Sec. 163(j) after OBBBA: Leveraging cost-recovery accounting methods

Editor: Jeffrey N. Bilsky, CPA

The law known as the One Big Beautiful Bill Act (OBBBA), H.R. 1, P.L. 119–21, made significant changes to Sec. 163(j), which limits the deductibility of business interest expense. These changes are both taxpayer–favorable, such as the permanent restoration of depreciation and amortization addbacks to adjusted taxable income (ATI), and unfavorable, such as the new ordering rule addressing the interaction of Sec. 163(j) and the Code’s interest capitalization provisions.

Given the importance of the updated rules and their potential interplay with other provisions, understanding the nuances of amended Sec. 163(j) will be essential to tax planning and compliance for the 2025 tax year and beyond. With careful analysis and modeling, taxpayers may be able to take advantage of new opportunities to mitigate the impact of the interest expense limitation, helping their business operations remain as tax–efficient as possible.

Summary of OBBBA changes to Sec. 163(j)

Sec. 163(j) generally limits a taxpayer’s business interest deduction to 30% of ATI. For tax years beginning before 2022, taxpayers were instructed to add back deductions allowable for depreciation, amortization, and depletion to taxable income when calculating ATI. The Tax Cuts and Jobs Act (TCJA), P.L. 115–97, eliminated that addback for tax years beginning in 2022 and later, meaning ATI was reduced by the amount of those deductions. The OBBBA permanently restored the addback of depreciation, amortization, and depletion for tax years beginning in 2025 and later. This favorable change may result in higher ATI, thereby increasing the amount of business interest expense taxpayers can deduct in a given tax year.

The OBBBA also introduced an unfavorable ordering rule concerning the types of business interest that are subject to the Sec. 163(j) limitation. Regs. Sec. 1.163(j)-3, finalized in 2020, specifies that Sec. 163(j) applies only to business interest expense that would be deductible in the current tax year without regard to Sec. 163(j). Under this regulation, Code provisions that disallow, defer, capitalize, or otherwise limit interest expense are applied first, followed by Sec. 163(j). However, under the OBBBA’s new ordering rule in Sec. 163(j)(10), the business interest limitation applies without regard to whether a taxpayer would otherwise deduct or capitalize the business interest, effective for tax years beginning in 2026 and later. That new rule does not apply to interest that must be capitalized under Sec. 263(g) or 263A(f).

Before the OBBBA’s enactment of the ordering rule, many taxpayers made elections under Sec. 266 or 263(a) to capitalize interest to various types of property (e.g., inventory or depreciable property). In doing so, taxpayers recharacterized the interest as amounts that would not be subject to the Sec. 163(j) limitation (e.g., cost of goods sold or depreciation). By applying Sec. 163(j) before any elective interest provisions, the new OBBBA rule effectively negates the Sec. 163(j) benefit of elective interest capitalization. That is because all of a taxpayer’s interest expense (minus only the amounts capitalized under Sec. 263(g) or 263A(f)) is subject to the Sec. 163(j) limitation.

Those two changes to Sec. 163(j) make accounting methods planning, particularly in the depreciation/amortization cost–recovery space, particularly important for future tax years. Below are some ideas taxpayers across a multitude of industries might want to consider exploring.

Fixed-asset planning

The OBBBA’s restoration of depreciation and amortization addbacks when calculating ATI under Sec. 163(j) has significantly changed the calculus for fixed–asset planning. Previously, taxpayers often hesitated to accelerate depreciation out of concern that larger depreciation deductions would reduce ATI. Now that depreciation and amortization are added back when calculating ATI, fixed–asset planning techniques are generally neutral from a business interest limitation perspective. That shift allows taxpayers to focus on the underlying cash tax and financial statement benefits of their fixed–asset strategies.

Specific fixed–asset planning techniques in this area include:

• Carrying out cost-segregation studies, which reclassify assets into shorter-lived categories for accelerated depreciation;
• Identifying any “missed” bonus depreciation for assets placed in service in prior years for which the taxpayer did not make a Sec. 168(k)(7) election; and
• Ensuring qualified improvement property assets are properly classified for 15-year recovery and bonus depreciation eligibility.

Taxpayers wanting to accelerate depreciation deductions into the current year typically can do so using automatic accounting method changes. Depreciation changes, like most other accounting method changes, are made with a Sec. 481(a) adjustment. That adjustment allows a taxpayer to take into account the cumulative difference between depreciation claimed under the historical method of accounting and depreciation that would have been claimed under the proposed method of accounting during prior tax years.

A taxpayer–favorable Sec. 481(a) adjustment is recognized as a decrease to taxable income entirely in the year of change. In Chief Counsel Advice memorandum 202123007, the IRS advised that a Sec. 481(a) adjustment arising from a depreciation accounting method change is treated as depreciation for determining a taxpayer’s ATI under Sec. 163(j). Now that Sec. 163(j) allows for the addback of depreciation and amortization to taxable income when calculating ATI, the Sec. 481(a) adjustment from any depreciation accounting method change will be added back to ATI, and the taxpayer’s Sec. 163(j) business interest limitation will not be reduced.

