Treasury Proposes Detailed Rules for New Restrictions on Deducting Business Interest

Roundtable Weekly

December 1, 2018

On Tuesday, the Treasury Department released proposed regulations governing the new limitation on the deductibility of business interest expense, including the exception for real estate businesses.

Under the Tax Cuts and Jobs Act (TCJA), businesses generally can no longer deduct their interest expense to the extent it exceeds 30 percent of their annual earnings before interest, tax, depreciation and amortization (EBITDA). Business interest deductibility was a key issue in Real Estate Roundtable President & CEO Jeffrey DeBoer's testimony before the Senate Finance Committee shortly before consideration of the tax bill. (Roundtable Statement for the Record, Sept. 19, 2017)
DeBoer testified that the proposal could have severe unintended consequences. Noting that the cost of debt is a necessary expense that must be accounted for when measuring income, he testified that our capital markets are the envy of the world and that responsible, appropriate leverage helps entrepreneurs and contributes to economic growth and job creation. (Roundtable Weekly, Sept. 29 and testimony video clips)
The final bill included a critical exception from the interest limit for an electing real property trade or business. An electing real property trade or business is defined broadly to cover: any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

In February, the Roundtable submitted comments to Treasury with recommendations for how the real estate exception should work in the case of tiered business structures, and in the case of businesses that involve both real estate and non-real estate activities. (Roundtable Weekly, Feb. 23, 2018)

Business interest deductibility was a key issue in Real Estate Roundtable President & CEO Jeffrey DeBoer's testimony before the Senate Finance Committee shortly before consideration of the tax bill. (Roundtable Statement for the Record, Sept. 19, 2017 and video clips ).

The proposed regulations are largely favorable. Most importantly, the regulations clarify that partner-level borrowing qualifies for the real estate exception. Thus, at the election of the taxpayer, the real estate exception can extend to debt that is incurred by a partner to acquire an interest in a partnership that is engaged in a real property trade or business. In addition, the regulations confirm the broad definition of a real property trade or business. The regulations also clarify that capitalized interest, which commonly arises during the development of real estate, is not subject to the interest limit.
With respect to taxpayers engaged in both real estate and non-real estate activities, the proposed regulations generally would allocate and apportion debt based on the relative amount of the taxpayer's adjusted basis in assets used in those activities. However, taxpayers would directly trace and allocate qualified nonrecourse indebtedness to the asset securing the loan (with no apportionment). This latter rule should result in the allocation of a larger share of debt to assets qualifying for the real estate exception.
Some concerns remain. Notably, the attribution rule that allows partners to qualify for the real estate exception based on partnership-level activities does not extend broadly to all upper-tier borrowing for investment in lower-tier real estate businesses. Thus, except in limited circumstances, debt incurred by a taxpayer to invest in a corporation (or REIT) that is engaged in a real property trade or business is not eligible for the real estate exception.

The Roundtable's Tax Policy Advisory Committee is continuing to review the 439-page regulatory package to understand its full implications for the financing of U.S. real estate. Comments on the proposed regulations will be due 60 days after their publication in the Federal Register.