Partnerships
Most real estate investment vehicles are structured as pass-through entities. The limitations on current interest expense is applied at the operating entity level, and any allowable deduction is included in the non-separately stated income or loss on each partner’s Form K-1. However, any disallowed interest will be carried forward at the partner level.
Aggregation Rules
In groups of related entities, it appears aggregation rules will apply in determining whether the $25 million gross receipts threshold has been exceeded. Additional guidance is anticipated on calculations of the limitation as well as explanations as to how this section will interact with other sections of the Internal Revenue Code.
We’ve Got Your Back
Rather than guessing at how the business interest rules apply to your situation, why not let the experts at KRS CPAs help? Check out the New Tax Law Explained! For Real Estate Investors page and then contact partner Simon Filip at sfilip@krscpas.com or 201.655.7411 for a complimentary initial consultation.