Article written by:
Nicole Dulle, CPA
Tax Senior Manager
After depreciation, one of the biggest deductions for real estate companies is typically interest expense. As such, it’s come as no surprise to see there has been a lot of discussion around a provision in the Tax Cuts and Jobs Act whereby the deduction for net business interest is limited to 30% of adjusted taxable income. For many real estate companies, this could seemingly result in a drastic reduction in operating expenses claimed by the entity. However, there are a couple of exceptions in this new provision that could allow the entity to avoid this limitation.
The first is the electing real property trade or business exception. You should work with your GBQ tax advisor to see if your entity meets these requirements and if its an eligible real property trade or business as defined by the IRS. Some examples of industries that could qualify are: real property development, redevelopment, construction, rental, management, lease or brokerage trade or business, etc. If qualified, the entity can then decide to make an irrevocable election with its tax return to be exempt from the 30% limitation on business interest. However, in doing so, the entity must then use the alternative depreciation system (ADS) to depreciate any of its non-residential real property, residential rental property and qualified improvement property. The ADS method is not eligible for bonus depreciation or Section 179 treatment and uses a longer recovery period to depreciate real property – 40 years (as opposed to the 39 and 27.5-year recovery periods in effect for the 2017 tax year for non-residential and residential properties, respectively).
The second exception is the small business exception. The business interest expense limitation doesn’t apply if the entity meets the $25 million gross receipts test for any tax year. To meet this exception, the taxpayer’s average annual gross receipts for the three-tax-year period ending with the prior tax year can’t exceed $25 million. Meeting the gross receipts test seems easy on the surface, but there are aggregation rules in play if your entities are deemed to be part of a controlled group (meaning, simply setting up new companies to collect a portion of the annual revenue won’t get you under the $25 million for purposes of this test).
For more detail and to determine the proper course of action for your business, please consult with your GBQ tax advisor.