Sec. 163(j) planning considerations

Editor: Robert Venables, CPA, J.D., LL.M.

In 2017, as part of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, Congress significantly restricted the ability to deduct business-related interest expense with the amendment of Sec. 163(j). The revised provision limits the current deduction to 30% of adjusted taxable income (ATI) plus business interest income (plus any “floor plan financing interest”). The original calculation of ATI for these purposes included the add-back of depreciation and amortization, such that ATI was more of a concept of earnings before interest, taxes, depreciation, and amortization (EBITDA). However, the add-back of depreciation and amortization expired for years beginning after Dec. 31, 2021.

This unfavorable change has resulted in many more taxpayers having their interest deduction limited and/or being subject to higher limitations, which has brought about significant tax liabilities to higher-leveraged taxpayers. Some of the options available to mitigate or eliminate the limitation include exceptions, elections, capitalization, and proper structuring. These as well as other considerations for taxpayers are explored more fully below.

Small business exception

Commonly known as the small business exception, Sec. 163(j)(3) provides an exception for any taxpayer (other than a tax shelter under Sec. 448(a)(3)) “which meets the gross receipts test of section 448(c) for any taxable year.” For tax years beginning after Dec. 31, 2022, a taxpayer meets the Sec. 448(c) gross receipts test if their average annual gross receipts for the prior three tax years is not more than $25 million, adjusted for inflation ($30 million in 2024).

To determine whether the Sec. 448(c) gross receipts test is met, the aggregation rules under Sec. 448(c)(2) apply. Generally, taxpayers (or entities) will be subject to aggregation if they are treated as a single employer under the controlled group rules of Sec. 52(a) or 52(b), under the affiliated service group rules of Sec. 414(m), or under the rules of Sec. 414(o)(3).

Real property trade or business election

Certain taxpayers are exempt from the application of Sec. 163(j) (Sec. 163(j)(7)(A)). One such exemption is for an electing real property trade or business (RPTOB) (Sec. 163(j) (7)(A)(ii)). Sec. 469(c)(7)(B) defines (by cross-reference to Sec. 469(c)(7) (C)) an RPTOB as a trade or business engaging in real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. Regs. Sec. 1.469-9(b) (2)(i)(A) defines real property as land, buildings, and other inherently permanent structures that are permanently affixed to land. However, it is important to note that an asset that serves an active function, such as an elevator; escalator; or heating, ventilation, and air conditioning system is excluded from the real property definition (Regs. Sec. 1.469-9(b)(2)(i)(C)).

The RPTOB exemption requires a one-time, irrevocable election under Sec. 163(j)(7)(B). However, an electing RPTOB must use the alternative depreciation system for certain types of property and will not be able to claim bonus depreciation on those properties (Regs. Sec. 1.163(j)-9(c)(3)). Therefore, an RPTOB needs to analyze the effects of the interest limitation and depreciation modifications to determine the most advantageous option.

Self-charged interest

Regs. Sec. 1.163(j)-6(n) sets forth guidance on lending transactions between a partner and a partnership in which the partner owns a direct interest. Loans by a partner to a partnership result in interest income to the partner and interest expense to the partnership. The interest expense of the partnership from such a loan is subject to Sec. 163(j) and thus could be limited. However, final regulations issued in 2021 provide some relief for these self-charged lending transactions where the lending partner owns a direct interest in the borrowing partnership. Regs. Sec. 1.163(j)-6(n) provides:

If in a given taxable year the lending partner is allocated excess business interest expense from the borrowing partnership and has interest income attributable to the self-charged lending transaction (interest income), the lending partner is deemed to receive an allocation of excess business interest income from the borrowing partnership in such taxable year.

The amount of the lending partner’s deemed allocation of excess business interest income is the lesser of such lending partner’s allocation of excess business interest expense from the borrowing partnership in such taxable year or the interest income attributable to the self-charged lending transaction in such taxable year.

This relief does not apply in the case of loans made by a partnership to a partner, loans made by an indirect partner, or loans made by an S corporation shareholder to an S corporation.

The implications and applicability of this relief should be considered for existing loans as well as future capital needs of a partnership. However, alternative options including equity financing structures such as preferred equity may provide more relief than is achievable under the self-charged lending transaction rule.

