Real Estate Partnerships and the New Business Interest Deduction Limitations

Prior to the Tax Cuts and Jobs Act (TCJA), business interest deductibility limits were rarely encountered; however, the TCJA has completely revised this section resulting in many situations where interest deductions are limited. The new law can significantly affect highly leveraged businesses including real estate.

In general, the limitation on the deduction of business interest expense is calculated as follows:

The deduction for business interest shall not exceed the sum of:

  1. The business interest income of the taxpayer for the taxable year, plus
  2. 30% of the adjusted taxable income of the taxpayer for the taxable year, plus
  3. The floor plan financing interest of the taxpayer for the taxable year.

Floor plan financing is a revolving line of credit that allows the borrower to obtain financing for retail goods.  Auto dealerships are a good example of floor plan financing.  This generally won’t apply to real estate businesses so this part of the equation will be ignored in the following examples.

Let’s assume a taxpayer has a commercial real estate building with the following 2018 activity:

Example

Revenues $50M
Expenses 41M
Business interest income -0-
Depreciation and amortization 8M
Business interest expense 3M
Net income (loss) $(2M)

We will also assume the three-year average receipts for this taxpayer exceed $25,000,000.

First we must calculate adjusted taxable income (ATI).  ATI is calculated without regard to the following:

  1. Any item of income, gain, deduction, or loss not allocable to a trade or business
  2. Any business interest or business interest income
  3. The amount of any net operating loss
  4. The amount of any deduction allowed under §199A
  5. For taxable years beginning before Jan. 1, 2022, any deduction allowable for depreciation, amortization, or depletion

Therefore, the calculation of ATI prior to 2022 is essentially EBITDA.  The calculation of ATI for the above example is:

Net loss $(2M)
Net business interest expense $3M
Depreciation and amortization $8M
Adjusted Taxable Income $9M

Therefore, the deductible business interest expense in the example is:

ATI x 30% ($9M x 30%) $2.7M
Business interest carried forward $300,000

Assuming no other differences in tax basis income, taxable income (loss) would be the net loss of $(2M) + $300,000 of business interest carried forward resulting in a taxable loss of $(1.7M).

Post Dec. 31, 2021 depreciation, amortization, and depletion are no longer added back in the calculation of ATI.  Using the example above but assuming instead it was 2022 activity ATI would be $1M.  This would allow $300,000 of business interest and $2.7M would be carried forward resulting in taxable income of $700,000.

Exception for Certain Small Businesses

If a taxpayer has average gross receipts that do not exceed $25,000,000 in the prior three taxable years then the taxpayer is not subject to the §163(j) limitation.  This exception is based on §448 rules governing a taxpayer’s limitation on use of the cash method of accounting.

The bad news is this section contains the caveat that tax shelters are not eligible for this exception.  A tax shelter includes a partnership or an S corporation in which more than 35 percent of its losses are allocable to limited partners or limited entrepreneurs.  Syndicated real estate deals with average gross receipts less than $25,000,000 may still be subject to the business interest expense limitation.

It should be noted that §448 includes aggregation rules that will prevent related party taxpayers from circumventing the $25,000,000 threshold for the business interest expense limitations by using either parent/child or brother/sister entities.

Electing Real Estate Trade or Business

An electing “real property trade or business” is not considered a trade or business for purposes of the business interest limitation. Therefore, once elected, the taxpayer may avoid the business interest limitation rules under §163(j).

A real property trade or business is defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.  A taxpayer that meets the above definition may elect as a real property trade or business and this election is irrevocable.

Once elected, the real property trade or business is required to use the alternative depreciation system (ADS) to depreciate any of its non-residential real property, residential real property, and qualified improvement property. The ADS method requires straight line depreciation over periods of 40 years, 30 years, and 40 years, respectively for these types of property.  Due to a drafting error in the TCJA, qualified improvement currently has a 40 year ADS though it appears that a 20 year ADS life was intended.  This may be corrected in a future technical corrections bill.

Proposed Regulations

Proposed Regulation §1.163(j)(6) was filed Nov. 26, 2018 and provides technical guidance for applying the business interest expense limitation to partnerships and S corporations. The proposed regulations address many technical matters including the character of business interest expense, calculating the adjusted taxable income of the partnership and the allocation of business interest income and excess interest deductions to the partners, as well as other technical issues.

Please contact our business advisors if your business requires an analysis of the provisions of the business interest expense limitation and the related issues.

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