Final Regulations Amend Proposed Regulations on Interest Deductibility
By Donald Zief and Mark Peltz
August 28, 2020
The “Tax Cuts and Jobs Act” (the “TCJA”) enacted into law in December 2017 significantly revised the rules regarding the deductibility of interest attributable to a trade or business. The Internal Revenue Service (“IRS”) issued proposed regulations (“Proposed Regulations”) in December 2018 interpreting many parts of the law but left many questions unanswered. Expanding upon these proposed regulations, the IRS published final regulations (“Final Regulations”) in July 2020 that clarified many outstanding issues but also requested comments on several others. The IRS also issued new proposed regulations (“New Proposed Regulations”) that would provide yet more changes and clarifications to the Final Regulations.
The Final Regulations will be effective 60 days after the date they are published in the Federal Register and are generally applicable to taxable years beginning on or after such date. The New Proposed Regulations are to apply to taxable years beginning at least 60 days after the date that the Treasury decision adopting the rules as final is published in the Federal Register. However, taxpayers may apply both the Final Regulations and certain aspects of the New Proposed Regulations retroactively to taxable years beginning after December 31, 2017, as long as they are applied consistently by the taxpayer and its related parties.
The deductibility of interest incurred in the operation of a trade or business is limited by the provisions of Code Section 163(j) (the “163(j) limitation”). Deduction is limited to the sum of (i) the business interest income of the taxpayer, (ii) 30% (50% for 2019 and 2020 taxable years) of its “adjusted taxable income” and (iii) the taxpayer’s floor financing interest expense. The 163(j) limitation applies to all interest expense of all taxpayers as opposed to only interest between related parties as under prior law. Any excess business interest (i.e., not deductible due to this limitation) may be carried forward indefinitely. This limitation applies, as well, to interest deductions that were suspended under prior law and carried forward to years beginning on or after January 1, 2018.
Definition of Interest – The Final Regulations partially scale back the expansive definition of “interest” contained in the Proposed Regulations. Thus, certain expenses are no longer treated as interest for the 163(j) limitation. This includes commitment fees to make a loan, debt issuance costs, partnership guaranteed payments for the use of capital, and hedging income and expense.
However, the Final Regulations retain a modified anti-avoidance rule that applies the 163(j) limitation to an expense or loss that is economically equivalent to interest and if a principal purpose of structuring the transaction is to reduce the taxpayer’s interest expense. The Final Regulations follow the Proposed Regulations in that the 163(j) limitation applies after other interest deduction limits, such as disallowance, deferral or required capitalization but before limitations on deductibility under the excess business loss, at-risk and passive activity rules.
Importantly, the Final Regulations do not address the interaction between cancellation of indebtedness income (“COD”) and the 163(j) limitation. The preamble to the Final Regulations states that, in light of the complex and novel issues raised by the interaction of these two sections, the IRS and Treasury have determined that further consideration is required and may be the subject of future guidance.
C Corporations – The Final Regulations continue the blanket rule of the Proposed Regulations that all interest incurred by a C corporation is business interest and, thus, subject to the 163(j) limitation; i.e., no allocation is required between business interest and investment interest for a C corporation. The Final Regulations add that any separately stated tax items that are allocated to a C corporation partner, and that are not properly attributable to a trade or business of the partnership, are treated as properly allocable to a trade or business of the C corporation partner. For example, tax items allocable to rental activities that do not rise to the level of a section 162 trade or business but otherwise give rise to allowable deductions are treated as allocable to a trade or business of the corporate partner.
In addition, whereas the Proposed Regulations provided that a transfer of a partnership interest between members of the same consolidated group would result in a “disposition” of the partnership interest, the Final Regulations reserve as to whether a taxable or non-taxable transfer of a partnership interest between members of a consolidated group that does not result in a termination of the partnership will be treated as a “disposition” for this purpose.
Consolidated C Corporations – The Final Regulations aggregate consolidated tax groups so that a consolidated tax group has a single Section 163(j) limitation. However, this rule does not apply to affiliated groups that do not file consolidated tax returns. The Final Regulations implement the Proposed Regulations’ complex rules for determining each member’s allowed business interest expense, the application of the 163(j) limitation when a corporation leaves or enters a consolidated group and the interaction of Section 163(j) with the exiting consolidated tax regulation rules.
Controlled Foreign Corporations – The Final Regulations confirm that a controlled foreign corporation (“CFC”) will be subject to the 163(j) limitation for purposes of computing subpart F income, GILTI tested income or loss, and effectively connected income to a United States trade or business. Generally, a U.S shareholder of a CFC must deduct any inclusions of the CFC’s income when the U.S. shareholder calculates its Section 163(j) limitation.
