The Tax Cuts and Jobs Act (“TCJA”) significantly revised the rules regarding the deductibility of interest attributable to a trade or business. Long-anticipated regulations were recently issued by the IRS that both interpret and expand upon these new rules (the “Proposed Regulations”).
The TCJA revises Internal Revenue Code Section 163(j) to impose a limit on the deduction of interest equal to the sum of (i) the business interest income of the taxpayer, (ii) 30% of “adjusted taxable income” and (iii) the taxpayer’s floor financing interest expense. The 163(j) limitation applies to all interest expense of the taxpayer, whether an individual, corporation, partnership or trust, as opposed to only interest between related parties as under prior law. Any excess business interest (i.e., not deductible due to this limitation) may be carried forward indefinitely. The Proposed Regulations confirm that this limitation applies, as well, to interest deductions that were suspended under prior law and carried forward to years beginning on or after January 1, 2018.
Definition of Interest
The Proposed Regulations incorporate an expansive definition of “interest,” and treat as interest items that are “closely related” to interest, such as commitment fees to make a loan. In addition, guaranteed payments to partners from partnerships for the use of capital are treated as interest. The Proposed Regulations also make clear that the 163(j) limitation applies after application of other interest deduction limits, such as disallowance, deferral or required capitalization but before limitations on deductibility under the at risk rules and passive activity rules.
The Proposed Regulations contain a blanket rule that provides that all interest incurred by a C corporation is business interest and thus subject to these limitations; i.e., no allocation is required between business interest and investment interest for a corporation. In the case of a consolidated group of C corporations, the 163(j) limitation applies to the group as a whole and the Proposed Regulations contain specific rules for allocation among consolidated group members. However, the 163(j) limitation does not apply to an affiliated group of corporations that does not elect to file a consolidated return.
In the case of debt incurred by a partnership, the 163(j) limitation is applied at the partnership level, and the partnership’s non-deductible interest expense is allocated to the partners. However, partner-level adjustments are required with respect to the “inside basis” adjustment under Code Section 743(b), built-in loss of contributed property under Code Section 704(c)(1)(c) and income allocations under the remedial allocation method for contributed property.
The Proposed Regulations provide that the allocation follows the same method as that used in allocating non-separately stated taxable income or loss. 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.
The Proposed Regulations prescribe some special rules for S corporations. First, unlike the rule that provides that all interest incurred by a C corporation is business interest and thus subject to the section 163(j) limitation, interest expense incurred by a S corporation is determined and treated in the same manner as that incurred by an individual (described in General Rules above). Second, the 163(j) limitation is applied at the S corporation level, as it is for partnerships, but there is no pass-through to shareholders of non-deductible interest.
There are several important exceptions to the interest deductibility rules:
Real property trade or business. A “real property trade or business” may elect out of the 30% deductibility limitation, but must then 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”). 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.
The management or operation of a hotel qualifies as a real property trade or business. However, if at least 80% of the business’s real property is leased to a trade or business under common control (50% of direct and indirect ownership interests in both businesses are held by related parties), the trade or business will not be eligible to make the election.
Significantly, the Proposed Regulations make clear that a REIT can be engaged in a real property trade or business and thus make use of the election to not be subject to the interest deductibility limitation. In addition, a REIT is permitted to lease qualified lodging or health care facilities to their taxable REIT subsidiaries (generally under common control with the REIT) and still be permitted to make the election. However, a mortgage REIT cannot make such an election.
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, although the election will terminate if the taxpayer ceases to exist or ceases the operation of the electing trade or business.
Special rule for REITs. REITs derive most (if not all) of their income from property held for investment. However, consistent with the rule for C corporations, the Proposed Regulations provide that all interest income and expense of a REIT are treated as business income and expense and all other items of income, gain, loss and deduction are subject to the rules allocating such items to a trade or business.
If a REIT chooses to be an electing real property trade or business and the value of the REIT’s “real property financing assets” is 10% or less than the value of the REIT’s total assets, a safe harbor exists to treat all of the REIT’s assets as those of an electing real property trade or business. If the value of the real property financing assets is more than 10% of the value of the REIT’s total assets, the REIT’s business interest income and expense, and other items of gross income and expense are allocated between excepted and non-excepted trades or businesses under specific allocation rules set forth in the Proposed Regulations.
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 include those of all “related” entities as well (i.e., aggregation is required). In the case of a partnership, the gross receipts test is applied at the partnership level. However, this exception does not apply to a “tax shelter,” one of the definitions of which is a partnership or other entity that allocates more than 35% of losses to limited partners or limited entrepreneurs.
No exception for lending businesses. The Proposed Regulations make clear that an entity engaged in a lending activity is engaged in real property financing and thus, the activity is not a real property trade or business. Consequently, an entity such as a debt fund or mortgage REIT cannot make an election to be exempt from the interest deduction limitation. However, most lending businesses experience interest income in excess of interest expense and the denial of the election out of the interest deductibility limitation should generally not have much of an impact on these activities.
The Proposed Regulations address several issues that were left to IRS interpretation under the TCJA and practitioners now have some firm guidance on planning and structuring transactions. 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, taxpayers 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. 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.
The Proposed Regulations have addressed many of the ancillary consequences of making the election to not be subject to the interest deductibility limitation, but have reserved on others, such as the treatment of self-charged interest. These topics and others covered by the Proposed Regulations will be discussed in more detail in a future Tax Alert.
Please contact your Mazars USA LLP professional for additional information.
 This is separate and apart from limitations on deductibility that apply to investment interest and qualified residence interest.
 “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 after, adjustable taxable income is also reduced by depreciation and amortization.
 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.