Commercial Real Estate Faces Cap On Interest Expense

The IRS has tightened its policy on interest expense, and commercial real estate is already feeling the crunch.

As part of the 2017 Tax Cuts and Jobs Act, CRE companies now face a cap on the amount of interest expense they can deduct from their annual taxes. Since the work of so many real estate companies relies on borrowed capital, the new law threatens to throw a wrench in the works.

“Interest expense is often one of the largest cash flow items for real estate businesses,” Berdon Tax Manager Joseph Most said. “Because so many CRE companies are highly leveraged, this new cap could have a huge effect.”

Before 2017, when a company borrowed capital, it was allowed to deduct all the interest on those loans in the year the interest was paid. But as of 2018, all companies are subject to a limitation on interest expense: They are only allowed to write off interest expenses equal to 30% of their adjustable income. Developers and REITs that regularly borrow large sums could be especially affected.

Most said the majority of CRE professionals know about the changes to interest expense limitations rule — known as 163(j) — but some are surprised by how complex the law is.

“Our clients come to us thinking that their choices are clear-cut, but when we delve into the numbers, they see that there are many factors and exceptions in play, and that each requires a trade-off,” Most said. “It’s important that they have someone who can dive deeper into the numbers and consult with them about their plans.”

Most said the change was not so much an update to tax policy as it was a wholesale replacement. While a few select companies had faced interest expense limitations before TCJA, the new law has generalized the policy to affect almost every company.

The IRS has laid out two special cases that would let CRE companies avoid the limitation: a “small business” exception and a “real estate” election. But Most warned that each comes with an associated set of risks.

“Some of these decisions are permanent, so it’s imperative that companies get advice from tax professionals before filing 2018 tax returns, especially when potentially making a permanent election,” Most said. “They need to look not just at their returns from the past, but also think carefully about their plans for the future.”

Many CRE companies would seem to be exempt from the IRS’ new cap because they qualify as small businesses: companies whose average annual gross receipts did not exceed $25M for the three preceding taxable years.

But Most cautioned that when a pass-through entity is part of a tiered structure, taking a small-business exception may just kick the limitation down to the next tier. The heavy reporting burden created by 163(j) may actually make it more time-consuming for small businesses to comply with the requirements than for larger companies, he said.

Real estate companies can also make a one-time, permanent election out of the interest expense cap. Most said that the IRS has defined “real estate companies” very broadly; even hotels can qualify.

But this election comes with a catch: These companies are required to use the Alternative Depreciation System. ADS forces companies to forgo the new bonus depreciation rules for qualified improvement property, which could save hundreds of thousands on construction and renovations, as long as Congress makes a much-discussed technical correction to the tax law.

Recent tax regulations have broadened what expenditures are eligible to be deducted as repairs, but the ADS requirement will still affect many real estate companies that elect to avoid the interest limitation.

“We’ve been sitting down with clients to discuss what their NOI looks like for the next five to 10 years and building a custom plan,” Most said. “If a company is taking on many more projects in the coming years, an interest expense limitation may be a worthy trade-off to be able to claim large amounts of bonus depreciation. But if they do not have large capital projects in the works, making the one-time election could be the better deal."

Most said the election remains risky because the bonus depreciation law features a well-known mistake in the text of the TCJA that concerns what property is eligible for bonus depreciation. Most said that depending on if and when Congress decides to fix that mistake, electing to be considered a real estate company could become far more or far less attractive.

“We’re currently advising many of our clients to wait as long as they can to file their 2018 tax returns, to see whether Congress fixes that mistake,” Most said. “We’re expecting further clarity on these rules in June or July of this year.”

This feature was produced in collaboration between Bisnow Branded Content and Berdon LLP. Bisnow news staff was not involved in the production of this content.