Is Being Highly Leveraged a Good Thing?Anchin’s Real Estate UpdateJuly 12, 2018
The 2018 Tax Act limits the deduction of business interest, therefore impacting the potential strategic value of being highly leveraged.
According to the Act, beginning in years after 12/31/17, a business will only be able to deduct interest expense up to 30% of its adjusted taxable income, plus its business interest income. Adjusted taxable income is defined as income before interest, depreciation and amortization (beginning in 2022, only interest is added back).
However, there are some exceptions to this new rule including a “small” taxpayer, which is a taxpayer that has average annual gross receipts of $25 million or less for the prior three taxable years. When computing the $25 million gross receipts, you must take into account all related entities (entities with 50% or more common ownership, attribution rules apply).
Partners A & B have an entity (“Company 1”) with average gross receipts of $10 million, and each own 50% of the entity.
Partners A, B & C have an entity (“Company 2”) with average gross receipts of $15 million, and each own 33.3% of the entity.
Partners B & D have an entity (“Company 3”) with $1 million of gross receipts, and each own 50% of the entity.
Therefore, all 3 entities do meet the exception. A & B own 50% of Company 1 and own 66.67% of Company 2, while Company B owns 50% of Company 3.
A further exception is for real estate entities. Real estate entities are entitled to take 100% of their interest deduction, if they elect; however, they will then be subject to the ADS system of depreciation on all buildings, building improvements, leasehold improvements and tenant improvements placed into service beginning in the year that they elect to take the 100% deduction and for all subsequent years.
Under the ADS system of depreciation, the entity will not be allowed to take bonus depreciation on any of their building improvements, tenant improvements and leasehold improvements.
Partner representatives should be very cautious in electing to take 100% of the interest deduction since, once you are in the ADS system, you are in it forever; this is a permanent election.
When an entity’s business interest deduction is limited, the excess interest expense will flow to the partner. It can be carried forward by them to be used in future years when that activity’s interest expense is below the 30% limit and only up to the 30% limit in any future year.
You may want to see what liabilities are creating the interest expense in order to see if there are ways to minimize the interest expense. If you have partner or related party loans, you may look to see if these can be capitalized so there would be no interest expense, or look at the rates being charged to determine if they could be lowered. In the event the loans are disproportionate to ownership, you might want to consider changing the loans to preferred equity with a preferred return instead of interest.
If you need help assessing if and how this impacts you and your business, contact your Anchin Relationship Partner or Marc Wieder at firstname.lastname@example.org.