The New Proposed Regulations provide for a CFC group election that would treat an affiliated group of CFCs in the same manner as a U.S consolidated group, with a single Section 163(j) limitation for the entire electing CFC group. Excess taxable income from a CFC group or certain stand-alone CFCs could be added back to the base amount of taxable income when calculating a U.S. shareholder’s 163(j) limitation.
Finally, CFC groups or stand-alone CFCs that satisfy certain requirements can make a safe harbor election to be exempt from the 163(j) limitation.
Partnerships – In the case of debt incurred by a partnership, the 163(j) limitation is applied at the partnership level, and the partnership’s non-deductible interest expense is allocated to the partners. Any non-deductible amount at the partner level may be carried forward and deducted to the extent of any excess taxable income or excess business interest income allocated to the partner from the applicable partnership in future years.
Certain partner-level adjustments are not taken into account in determining a partnership’s adjusted taxable income. Items such as the “inside basis” adjustment under Code Section 743(b), built-in loss of contributed property under Code Section 704(c)(1)(c) and income and loss allocations under the remedial allocation method for contributed property are taken into account at the partner level as items derived directly by the partner in determining its 163(j) limitation.
The New Proposed Regulations provide that partnerships bifurcate interest income and expense (and all other items of income and deduction), allocable to activities that are per se non-passive between partners that materially participate and partners that are passive investors. The partnership’s 163(j) limitation would be based solely on items attributable to partners that materially participate, and all items properly allocable to passive investors would be treated as items from investment activity and subject to those partners’ investment interest limitations.
Although not addressed in the Final Regulations, the New Proposed Regulations provide rules for “self-charged” lending transactions between a partner and partnership. If a lending partner is allocated excess business interest expense from the borrowing partnership and also has interest income attributable to the self-charged loan, the lending partner treats such interest income as an allocation of excess business interest income to the extent of the lending partner’s allocation of excess business interest expense from the borrowing partnership in such taxable year.
The New Proposed Regulations also contain special rules for publicly traded partnerships to achieve fungibility between units, as well as rules for the allocation of excess interest expense from a lower-tier partnership to an upper-tier partnership.
S Corporations – The Final Regulations follow the Proposed Regulations on the special rules for S corporations. First, unlike the rule that provides that all interest incurred by a C corporation is business interest and thus subject to the section 163(j) limitation, interest expense incurred by a S corporation is determined and treated in the same manner as that incurred by an individual (described in General Rules above). Second, the 163(j) limitation is applied at the S corporation level, as it is for partnerships, but there is no pass-through to shareholders of non-deductible interest.
The Proposed Regulations ask for comments on whether a rule requiring bifurcation of interest income and expense (along with all other items of income and expense) between shareholders that materially participate and shareholders that are passive investors (much like the partnership proposed rule discussed above) would violate the prohibition on a second class of stock.
Exceptions: There are several important exceptions to the 163(j) limitation.
Real Property Trade or Business – A “real property trade or business” may elect out of the 30% deductibility limitation but then must depreciate its non-residential real property, residential rental property, and qualified improvement property over longer periods under the alternative depreciation system (“ADS”) rather than the general depreciation system (“MACRS”). Further, the new 100% bonus depreciation deduction generally will not be available to taxpayers that make the election to not be subject to the interest deduction limitation rules. Once made, the election is irrevocable, although the election will terminate if the taxpayer ceases to exist or ceases the operation of the electing trade or business.
For this purpose, a “real property trade or business” is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. The management or operation of a hotel qualifies as a real property trade or business. In addition, a proposed revenue procedure issued along with the Final Regulations provides a safe harbor that allows taxpayers engaged in a trade or business that manages or operates qualified residential living facilities to treat such trade or business as a real property trade or business for purposes of making the election.
However, if at least 80% of the business’s real property is leased to a trade or business under common control (50% of direct and indirect ownership interests in both businesses are held by related parties), the trade or business will not be eligible to make the election. The Final Regulations provide both a de minimis exception and a “look-through” exception, respectively, to this anti-abuse rule in cases where (i) at least 90% of a lessor’s real property is leased to a related party that operates a real property trade or business and has made a real property trade or business election, or (ii) a lessor leases real property to a lessee business under common control and a portion of the real property is ultimately leased to (or used by) unrelated parties and/or related parties that operate a real property trade or business.
Clearing up confusion about whether a net lease constitutes a real property trade or business, the Final Regulations provide that a taxpayer engaged in rental real estate activities (e.g., through a triple net lease) that would be eligible to be an electing real property trade or business, if such activities rose to the level of a trade or business (under Code section 162), may elect for such activities to be treated as an electing real property trade or business.
The Final Regulations also provide that in the case of a partnership that qualifies for the small business exemption (discussed below) and makes the election to be a real property trade or business, the partners can characterize their partnership interests as belonging to an electing real property trade or business by looking through to the assets of the partnership. This treatment would not be permitted in the case of a partnership without a real property trade or business election.
