Final Treasury regulations released on July 28 create a detailed legal framework to implement the new limitation on the deductibility of business interest enacted in the Tax Cuts and Jobs Act of 2017. The underlying provision—section 163(j) —caps the deduction for business interest expense at no more than 30 percent of modified gross income but allows real estate businesses to elect out of the regime altogether.
- The deductibility of business interest expense was front and center in the 2017 tax reform debate. Elimination of the deduction was viewed by some as a necessary “pay-for” to help offset the cost of immediately expensing capital investment and reducing the corporate rate from 35 to 21 percent. The Roundtable worked to preserve the full deduction, noting that it was necessary to accurately measure income and critical to the normal financing of real estate investment and activities. (Roundtable President & CEO Jeffrey DeBoer Statement for the Record before Senate Finance Committee, video clips and full hearing on September 19, 2017)
- During the rulemaking process, The Roundtable focused on ensuring that the regulations would not restrict unnecessarily the ability of a real property trade or business (RPTOB) to elect out of the provisions of the new limit (section 163(j)). Previously proposed regulations clarified, as requested, that interest on debt incurred by a partner to fund an investment in a partnership engaged in a real estate business would be allocable to that business and therefore qualify for the RPTOB election. The proposed regulations also clarified that an RPTOB election by a partnership did not bind a partner with respect to any activity conducted by the partner outside the partnership.
- For example, the regulations clarify that a business entity can be in a real property trade or business even if it is not in a trade or business under the general tax rules of section 162 (the provision that authorizes taxpayers to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business). Unlike the proposed rules, the final regulations provide that a small business that is exempt from the business interest limit can still make a RPTOB election.
- This clarification is important because individual partners in a small business may not qualify for the exemption once their interests in multiple properties are aggregated. The final regulations favorably revise troubling language in the proposed rules that suggested the RPTOB exception was only available for trades or businesses involved in rental real estate activities.
- Consistent with Roundtable recommendations, the Treasury guidance also includes a notice (IRS Notice 2020-59) with a proposed revenue procedure that creates a safe harbor for assisted living facilities so they can qualify for the RPTOB exception – notwithstanding their provision of other services, such as nursing and routine medical services. Other elements of the Treasury guidance include new proposed regulations on specific issues, such as application of the rules to foreign taxpayers.
Collectively, the final regulations should provide greater certainty to real estate owners and investors that debt used to acquire, improve, and operate commercial real estate remains fully deductible for federal income tax purposes, provided the taxpayer complies with specific tax and filing requirements.
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