Managing the Deductibility of Interest Expense

As Seen in Anchin’s Real Estate Year-End Tax Planning Guide

*The information contained in this article may be subject to change with the passing of the proposed bill titled “Tax Relief for American Families and Workers Act of 2024.”*

The Tax Cuts and Jobs Act of 2017 limited the deductibility of business interest expense for taxpayers. This has had a significant impact on the real estate industry and can be especially concerning given current interest rates. The following is a discussion of the potential limitations as well as some considerations for real estate owners and businesses.

For tax years beginning after December 31, 2021, the deduction for interest expense is limited to 30% of a taxpayer’s adjusted taxable income (ATI). Generally, ATI is an entity’s net income with interest expense added back (there are several other potential adjustments outside the scope of this article). Prior to the 2022 tax year, entities were able to add back depreciation and amortization as part of the ATI calculation, in addition to interest expense. The sunsetting of the depreciation and amortization addbacks have further limited the deductibility of interest expense in a given tax year. One important item to note is that any limited interest expense is suspended until there is either future income or disposition of the activity; it is not lost forever.

Fortunately, not all real estate businesses are subject to the expense limitation. Taxpayers that are considered “small business taxpayers” are exempt from this interest limitation. To qualify, a taxpayer’s average gross receipts from the prior three years must be less than $29 million starting in 2023 (receipts may be aggregated amongst entities with similar ownership).

While the small business taxpayer rule can exempt a lot of entities from the limitation, taxpayers still need to consider what’s known as “tax shelter” rules. An entity is considered a tax shelter if there are taxable losses for the year and more than 35% of the losses are allocated to taxpayers that are not active in the business. If deemed a tax shelter, an entity will be subjected to the interest limitation regardless of receipts.

Real estate entities that exceed the gross receipts limitation or are considered a tax shelter can make an election to be a Real Property Trade or Business (RPTOB). The interest limitation described above does not apply to electing taxpayers. An electing taxpayer can deduct all its interest expense for the year the election is made and all subsequent years. Once made, the election is irrevocable. The tradeoff for a real estate entity making the RPTOB election is longer depreciable lives. Taxpayers must switch from the MACRS method of depreciation to ADS.

For residential property, the 27.5-year life increases to 30 years and for commercial property, the 39-year life increases to 40 years. Electing entities with commercial property will no longer be able to take advantage of bonus depreciation on certain 15-year property called Qualified Improvement Property (QIP). The ineligibility of bonus depreciation for electing entities on QIP property can have a significant impact on taxable income or loss. While the increase in depreciable lives from 39 to 40 years may seem inconsequential, taxpayers need to consider any major future renovations or improvements before making the RPTOB election.

If interest expense had previously been subject to this limitation, and the entity subsequently makes the RPTOB election, the previously limited interest expense could be suspended until the entity is liquidated. The taxpayer will not be able to utilize any of the suspended interest with future operating income. While interest expense will not be lost, it will be added to the basis of the activity. This will result in a conversion of an ordinary interest deduction to a reduction of a capital gain.

The discussion above presents just a few of the high-level items related to interest that every real estate business should consider when planning for taxes. Taxpayers need to weigh immediate benefits compared to long term planning in order to successfully utilize interest expense deductions while factoring in any offsetting depreciation impact.