May 22, 2019 — Taxpayers who are in the real estate or construction industry may benefit from making an election to not be subject to the business interest expense deduction limitation that came about through tax reform.
For tax years beginning in 2018, taxpayers with average annual gross receipts of $25 million or more are subject to a limitation on the amount of business interest expense that can be deducted in a tax year. The business interest expense deduction is limited to 30% of adjusted taxable income (a similar calculation to EBITDA). The amount of business interest expense in excess of the 30% limitation is not deductible in the current year and will be carried forward to the following tax year.
A taxpayer in a “real property trade or business” may choose not to be subject to the business interest expense deduction limitation by making an election with their tax return.
Section 469(c)(7)(C) of the Internal Revenue Code defines “real property trade or business” as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
Taxpayers who make the election not to be subject to the business interest expense deduction limitation will be required to use the ADS method of tax depreciation for all of their real property. This includes real property placed into service before 2018. The ADS method for tax depreciation uses longer recovery periods than the standard MACRS periods. Here is a comparison of the MACRS and ADS recovery periods for real property.
| Property placed in service in 2018: | MACRS depreciation recovery period | ADS depreciation recovery period |
| Nonresidential real property (buildings and improvements) | 39 years | 40 years |
| Residential rental real property (buildings and improvements) | 27.5 years | 30 years |
| Property placed in service before 2018: | MACRS depreciation recovery period | ADS depreciation recovery period |
| Nonresidential real property (buildings and improvements) | 39 years | 40 years |
| Residential rental real property (buildings and improvements) | 27.5 years | 40 years |
The longer recovery period for depreciation under the ADS method will result in reduced depreciation expense deductions each year. Before making the election not to be subject to the business interest expense limitations, it is important that the taxpayer considers the net effect of the unlimited interest expense deduction in light of the reduced depreciation expense—the election not to be subject to the business interest deduction limitation is permanent and can’t be revoked.
Company A owns a commercial building it leases to an unrelated party. Company A actively manages the day-to-day activities of the commercial building and is responsible for the operating expenses of the building. Company A is considered to be a “real property trade or business” because of its real estate rental activity. Company A has average annual gross receipts in excess of $25 million so it is subject to the business interest expense deduction limitation.
In 2018, Company A’s income and expenses were:
Because it is subject to the business interest expense deduction limitation, Company A will need to calculate how much business interest expense is deductible in 2018.
For purposes of calculating the allowable business interest expense deduction, Company A’s adjusted taxable income is $25,000,000 (rental income of $30,000,000 less $5,000,000 of other expenses). The allowable amount of business interest expense deductible in 2018 is $7,500,000 (30% of adjusted taxable income of $25,000,000).
Company A’s taxable income for 2018 will be $7,500,000 ($30,000,000 of rental income less deductible business interest expense of $7,500,000, depreciation expense of $10,000,000, and other expenses of $5,000,000).
Since it is a “real property trade or business”, Company A may make an election in its tax return to not be held subject to the business interest expense deduction limitation. Before making the election, Company A determines its depreciation expense using the ADS recovery period would be $9,000,000. If Company A makes the election not to be subject to the business interest expense deduction limitation, its taxable income would be $1,000,000 ($30,000,000 rental income less business interest expense of $15,000,000, depreciation expense of $9,000,000 and other expenses of $5,000,000).
By making the election not be subject to the business interest expense deduction limitation,” Company A’s taxable income is reduced from $7,500,000 to $1,000,000.
This example illustrates the potential benefit available to taxpayers in real property trades or businesses by making the election not to be subject to the business interest expense deduction limitation.