The Treasury recently released proposed regulations under Internal Revenue Code (IRC) Section 163(j), which created business interest deduction limitations. The proposed regulations generally apply for tax years beginning after December 31, 2017. Taxpayers may apply the proposed regulations until final regulations are published, as long as the rules of the proposed regulations are consistently applied.
For tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act (TCJA) amended IRC Section 163(j) to limit a taxpayer’s business interest expense deduction to the sum of: (i) business interest income, (ii) 30% of adjusted taxable income (ATI), and (iii) floor plan financing interest expense. Any business interest expense not deductible in a tax year is generally carried forward to the succeeding tax year. The limitation applies to all taxpayers, except for specific small businesses that meet the gross receipts test and
certain trades or businesses.
The business interest deduction limitations under the proposed regulations do not apply to small businesses and ‘excepted trades or businesses’ that qualify for one of the following exceptions:
- Small business exemption – A small business exemption applies for a tax year to taxpayers with an annual average of $25 million or less in gross receipts over the three prior tax years. If a small business is commonly controlled by the same owner(s) and the related-party rule under IRC Section 267 applies, the prior three years of annual average gross receipts from each entity will need to be aggregated in applying the $25 million threshold for the small business exception. In addition, the exception may also not apply if the business is considered as a tax shelter.
- Excepted trade or business – An excepted trade or business includes the trade or business of performing services as an employee, an electing real property trade or business, an electing farming business, and certain regulated utility businesses.
Electing Real Property Trade or Business
IRC Section 163(j) does not apply to any “electing real property trade or business” (RPTB). Real estate professionals should be aware that once the election is made, it is irrevocable. This may appear attractive for highly leveraged real estate investments, but there is a trade-off which may not be advantageous. An electing RPTB must depreciate its nonresidential real property, residential rental property and qualified improvement property using the alternative depreciation system. This would have the effect of disqualifying certain assets from accelerated depreciation (e.g., bonus depreciation) and longer depreciable useful lives. As a result, one must carefully consider the benefit of making this election in lieu of accelerated depreciation.
A trade or business includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
Additional proposed regulations provide the following rules for defining the term “real property” for purposes of the types of trades or businesses that qualify as “real property trades or businesses:”
- Generally, “real property” means land, buildings, and other inherently permanent structures that are permanently affixed to land, but not assets that serve an “active function,” such as an item of machinery or equipment (e.g., HVAC system, elevator or escalator).
- Provides definitions of the terms “real property operation” and “real property management,” but reserves definitions for real property “development,” “redevelopment,” “construction,” “reconstruction,” “acquisition,” “conversion,” and “rental.” An example clarifies that a taxpayer’s ownership and operation of a luxury hotel may constitute a “real property operation” and thus be an eligible RPTB.
These proposed regulations contain an example in which a partner in a partnership that engages in a real property trade or business is treated as engaging in the partnership’s activities, further suggesting that the partner may elect to treat its partnership interest as an electing RPTB.
The proposed regulations provide much-needed clarification to the real estate industry regarding the application of IRC Section 163(j).
If you have questions or would like more information, please contact Ed Fazio at firstname.lastname@example.org or 844.4WINDES.