Capitalization strategies 

Sec. 263A applications: One of the ways taxpayers may be able to maximize their interest deductions is capitalization of interest under Sec. 263A. Regs. Sec. 1.163(j)-3(b)(5) states that “[s]ection 163(j) applies after the application of provisions that require the capitalization of interest, such as section[] 263A” and “[c]apitalized interest expense under [that] section[] is not treated as business interest expense for purposes of section 163(j).”

Sec. 263A requires interest to be capitalized only in the production of designated property. Regs. Sec. 1.263A-8(b) defines designated property as:

1. Real property; or

2. Tangible personal property, other than inventory or property held primarily for sale to customers in the ordinary course of a trade or business (as defined in Regs. Sec. 1.263A-2(a)(2)) that meets any of the following criteria:

A. Property with a class life of 20 years or more (see Appendix B of IRS Publication 946, How to Depreciate Property, for assets classified as 20-year property) under Sec. 168, but only if it is not property described in Sec.1221(a)(1) in the hands of the taxpayer or a related person;

B. Property with an estimated production period (as defined in Regs. Sec. 1.263A-12) exceeding two years; or

C. Property with an estimated production period exceeding one year and an estimated cost of production exceeding $1 million.

Regs. Sec. 1.263A-9 requires interest to be capitalized under the avoided-cost method, under which interest incurred on indebtedness directly attributable to accumulated production expenditures for real or other designated property is capitalized first. Directly attributable indebtedness is referred to as “traced debt.” If accumulated production expenditures for a designated property exceed the amount of traced debt, interest on other debt is capitalized to the extent that such interest could have been reduced if there were no production expenditures.

The amount of interest capitalized by a taxpayer under the avoided-cost method is determined separately for each unit of designated property produced by or for the taxpayer. In the case of real property, units may consist of individual apartments, condominiums, offices, or buildings in a shopping mall if they are expected to be separately placed in service or sold. In accordance with Sec. 263A(f), taxpayers may make an election to not trace the debt to the various production units.

If that election is made, the average excess expenditures and weighted average interest rate are determined by treating all eligible debt as nontraced debt.

Example: Corporation X has incurred $1.5 million of production expenditures for a unit of real property it is constructing. Interest on an outstanding $1 million loan that it obtained for the construction of the property must be capitalized because the $1 million loan is directly attributable to the production expenditures. In addition, because the corporation has $500,000 of production expenditures in excess of the traced debt, i.e., the $1 million of directly attributable indebtedness, it must capitalize additional interest by multiplying excess production expenditures (i.e., $500,000) by a weighted average interest rate computed with respect to its nontraced debt.

Taxpayers should also consider the downside of capitalizing the interest. Capitalized interest gets added to the basis of the property, which could make realization of the benefit of the deduction take longer than if it were suspended interest expense under Sec. 163(j).

Sec. 266 applications: Regs. Sec. 1.266-1(b) allows the taxpayer to capitalize certain costs into the cost or adjusted basis of the relevant property by making an election. The scope of the election depends on the actual property and/or project but once made is irrevocable without consent. Capitalizable expenses are divided into four classes depending on the related property:

1. Unimproved and unproductive real property: Capitalizable expenses are annual taxes, interest on a mortgage, and any other charges for carrying the property.
2. Real property, whether improved or unimproved and whether productive or unproductive: Capitalizable expenses are costs, incurred no later than the project’s completion, for interest on loans made to provide funds for development, taxes that are measured by the compensation paid for work on the development, state sales or use tax paid on the materials used in the development, and other necessary expenditures.
3. Personal property: Capitalizable expenses are costs, paid or incurred up to the later of the date the property is installed or first used, for taxes paid on compensation for transporting or installing the property; interest on a loan to purchase, transport, or install it; and sales or use taxes incurred up to the date of installation.
4.  Any other eligible taxes and carrying charges the IRS considers chargeable to capital.

As discussed above, one of the costs addressed in the regulation is interest. When eligible for capitalization, it may allow for similar treatment for Sec.