Uniform capitalization under Sec. 263A for self-constructed property

For capital–intensive businesses, a careful review of their Sec. 263A methodologies can optimize Sec. 163(j) outcomes and, in some situations, improve compliance. For example, a taxpayer that self–constructs depreciable property used in its trade or business has the opportunity under Sec. 263A to capitalize additional direct and indirect costs to the depreciable basis of the property. For purposes of the uniform capitalization rules, “self–constructed property” is a broader and more ambiguous concept than the term might initially suggest. Under Regs. Sec. 1.263A–2(a)(1)(ii)(B), property can be treated as self–constructed even when the physical work is performed by third–party contractors. As a result, costs incurred for contractor labor, engineering, project management, and similar services can fall in the scope of Sec. 263A, even if the taxpayer did not directly perform the underlying construction activities.

Taxpayers that are deducting capitalizable Sec. 263A costs when paid or incurred should consider filing an accounting method change to properly capitalize those amounts to the basis of the property being produced. Once the property is placed in service, the incremental depreciation expense associated with the capitalized additional Sec. 263A costs can be added back when calculating ATI under Sec. 163(j).

Capitalization of R&E expenditures

Under the OBBBA, domestic research or experimental (R&E) expenditures can be deducted when paid or incurred under new Sec. 174A for tax years beginning in 2025. However, taxpayers can elect to capitalize domestic R&E costs and amortize the amounts for a period of no less than 60 months, beginning with the month in which they first realize benefits from the expenses (Sec. 174A(c)). Similarly, Sec. 59(e) allows taxpayers to elect to capitalize domestic R&E costs and amortize the amounts over 10 years. If taxpayers choose either election to capitalize otherwise deductible domestic R&E costs, the recovery of such capitalized amounts is eligible as an amortization addback for Sec. 163(j) purposes (see also “Practical Sec. 174A Tax Planning in the Post–OBBBA Landscape“).

Repair and maintenance costs and the book-conformity safe harbor

The Sec. 263(a) tangible property regulations set forth principles addressing when a taxpayer must capitalize costs related to the acquisition, production, and improvement of tangible property. Once a cost is capitalized under Sec. 263(a), it is recovered under the applicable provisions of the Code and regulations (e.g., depreciation expense under Secs. 167 and 168).

While many taxpayers made significant efforts to apply the tangible property regulations when the regulations were finalized well over a decade ago (T.D. 9636, issued Sept. 13, 2013), they might not have continued with such thorough analysis in succeeding tax years. Accordingly, taxpayers might benefit from revisiting the regulations to determine whether any capitalizable costs incurred in recent years were improperly deducted (e.g., as a repair and maintenance expense) for tax purposes. If so, a taxpayer can file an automatic accounting method change to reclassify amounts from deductible repairs to capitalizable improvements.

Taxpayers might also want to consider making the book–conformity safe–harbor election under Regs. Sec. 1.263(a)-3(n). That annual election allows taxpayers to capitalize any deductible repair and maintenance costs that are capitalized for financial reporting purposes. In the context of Sec. 163(j), capitalizing repair and maintenance costs converts ordinary Sec. 162 deductions into depreciable basis, resulting in larger depreciation deductions that are added back in the ATI calculation. If the capitalized costs qualify for 100% bonus depreciation, taxpayers making the election might not see a significant difference (if any) in the timing of cost recovery.

Revisiting the de minimis safe-harbor election

The de minimis safe–harbor election under Regs. Sec. 1.263(a)-1(f) allows taxpayers to currently deduct specific amounts paid to acquire or produce tangible property, subject to specified thresholds (see Galletta and Lau, “The De Minimis and Routine Maintenance Safe Harbors,”55–5 The Tax Adviser 46 (May 2024)). In the Sec. 163(j) context, forgoing the safe harbor could allow taxpayers to capitalize amounts that would otherwise be expensed, increasing depreciable basis and future depreciation addbacks when calculating ATI. Alternatively, taxpayers might want to lower the dollar thresholds in their book capitalization policy, which would result in more costs being capitalized and depreciated for both financial reporting and tax purposes. While that strategy requires balancing administrative complexity and timing considerations, it can be an effective lever for increasing ATI and maximizing interest deduction potential under Sec. 163(j).

Reverse or defensive depreciation planning

In some situations, such as when business interest expense is already fully deductible in the current tax year or other tax attributes are affected, taxpayers might determine that slowing depreciation is advantageous. Electing out of bonus depreciation under Sec. 168(k)(7) or using the alternative depreciation system under Sec. 168(g) can smooth depreciation deductions and help manage ATI and interest limitations across multiple years. Because those elections might also have implications beyond Sec. 163(j), modeling is essential to align defensive depreciation strategies with the taxpayer’s overall tax planning objectives.

Key takeaways

The OBBBA’s restoration of depreciation and amortization addbacks when computing ATI fundamentally changes the Sec. 163(j) planning landscape. While the new ordering rule limiting interest capitalization eliminates some historical strategies, the expanded definition of ATI opens the door to a wide range of accounting methods and cost–recovery planning opportunities.

Importantly, those strategies do not exist in isolation. Changes to depreciation, capitalization, and accounting methods can have downstream effects on other regimes, including the base–erosion and anti–abuse tax, corporate alternative minimum tax, foreign–derived intangible income (now foreign–derived deduction–eligible income), and earnings–based modeling. Many of those opportunities require lead time to analyze, model, and implement. Taxpayers should begin evaluating those issues now and apply a comprehensive, cross–regime approach to planning under revised Sec. 163(j).

Editor

Jeffrey N. Bilsky, CPA, is managing principal, Washington National Tax, with BDO USA, P.C. in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA, P.C.