The Tax Cut and Jobs Act imposed a new limitation for business interest expense. Interest expense for the year is limited to 30% of adjusted taxable income plus any floor plan financing interest paid by vehicle dealers under new code section 163(j)(1).
This limitation applies to all businesses, regardless of form however; many taxpayers, including small businesses will fall into one of several exceptions:
- Taxpayers may fully deduct business interest expense if their average annual gross receipts for the three-tax-year period ending with the prior tax year are $25 million or less per §163(j)(3). For a business that hasn’t been around for three tax years, the gross receipts test is based on the period it has been in existence
- An electing real property trade or business
- An electing farming business
Both the electing real property trade or farm business elections come at a cost:
Real property trades or businesses can elect out of the interest limitation rules if they use the Alternative Depreciation System (ADS) to depreciate nonresidential real property, residential rental property, and qualified improvement property. Real property trades or businesses include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trades or businesses.
Farming businesses can elect out of the interest limitation rules if they use ADS to depreciate property used in the farming business with a recovery period of 10 years or more. A farming business includes operating a nursery or sod farm and raising or harvesting trees bearing fruit, nuts, or other crops, or ornamental tress
A taxpayer that elects out of the business interest expense limitation won’t need to file an accounting method change when switching to the MACRS alternative depreciation system (ADS) as the IRS allows electing farmers and real estate businesses to make the required switch to ADS under “change in use” regulations. The changes described in these regulations are not accounting method changes.
This means electing taxpayers won’t have to:
- file Form 3115, Application for Change in Accounting Method, or
- include a Code Sec. 481(a) adjustment in income.
The taxpayers will recover the remaining basis over the remaining ADS life. This applies to long lived assets (15 years or more for real property trade or businesses or 10 years or more for farming businesses).
Here is an example of a MACRS to MACRS ADS switch:
- Depco, a calendar year real property business, placed 27.5-year residential property costing $100k in service in January 2010. The ADS recovery period for residential property is 40 years
- At 12-31-17, property has been depreciated for 7 years and 11.5 months which totaled $28,937. Remaining basis is $71,063
- Depco will depreciate the remaining $71,063 basis using the straight-line method over the remaining ADS recovery period of 32 years and .5 months
If a business doesn’t qualify for an exception, its business interest deduction for any tax year can’t exceed the sum of
(1) its business interest income (does not include investment income);
(2) 30% of its adjusted taxable income (defined below); and
(3) any floor plan financing interest.
Adjusted Taxable Income is defined as the taxable income of the taxpayer computed without regard to:
- any item of income, gain, deduction, or loss that isn’t allocable to a trade or business;
- any business interest income or expense;
- any Net Operating Loss (NOL) * any deduction under IRC Sec. 199A (for qualified business income);
- any allowable depreciation, amortization, or depletion for tax years beginning before 1/1/22; (depreciation, amortization, or depletion expense is not added back after 12/31/21).
If you need any assistance navigating these rules, please contact John Csargo, CPA, MBT, CFP® at email@example.com.