Are your business interest expenses deductible?
Before Congress passed the Tax Cuts and Jobs Act (TCJA), most business-related interest expenses were deductible, although corporations could not deduct interest paid to or guaranteed by a related party under certain circumstances. But for tax years beginning after 2017, the TCJA imposes a limit on business interest deductions, with exceptions for small businesses and electing real estate and farming businesses.
All businesses should evaluate the impact of the new deduction limit on their tax liability and plan accordingly.
Do you qualify for the small business exemption?
The business interest deduction limit does not apply to small businesses, defined as those whose average annual gross receipts for the preceding three years is $25 million or less. Certain related businesses must aggregate their gross receipts for purposes of the $25 million threshold. This requirement is designed to prevent larger businesses from splitting themselves into several smaller entities to avoid the limit.
How do you calculate the limit?
If the limit applies to your business, your annual deduction for business interest expense cannot exceed the sum of 1) your business interest income, if any, 2) your floor plan financing interest, if any, and 3) 30% of your adjusted taxable income. In other words, you can use an unlimited amount of business interest expense to offset business interest income, and you can fully deduct floor plan financing interest, which is commonly used by vehicle dealers and large appliance retailers to finance their inventories.
Any interest in excess of those amounts is limited to 30% of adjusted taxable income. Be aware that business interest income and expense does not include investment interest income or expense. Disallowed interest expense may be carried forward indefinitely.
Adjusted taxable income means taxable income, computed without regard to:
- Nonbusiness income, gain, deduction or loss;
- Business interest income or expense;
- Net operating loss deductions;
- The 20% deduction for qualified business income of pass-through entities and sole proprietorships; and
- For tax years beginning before 2022, depreciation, amortization or depletion.
For tax years beginning after 2021, depreciation, amortization and depletion will be subtracted in computing adjusted taxable income, shrinking business interest deductions even further.
Special rules apply to pass-through entities. For partnerships, the business interest limit applies at the entity level, but any interest in excess of the limit is passed through to the partners and carried forward on their individual tax returns. The partnership also passes through “excess taxable income”—the amount by which the deduction limit exceeds actual interest expense. Partners can offset this amount against unused interest deductions. For S corporations, the limit also applies at the entity level, but unused deductions are carried over at the entity level until they can be offset against corporate income.
Should you opt out?
Certain real property and farming businesses may elect not to apply the limit on business interest expense deductions. Real property businesses include development, construction, reconstruction, acquisition, conversion, rental, operation, management, lending and brokerage businesses.
If you are eligible to opt out of the deduction limit, doing so can yield significant tax benefits. But these benefits come at a price. After you make the election, which is irrevocable, you must depreciate certain business property under the alternative depreciation system (ADS). This means longer recovery periods and lower depreciation deductions. For real property businesses, ADS applies to nonresidential real property, residential rental property and qualified improvement property. For farming businesses, it applies to any property held by the business with a recovery period of ten years or more.
To determine whether making the election is right for your business, you need to weigh the benefits of unlimited business interest deductions against the cost of lower depreciation deductions.
Have a plan
If your business is subject to the business interest limitation, be sure to evaluate the impact of reduced interest deductions on your tax liability. If it is significant, you might consider strategies for reducing your interest expense, such as relying more heavily on equity financing instead of debt.
If your business owns debt-financed real property, another option is to transfer such property to a separate entity, such as a partnership that you control, in a sale-leaseback transaction and have the entity opt out of the interest limitation as a real property business. For this strategy to work, there must be a legitimate business purpose for the transaction other than tax avoidance.
Sidebar: IRS guidance is on the way
The IRS plans to issue regulations on the application of the business interest limit. In the meantime, the IRS has issued Notice 2018-28, which provides interim guidance on several issues, including:
- Pre-Tax Cuts and Jobs Act Interest
The guidance suggests that disallowed interest carried forward under prior law will be treated as business interest expense in the first tax year after 2017 and subject to the new limit.
According to the guidance, the regulations will provide that, for purposes of the business interest limit, all C corporation interest expense and income, even if investment-related, will be treated as business interest expense and income.
- Pass-Through Entities
The guidance provides rules to avoid double counting of income and expense by pass-through entities and their owners.
- Consolidated Groups
The net interest expense limitation is determined on a consolidated basis, without considering obligations between group members. The regulations will provide technical rules.
- Earnings and Profits
The guidance clarifies that disallowed interest expense will nevertheless reduce a corporation’s earnings and profits.
Owning a vacation home requires tax planning
A vacation home can be many things to different people. For example, it can be a relaxing refuge for friends and family, or the property can serve as an income-producing investment if you choose to rent it out when you are not using it.
However you plan to use your vacation home, it pays to understand the tax rules regarding income and expenses associated with the property. To ensure that the home stays in the family, it is important to be familiar with specific estate planning strategies.
You can generally deduct interest on up to $1 million in combined acquisition debt on your main residence and a second residence, such as a vacation home. However, be aware that the $1 million amount may be limited to $750,000, depending on when the debt was acquired. In addition, you can also deduct property taxes on any number of residences, although the deduction for state and local taxes is limited to $10,000
If you use the home for at least 14 days and rent it out for less than 15 days during the year, the IRS will consider the property a “pure” personal residence and you do not have to report the rental income. But, any expenses associated with the rental, such as advertising or cleaning, are not deductible.
If you rent out the home for more than 14 days and you occupy the home for more than the greater of 14 days or 10% of the days you rent the property, the IRS will still classify the home as a personal residence (in other words, vacation home), but you will have to report the rental income.
In this situation, you can deduct the personal portion of mortgage interest, property taxes and casualty losses as itemized deductions. In addition, the rental portion of your expenses is deductible up to the amount of rental income. If your rental expenses are greater than your rental income, you may not deduct the loss against other income and the loss carries forward.
If you use the vacation home for 14 days or less, or under 10% of the days you rent out the property—whichever is greater—the IRS will classify the home as a rental property. You must report the rental income and may deduct all allocable rental expenses, including depreciation, subject to the passive activity loss rules.
Planning for the future
As with any asset, it is critical to account for your vacation home in your estate plan. What will happen if an owner dies, divorces or decides to sell his or her interest in the home? It depends on who owns the home and how the legal title is held. If the home is owned by a married couple or an individual, the disposition of the home upon death or divorce will be dictated by the relevant estate plan or divorce settlement.
If family members own the home as tenants-in-common, they are generally free to sell their interests to whomever they choose, to bequeath their interests to their heirs or to force a sale of the entire property under certain circumstances. If they hold the property as joint tenants with rights of survivorship, an owner’s interest automatically passes to the surviving owners at death. If the home is held in a Family Limited Partnership or LLC, family members have a great deal of flexibility to determine what happens to an owner’s interest in the event of death, divorce or sale.
Keep it in the family
If your vacation home has been in your family for generations, you will want to do everything possible to hold on to it for future generations. Contact your advisor to learn more about the tax and estate planning aspects of owning a vacation home.