How New Interest Deduction Limits Under Tax Reform Impact Real Estate
The 2017 Tax Cuts and Jobs Act changed a number of rules surrounding deductions that impact real estate. One key change is a new limitation on the business interest expense deduction.
Business interest expense is the interest paid or accrued on indebtedness related to a trade or business net of business interest income, but it does not include interest expense related to investments. The Act, effective for taxable years beginning after December 31, 2017, replaces prior IRC Sec. 163(j) and limits the net business interest deductions for all taxpayers to 30% of the adjusted taxable income (after interest, taxes, depreciation and amortization). The interest deduction limitation is applied at the entity/taxpayer level. However, businesses with average annual gross receipts of $25 million or less for three years are exempt from the limitation, though it is subject to attribution rules. Taxpayers can also carry forward the disallowed interest to future tax years.
The Act allows real estate trades and businesses to opt out of the business interest expense limitation by requiring real property to be depreciated using the alternative depreciation system (ADS). Depreciation must be spread out over 40 years instead of 39 for commercial properties to qualify for exemption. With residential properties, depreciation would be 30 years instead of 27.5. The election also applies to Qualified Improvement Property, which includes leasehold improvement which changes by providing a 20-year life under ADS. The election to use ADS only applies to nonresidential real property, residential real property and qualified improvement property.
As of this writing, there is no guidance on how to opt out of the business interest expense deduction limitation and change the depreciation method to ADS; however, the consensus is that taxpayers will need to file Form 3115, Application for Change in Accounting Method, and true-up in the basis—generally over four years or less.
Since many real estate entities depend on leverage and borrowed funds for capital investments, this limitation could have a significant impact on taxable income in real estate companies. Businesses and individuals with real estate assets need to factor the new limits on interest deductibility into their tax planning as they look at future financing options and decide on their capital structures. Once final guidance is issued on changing depreciation methods, it will be important to evaluate the impact of a lengthier depreciation life as compared to the impact of potential deferrals of a portion of the interest deductions. For more information on the top tax trends for the real estate sector, visit eisneramper.com/RETAXTRENDS.