With respect to REITs, the Final Regulations continue the rule that a REIT can be engaged in a real property trade or business and thus make use of the election to not be subject to the interest deductibility limitation. In addition, a REIT is permitted to lease qualified lodging and qualified health care facilities to their taxable REIT subsidiaries (generally under common control with the REIT) and still be permitted to make the election. However, as discussed below, a mortgage REIT cannot make such election.
Special Rule for REITs – REITs derive most, if not all, of their income from property held for investment. However, consistent with the rule described above for C corporations, the Final Regulations confirm that all interest income and expense of a REIT is treated as business income and expense, and all other items of income, gain, loss and deduction are subject to the rules allocating such items to a trade or business.
If a REIT is an electing real property trade or business and the value of the REIT’s “real property financing assets” is 10% or less of the value of the REIT’s total assets, a safe harbor exists to treat all of the REIT’s assets as those of an electing real property trade or business. If the value of the real property financing assets is more than 10% of the value of the REIT’s total assets, the REIT’s business interest income and interest expense, and other items of gross income and expense, are allocated between excepted and non-excepted trades or businesses under specific allocation rules set forth in the Final Regulations.
The Final Regulations add that a partnership may apply the REIT safe harbor election at the partnership level if one or more REITs own, directly or indirectly, at least 50% of the partnership’s capital and profits, the partnership would satisfy the REIT income and assets requirements if the partnership were a REIT, and the partnership satisfies the requirements to qualify for the REIT safe harbor election as if the partnership were a REIT.
The Final Regulations also clarify that a REIT or a partnership that chooses not to apply the REIT safe harbor election may still gain the benefits of a real property trade or business election for one or more of its trades or businesses if such businesses are otherwise eligible for the election.
Small Business Exemption – The business interest limitation does not apply to taxpayers with average annual gross receipts, over the prior three-year period, that are $25 million or less ($26 million for the 2020 taxable year as a result of indexing). “Gross receipts” of an entity includes those of all “related” entities as well (i.e., aggregation is required). The IRS has issued a set of FAQs that address certain aggregation issues.
In the case of a partnership, the gross receipts test is applied at the partnership level. However, this exception does not apply to a “tax shelter,” one of the definitions of which is a partnership or other entity that allocates more than 35% of losses to limited partners or limited entrepreneurs.
In a change from the Proposed Regulations, the Final Regulations permit an entity qualifying for the small business exemption to nevertheless make a real property trade or business election if it so qualifies.
No Exception for Lending Businesses – The Final Regulations make clear that an entity engaged in a lending activity is engaged in real property financing, and thus, the activity is not a real property trade or business. Consequently, an entity such as a debt fund or mortgage REIT cannot make an election to be exempt from the interest deduction limitation. However, most lending businesses experience interest income in excess of interest expense and the denial of the election out of the interest deductibility limitation should generally not have much of an impact on these activities.
It is expected that most real property trades or businesses that are moderately or highly leveraged will elect to be exempt from the new business interest deductibility limits. The interest deduction is potentially more valuable than the slightly shorter life available for depreciation of real estate assets. In addition, entities that are required to use ADS, such as partnerships with tax-exempt partners, or REITs that use ADS in connection with earnings and profits calculations, should not suffer adverse tax consequences by making the election.
Taxpayers engaged in a real property trade or business can elect out of the interest deductibility limitation at any time, bearing in mind that once made, the election is irrevocable. Thus, a taxpayer can decide not to elect out in 2019 and allow an amount of interest deductions to be suspended, and it can then elect out in 2020 when the freed-up deductions are available to offset other income. In addition, it may be possible to claim bonus depreciation in one year and elect out of the deduction limitation the next year without recapturing the bonus depreciation claimed.
Please contact your Mazars USA LLP professional for additional information.
 This is separate and apart from limitations on deductibility that apply to investment interest and qualified residence interest.
 The 50% increased limitation is contained in the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”), enacted in March 2020. Taxpayers may elect out of this limitation and may also elect to use 2019 ATI (in lieu of its 2020 ATI) for the 2020 calculations. “Adjusted taxable income” is computed without including interest income or deductions for interest expense, net operating losses (“NOLs”), the special 20% deduction for pass-through entities, and depreciation and amortization. The Final Regulations make clear that the amount of any depreciation, amortization or depletion that is capitalized into inventory under section 263A during taxable years beginning before January 2022 is added back to when calculating ATI for that taxable year. For taxable years beginning in 2022 and after, adjustable taxable income is also reduced by depreciation and amortization.
 ADS extends the depreciable life of residential rental property from 27.5 years to 30 years, non-residential real property from 39 years to 40 years, and qualified improvement property from 15 years to 20 years.