US Tax Reform: Tax Cuts and Jobs Act Imposes New Limitations on Deductibility of Trade or Business Interest

The Tax Cuts and Jobs Act (the “TCJA”), signed into law in December 2017, and applicable to taxable years beginning after December 31, 2017, contains several provisions that will have a significant impact on specific types of entities and investments.   One of the most radical departures from current law involves new limitations on the deductibility of interest attributable to a trade or business.[1]

General Rule

The prior law limitation on the deduction of interest under the “earnings stripping” provisions under Code Section 163(j) has been repealed. The deduction for interest is now limited to the business interest income of the taxpayer, plus 30% of its “adjusted taxable income. The limitation now applies to all interest expenses of the taxpayer, as opposed to only interest between related parties. This limitation seemingly applies to interest on existing debt, as well as interest deductions that were suspended previously.

Prior to 2022, “adjusted taxable income” is computed without including interest income or deductions for interest expense, net operating losses (“NOLs”), the special 20% deduction for pass-through entities, and depreciation and amortization. For taxable years beginning in 2022 and beyond, adjustable taxable income is also reduced by depreciation and amortization. Any excess business interest (i.e., not deductible due to this limitation) may be carried forward indefinitely; however, it is expected that any remaining carryforward amount will be lost upon liquidation in the case of a corporation. In the case of debt incurred by a partnership, the limitation is applied at the partnership level, and the partnership’s non-deductible interest expense is allocated to the partners, which reduces the partner’s basis in its partnership interest.

The non-deductible amount may be carried forward by the partners and deducted to the extent of any excess taxable income allocated to the partner from the applicable partnership in future years. In the case of a disposition of a partnership interest or transfer of such an interest in a non-taxable transaction, the partner’s basis is increased by the excess of the amount of the reduction noted above over the amount of excess interest treated as paid or accrued by the partner. In the case of an S corporation, the limitation is applied at the entity level but with no pass-through to shareholders of non-deductible interest.

Exceptions

Real property trade or business

A “real property trade or business” may “elect out of” the 30% deductibility limitation, but then must depreciate its non-residential real property, residential rental property, and qualified improvement property over longer periods under the alternative depreciation system (“ADS”) rather than the general depreciation system (“MACRS”).[2] For this purpose, a “real property trade or business” is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Both the management or operation of a hotel and the operation of a health care facility qualify as a real property trade or business. Further, the new 100% bonus depreciation deduction generally will not be available to taxpayers that make the election to not be subject to the interest deduction limitation rules. Once made, the election is irrevocable.

Gross Receipts less than $25 million

The business interest limitation does not apply to taxpayers with average annual gross receipts, over the prior 3-year period, that are $25 million or less. “Gross receipts” of an entity includes those of all “related” entities. In the case of a partnership or S corporation, the gross receipts test is applied at the partnership or S corporation level.

Lending businesses

Although there is no specific exclusion for a lending business, the interest deductibility limit does not apply unless business interest expense exceeds business interest income. Consequently, an entity engaged in a lending activity, such as a debt fund or mortgage REIT, should generally not be subject to this limitation.

It is expected that most real property trades or businesses that are moderately or highly leveraged will elect to be exempt from the new business interest deductibility limits. The interest deduction is potentially more valuable than the slightly shorter life available for depreciation of real estate assets. In addition, entities that are required to use ADS, such as partnerships with tax-exempt partners, or REITs that use ADS in connection with earnings and profits calculations, should not suffer adverse tax consequences by making the election.

Further, the taxpayer can elect out of the interest deductibility limitation at any time, bearing in mind that once made, the election is irrevocable. Thus, a taxpayer can decide not to elect out in 2018 and allow an amount of interest deductions to be suspended, and can then elect out in 2019 when the freed-up deductions are available to offset other income. In addition, it may be possible to claim bonus depreciation in one year and elect out of the deduction limitation the next year without recapturing the bonus depreciation claimed.

However, there are many unanswered questions regarding the ancillary consequences of making the election to not be subject to the interest deductibility limitation: (i) whether all investments held by an entity are aggregated to constitute a single trade or business, (ii) the extent to which differences in properties result in separate trades or businesses, (iii) the proper allocation of interest expense among several activities (e.g., pro rata based on fair market value or pursuant to the interest tracing rules), and (iv) whether borrowing at the partner level, S corp level or S corporation shareholder level is attributable to the partnership trade or business. Treasury and IRS representatives have stated that providing guidance on these issues is near the top of their list, and we expect such guidance in time to help taxpayers assess how, whether and when to make the election.

[1] This is separate and apart from limitations on deductibility that apply to investment interest and qualified residence interest.
[2] ADS extends the depreciable life of residential rental property from 27.5 years to 30 years, non-residential real property from 39 years to 40 years, and qualified improvement property from 15 years to 20 years.