Competing Considerations: Balancing Full Expensing Provisions with Limitations on Deductibility of Interest (article)
The 2017 tax law commonly referred to as the Tax Cuts and Jobs Act (TCJA), represents a sea change for the real estate industry. While the TCJA introduced a number of new provisions—such as the deduction for qualified business income for pass-through entities—some of the most important changes can be found in alterations to preexisting tax laws. For the real estate industry, two of these changes concern balancing full capital expensing against the newly imposed limitation on the deductibility of business interest.
The TCJA significantly expanded the rules for bonus depreciation of qualifying property, increasing it from 50 to 100 percent for the first year it is placed in service. Notably, this increased limit is now applicable not only for new equipment but also used as well.
While increased bonus depreciation limits clearly benefit and incentivize real estate owners to invest in new projects or reinvest in the property they already own, the introduction of a limitation imposed on the deductibility of business interest—a previously unlimited deduction—necessitates detailed evaluation of the benefit trade-off. The interest deduction is now limited to interest income plus 30 percent of a business’s adjusted taxable income (ATI). Until 2022, ATI is calculated with addbacks for depreciation and amortization—roughly equating to a familiar EBITDA calculation. This new limitation, however, is set to become more onerous after 2021, however, when the ATI number loses the depreciation and amortization addback.
The TCJA curtailed the subsidy provided to highly leveraged businesses, including of course, the real estate industry. To mitigate the harsh effects of the limited interest deduction, the TCJA permits a real property trade or business (RPTB) to elect out of the business interest limitation, making its interest expense fully deductible. There is, of course, a trade-off for this election -- the RPTB must depreciate its assets, including qualified improvement property, using the slower ADS rules, which means bonus depreciation is not available.
Consequently, real estate professionals must now assess and evaluate the present value of bonus depreciation deductions against any potential disallowed interest deduction. Conversely, they must calculate the value of deducting all interest paid against using slower depreciation lives and no bonus depreciation. The following examples are illustrative (assume there is no interest income):
Developer has $100 of taxable income in 2020 related to Property A. During that year, Developer utilized the bonus depreciation deduction for qualified improvement property to make $50 of improvements. Property A’s ATI will be equal to $150, thus producing a limitation on deductibility of business interest equal to no more than $45 (150 x .30).
That same Developer has $100 of income in 2022 related to Property A. Developer spends another $50 on improvement qualifying for bonus depreciation; however, in this year Property A’s ATI will remain at $100 without the addback for the depreciation and amortization. This results in an interest deduction capped at no more than $30 (100 x .30).
As these rudimentary examples demonstrate, if Property A is highly leveraged, the looming change in how ATI is calculated after 2021 may be very negative. The ripple effects of disallowed interest may affect mandatory tax distributions for partnerships and loan coverage ratios negotiated under prior law.
Accordingly, now more than ever before, the real estate industry must rely on comprehensive financial modeling to accurately assess these tax trade-offs. Strategies to mitigate or resolve these issues exist, but they are unlikely to be easy. Working with lenders in anticipation of change is necessary. Finally, in addition to these considerations discussed, real estate partnerships must also account for how their decisions will affect the calculation of their qualified business income deduction.
For more information about this and other tax and accounting issues, contact Chris Hanewald (901-685-5575), or your local CBIZ MHM tax professional.