The Tax Cuts and Jobs Act’s Impact on Section 163(j)

In 2017, the Tax Cuts and Jobs Act amended Section 163(j) making it applicable to a much larger number of taxpayers. The regulation limits deductible business interest expense to the sum of business interest income, 30% of adjusted taxable income (ATI), and floor plan financing interest expense. Any amount in excess of the limitation is carried forward by the taxpayer indefinitely for deduction in a subsequent year. While many taxpayers are understandably frustrated by these limitations, an exemption exists for qualifying small businesses, and some industries, such as certain real property and farming businesses, can elect out of being subject to the limitation – with a trade-off, of course, as seen later. The exemption for small businesses is seen most often in practice, and this applies to certain taxpayers with average annual gross receipts for the three preceding tax years of $26 million or less. However, it is important to note that there is one large hiccup with this exemption.

Aid in The Form of The CARES Act

In March of 2019, Congress responded to the country’s economic hardships caused by COVID-19 with the Coronavirus Aid, Relief, and Economic Security Act, or the CARES Act. Included in the act were provisions introduced as measures to relieve the negative impact of business interest expense limitations incurred because of the pandemic. These provisions included increasing the deductible business interest expense threshold from 30% to 50% of adjusted taxable income (ATI) for all taxpayers other than partnerships for 2019, and then for all taxpayers in 2020. Another provision included in the act was the allowance for taxpayers to use their 2019 adjusted taxable income to determine the applicable threshold for 2020. It is important to note that both positions are elective should a taxpayer prefer to use the “old” rules.

 Avoiding the Limitation

Even with the relief provisions provided in the CARES Act, avoiding the limitation entirely would still be the preferred course of action. Earlier, the small business exemption was mentioned as a common method employed for avoiding application of the Section 163(j) rules. This exemption applies when aggregated gross receipts for the prior three tax years averages below $26m. However, this exemption is not applicable for tax syndicates, and even though this sounds like a specific type of entity – it is not. Under the current rules, a tax syndicate classification applies if the taxpayer is a partnership, S-Corporation, or LLC with 35% or more of losses allocated to owners who are not actively involved in the business. It is easy to see how unsuspecting taxpayers may stumble into the tax syndicate status. There are some additional relief measures that can be applied that go beyond the scope of this article, but you should contact your tax adviser if you believe this situation applies to your current tax position. 

Instead of the small business exemption, certain taxpayers may elect to be treated as excepted trades or businesses. For qualifying taxpayers, such as real property trade or businesses, making this irrevocable election allows business interest expense to be deducted without limitations. However, making the election also requires that any real property and qualified improvement property must be depreciated under the Alternative Depreciation System (ADS) which mandates longer depreciation periods and disallows bonus depreciation. Under the old regulations, there may have been more of a trade-off for making the election. However, couple the fact that Section 179 is still allowed to be taken on qualified improvement property even if the election is made, with the recent changes to ADS depreciable lives under the Consolidated Appropriations Act signed into law in late December, and the impact may not be as severe.

How Does This All Come Together For 2020?

Assume AB is a partnership equally owned by individuals A and B. A provided all services for the partnership for 2020. B provided all the capital for the partnership but does not participate in the partnership’s business. The partnership owns and operates two large residential rental properties that cost $5,000,000to acquire and were placed into service in 2018. The partnership’s average annual gross receipts for the three previous tax years is $8,000,000. For the current taxable year, the partnership has a taxable loss of $300,000, which includes depreciation of $180,000 and interest expense of $100,000.

Ordinarily, the partnership would meet the small business exemption for the 2020 tax year with average annual gross receipts of less than $26 million. However, Since the tax loss is allocated equally between A and B with 50% of the loss allocated to B, a limited partner, Partnership AB is considered a tax syndicate for the 2020 tax year and cannot use the small business exemption rule to avoid the business interest limitation. Worse-case scenario would result with a disallowance of the full $100,000 business interest expense.

Although the exemption is not available, the partnership does qualify to make the election to be treated as a real property trade or business. However, by making the election, the partnership would have to agree to change its depreciation recovery period on the buildings to the longer ADS life, which in this example would result in 2020 depreciation expense of around $167,000. Although the partnership would forego around $13,000 in depreciation expense, making the election would avoid the 163j limitation provision and preserve the $100,000 business interest expense deduction. 

Section 163(j) is a complicated area of the tax code. The example provided above is a very simplified one that does not consider all possible 2020 tax avenues available, but it does just scratch the surface of its complexity. Please consult your tax adviser to help navigate these issues and remain informed.