The last two columns (Feb. 21, 2018 and April 17, 2018) discussed changes affecting real estate including the pass-through business deduction adopted in new Section 199A of the Tax Cuts and Jobs Act (Tax Act) and the workings of the pass-through business deduction. Pub. L. No. 115-97 (enacted December 22, 2017). This column will review the limitation on the deductibility of interest and its application to real estate.
Summary of the Limitation
The Tax Act establishes a limit on the deductibility of net business interest expense equal to 30 percent of an amount that is similar to earnings before interest, taxes, depreciation and amortization (EBITDA) for taxable years 2018 through 2021, and similar to earnings before interest and taxes (EBIT) for taxable years 2022 and thereafter. I.R.C. Section 163(j). In both cases, the Tax Act permits the indefinite carryforward of any disallowed interest expense. The Tax Act does not provide any grandfather provision for outstanding debt; the interest deduction limitation applies to all interest that is paid or accrued on and after Jan. 1, 2018. The limitation on deductibility of interest effectively places a cap on the amount of debt in a capital structure of an entity.
In general, a taxpayer is prohibited from deducting business interest expenses (i.e., interest allocable to a trade or business) in excess of the sum of:
- business interest income, and
- 30 percent of adjusted taxable income (ATI). For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2022, ATI is taxable income other than items not allocable to a trade or business, business interest income and deductions, depreciation, amortization, and depletion, the 20 percent pass-through deduction for business income, and net operating losses (NOLs). For taxable years beginning after Dec. 31, 2021, depreciation, amortization, and depletion is excluded from the calculation.
- For taxpayers with relatively low leverage, the exclusion of depreciation in determining ATI through 2021 might produce a situation where interest deductions would not be limited until 2022, such that the more beneficial depreciation and expensing provisions could justify a delay in the election.
- Any disallowed interest may be carried forward indefinitely.
- Partnerships are evaluated on a separate entity basis, with excess ATI allowed to flow up to partners in certain circumstances.
The limitation on deductibility of interest applies to taxable years beginning after Dec. 31, 2017, so interest on existing debt instruments is not grandfathered.
Exclusion From the Interest Limitation
A person may elect to be excluded from the new interest limitation provision if that person is engaged in a real property trades or businesses under Section 469(c)(7)(C). For this purpose, 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.” The Conference Report makes clear that the exception is not limited to rental businesses and indicates that it is “intended that a real property operation or a real property management trade or business includes the operation or management of a lodging facility,” “Conference Report to Accompany H.R. 1, Tax Cuts and Jobs Act,” 115th Congress, 1st Session, Rept. 115-466 (December 15, 2017) at 268. Small businesses that satisfy the $25 million gross receipts test in Section 448(c) (other than tax shelters) are excluded from the new interest limitation provision. The election to be excluded from the interest limitation provision, once made, is irrevocable.
New permanent Alternative Depreciation System (ADS)
If the taxpayer has a real property trade or business, and elects not to be subject to the interest deduction limitation, the taxpayer must use the ADS depreciation periods for all real estate (residential, nonresidential and qualified improvement property). The useful depreciable periods are:
- Residential real estate: 27.5 years regular period and new 30 year ADS period
- Nonresidential real estate: 39 years regular period and 40 year ADS period
- Qualified improvement property: new 15 year (straight line) regular period and 20 year ADS period
- The new depreciable periods apply to taxable years beginning after 2017. It is not clear how the amendments apply to existing property.
For real property trades or businesses that elect to be exempt from the limitation on interest deductions, all nonresidential real property, residential rental property, and qualified improvement property must be depreciated using the applicable ADS lives (i.e., longer lives). There is a trade-off for electing the interest limitation exemption. For owners who do not rely heavily on leverage, the shorter depreciable lives of real property (and bonus depreciation for qualified improvement property) may outweigh any detriment from the limitation on interest deductions. If the election is made regarding deductibility of interest, the switch to ADS applies to all nonresidential rental property, residential rental property, and qualified improvement property, not just property placed in service beginning in 2018.
Application for Partnerships
The limitation 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 flow up to the partners and will be carried forward at the partner level. Partnerships subject to the interest limitation rules will need to report to their partners whether they have either excess business interest (interest expense that is not able to be deducted by the partnership) or excess business income (the capacity to deduct additional interest expense if it were incurred). A partnership with excess income following a year or years of limitation will then pass that out to its partners, allowing the interest expense carryover to be deducted. This will represent a significant increase in the quantity of information being reported to partners.
When a taxpayer is allocated excess business income from a partnership, it initially frees up any previously disallowed excess interest expense from that partnership. If there is no excess interest expense from prior years, then it appears that the excess business income can be used to support a deduction of interest incurred at the partner level, but not any excess interest expense from other partnerships owned by the partner.
Example of Application to a Partnership
In year one, a partnership (P) has income of $500, and its only expense is interest of $200. P is allowed a deduction of $150 to be included in the non-separately stated distributive share of the partners. The remaining $50 is reported to the partners as excess business interest, which the partners can potentially deduct in subsequent years against excess business income.
In year two, P has income of $500 and incurs interest expense of $100. The full $100 is deductible by P, and P could deduct up to $50 more of interest if it were incurred. P reports this excess interest deductibility capacity to its partners, which allows the partners to deduct $50 more of interest expense (the amount carried over from the preceding year).
The limitation first applies at the partnership level by reference to the business interest income of the partnership and 30 percent of the ATI of the partnership, and business interest deductions that are allowed then are taken into account in determining the nonseparately stated taxable income or loss of the partnership. Disallowed excess business interest is allocated to the partners and is allowed in future years only to the extent of the excess amount allocated by the partnership to such partners.
To the extent that the sum of the partnership’s business interest income and 30 percent of ATI exceeds the partnership’s business interest deductions, that excess capacity to deduct interest is allocated to the partners who then could take advantage of such excess amount in determining the deductibility of business interest incurred outside the partnership. The excess amount is first be used to allow for the deduction of disallowed excess business interest previously allocated by the partnership. Otherwise, for purposes of applying the business interest deductibility limitation at the partner level, the partner’s share of income, gain, loss, and deduction from the partnership is ignored in calculating the partner’s ATI.
A partner generally is required to reduce the basis in its partnership interest by the amount of any allocated disallowed excess business interest, but that basis reduction is reversed to the extent of excess business interest that remains disallowed at the time of a disposition of the partnership interest. The reversal of the basis adjustment allows the partner to recognize a capital loss upon the sale or liquidation of its partnership interest for the remaining disallowed excess business interest.
Peter M. Fass is a partner at Proskauer Rose.