163(j) purposes as interest capitalized under Sec. 263A. As a result, the interest expense would become a timing difference that will allow the taxpayer to deduct the interest as the property is sold. Sec. 266 regulations take a back seat to Sec. 263A as well as various other provisions in Regs. Sec. 1.163(j)- 3(b). As a result, it is important for taxpayers and tax practitioners to properly apply any ordering rules before contemplating the use of Sec. 266.

Furthermore, it is important to note that the IRS has included guidance under Sec. 163(j) regarding the limitation on business interest, including the application of Sec. 163(j) to interest capitalized under Sec. 266, in its 2023–2024 Priority Guidance Plan. Therefore, taxpayers and practitioners should closely monitor guidance on this topic for any applicable changes.

Buy vs. lease considerations 

Taxpayers should consider the most advantageous way to acquire the capital expenditure needs of the business.

Taxpayers may have to decide between buying and leasing, and the preferred route may depend on the tax implications, economic considerations, and financial statement reporting. Ignoring the financial statement considerations for a moment, if taxpayers decide to lease, the desired tax treatment may affect the structure of the lease. In general, leases will be classified as either capital or operating.

A capital lease (with the introduction of FASB ASC Topic 842, Leases, also known as finance leases) entitles the lessee to depreciation deductions and treats a portion of the lessee’s payment to the lessor as interest expense. An operating lease (sometime referred to as a “valid lease” or “true lease”), on the other hand, entitles the lessee to rental/lease deductions. Historically, lessees often preferred capital lease treatment due to the possibility of accelerated depreciation. However, with the phaseout of bonus depreciation and the limitations of Sec. 163(j), this may no longer be the case. 

The classification of leases as capital or operating depends on facts and circumstances. While neither the Code nor regulations define the terms “capital lease” or “operating lease,” Rev. Proc. 2001-28 does provide some level of insight into the classification. Rev. Proc. 2001-28 sets forth the “guidelines that the Internal Revenue Service will use for advance ruling purposes in determining whether certain transactions purporting to be leases of property are, in fact, leases for federal income tax purposes.” As such, taxpayers and tax professionals often use it as a guide to structuring leases in order to obtain the intended lease classification. The revenue procedure provides that leases will be treated as operating leases if the following guidelines are met:

1. Minimum unconditional “at risk” investment: The lessor must meet the minimum investment threshold at the lease’s inception, throughout the entire term of the lease, and at the end of the lease. In general, the minimum investment is at least 20% of the cost of the property. All renewal and extension periods will be included in the lease term except renewals or extensions “at the option of the lessee at fair rental value at the time of such renewal or extension.”
2. Purchase and sale rights: Neither the lessee nor a member of the lessee group may have a contractual right to purchase the property from the lessor at a price less than its fair market value at the time the right is exercised.
3. No investment by lessee: Unless otherwise specified in the revenue procedure, no part of the cost of the property, improvements, modifications, or additions may be furnished by any member of the lessee group.
4. No lessee loans or guarantees: Neither the lessee nor a member of the lessee group may lend to the  lessor any of the funds necessary to acquire the property or guarantee an indebtedness created in connection with the acquisition of the property.
5. Profit requirement: The lessor must represent and demonstrate that it expects to receive a profit from the transaction, apart from the value of or benefits obtained from the tax deductions, allowances, credits, and other tax attributes arising from such transaction.

Taking a step back from the tax side of things, taxpayers also need to consider any financial statement reporting implications of the lease. Topic 842 brought about significant changes to how taxpayers must classify and report their capital assets for financial reporting purposes. A right-of-use asset and corresponding right-of-use liability are now recorded at inception and amortized over the life of the lease. For GAAP purposes, this results in interest and amortization expenses being reported on the income statement. Taxpayers and their professionals need to understand the differences between financial statement and tax classification and reporting of leases to correctly calculate any book vs. tax differences that may be required.

Challenges and opportunities

The Sec. 163(j) limitation has brought about plenty of challenges to organizations as they look to manage cash flow not only for the rising rates but also for the increased tax liabilities. However, with these challenges, there are great opportunities to provide value to the organizations through tax planning and discussions.

Editor Notes

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.

For additional information about these items, contact Venables at rvenables@cohencpa.com.

Contributors are members of or associated with Cohen & Co. Ltd.