The Four ‘W’s of 163(j)

Why it’s Important

The recent overhaul to our tax system has resulted in some significant changes to many provisions of the Internal Revenue Code. One such change, which is of importance to many real estate operators, is the new limitation on the deductibility of business interest expense. In its simplest terms, the deduction for business interest expense is now limited to 30% of a Net Operating Income (NOI) like measure. This is an important provision that can severely limit the interest expense deduction for highly leveraged real estate operators. Many real estate operators have an option to make a permanent and irrevocable election to avoid the interest expense limitation regime, but it comes at a cost of longer depreciable periods and the loss of bonus depreciation.

What’s Missing

The regulations detailing how to comply with these new rules have not yet been finalized but instead, are still in proposed form. In many instances, the proposed regulations provide a good foundation for determining appropriate filing positions. However, there are a few key issues left unaddressed in those regulations, and as a result, taxpayers and their tax preparers are forced to wait for final regulations to be issued, or to establish filing positions based on the incomplete guidance.

Why we are waiting on it

While the Internal Revenue Service has made these regulations their top priority, there is no scheduled release date.  Real estate operators who have not yet filed their 2018 tax returns are in a precarious position with only a few months left before the extended filing date. Without final regulations and concrete guidance on many of the issues surrounding the limitation on the deductibility of interest expense, they may be forced to make a painful permanent election, or file their 2018 tax returns claiming a filing position without having the benefit of a clear understanding of the ultimate treatment of any disallowed interest.

What we should be thinking about

One of the biggest issues that are not addressed in the proposed regulations is how these rules apply in the case of a tiered ownership structure. There is no guidance whatsoever on the application of these rules to real estate operators with multiple entities owned by a holding company.  Taxpayers may be tempted to make the irrevocable election mentioned above in instances where there is a significant reduction in the amount of deductible interest expense. This decision, however, may not be in the taxpayer’s best interest, particularly in the case of taxpayer’s with multiple properties. The proposed regulations do not clearly address the dynamics between activities where the limitation applies to some properties, but not others. While certain sections of the proposed regulations state that taxpayers cannot net separate activities together for purposes of the limitation, there are other passages that provide conditions to do so.  While waiting for final guidance, our recommendation is that a detailed analysis be done on an activity by activity basis in order to understand how these rules might apply.  With that data available, a more reasonable filing position can be discussed pending the issuance of final regulations.