New Rules on Interest Deduction Taking Shape, but Real Estate Questions Remain

This afternoon, the Treasury Department released Notice 2018-28, which provides initial guidance related to the new limitation on the deductibility of business interest (section 163(j).  The Notice indicates that taxpayers can rely on the guidance until proposed regulations are issued.

The Notice leaves unanswered some of the key issues related to the financing of real estate.  For example, Treasury should clarify that interest on debt incurred by an owner to fund an investment in a partnership or other entity engaged in a real property trade or business, constitutes interest on debt properly allocable to that real estate business.

Depending on the outcome of the rule-making process, the new limitation on business interest expense (section 163(j)) could have significant implications for real estate markets and the financing of real estate transactions.  Clarifying the rules for real estate in the context of tiered arrangements will help avoid potential disruptions.

Key issues for real estate under the new business interest limitation were addressed in a comment letter from The Real Estate Roundtable to Treasury Secretary Steven Mnuchin in February.  Discussion of the Roundtable’s comments was included in Roundtable Weekly.

Highlights from IRS Notice 2018-28:

  • Business interest income of partnerships, partners, S corporations, and S corporation shareholders. While noting that section 163 requires that the business interest limitation be applied at the partnership level, the Notice states that the limitation may also be applied at the partner level in certain circumstances.  Treasury intends to issue regulations which provide:“. . .for purposes of calculating a partner’s annual deduction for business interest under section 163(j)(1), a partner cannot include the partner’s share of the partnership’s business interest income for the taxable year except to the extent of the partner’s share of the excess of (i) the partnership’s business interest income over (ii) the partnership’s business interest expense (not including floor plan financing).
  • Carryforward of interest expense. The Notice states that the regulations will allow taxpayers with disqualified interest under the old law to carry forward such interest as business interest under the new law.  Such interest will be subject to potential disallowance under the new limitation in the same manner as any other business interest.  The Notice further states that business interest that is carried forward from prior years will be subject to the rules related to the new base erosion minimum tax in the same manner as future interest.
  • Corporate business interest. The regulations will clarify that interest paid by a C corporation is business interest for purposes of section 163(j).  The Notice states that  “Regulations also will address whether and to what extent interest paid, accrued, or includible in gross income by a non-corporate entity such as a partnership in which a C corporation holds an interest is properly characterized, to such C corporation, as business interest . . . or business interest income . . . .”  Unfortunately, however, the Notice does not provide much insight into Treasury’s current thinking on these issues.
  • Consolidated groups. The regulations will clarify that the business interest limit properly applies at the level of a consolidated group.  The regulations will address the application of section 163(j) to a consolidated group when one of the members is an electing real property trade or business, and to a consolidated group in which a member holds an interest in a partnership that is engaged in a real property trade or business.
  • Earnings and profits. The regulations will clarify a disallowed business interest deduction will not affect whether or when such business interest expense reduces a C corporation’s earnings and profits.

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