Like the last two years, 2022 has proven to be uncharted territory – though for different reasons. Inflation is the highest it’s been in decades, and rising interest rates are squeezing costs from companies that already have tight margins. Compounding these issues is that certain strategic tax moves have less impact now than last year.

Specifically, the Section 163(j) limitation on deductible interest expense isn’t nearly as helpful for capital-intensive businesses like real estate, construction, or private equity. Tax planning and forecasting can help to offset some of these restrictions, but the solution depends on the company’s financial position, risk profile, and investor preferences.

Rising Interest Costs for Commercial Real Estate

Even though real estate can be an effective hedge against inflation, properties and investors still feel the impact of higher interest rates.

During the pandemic, interest rates were at all-time lows, so debt financing was easier and debt instruments were less costly to maintain. Investments that may have otherwise been deemed too risky were more acceptable. Cash flow was generally more available for deals, though slowdowns from the pandemic had varying effects across different real estate sectors.

Now with higher interest rates, it’s a different story.

This summer alone, the Fed has raised interest rates twice. Another rate hike is expected in September (though to a lesser degree), for a projected rate of 2.75 to 3 percent in the fourth quarter. Higher interest rates are expected to continue into 2023.

For many real estate investors and owners, the high rates signal a potential decrease in new projects, investments, asset value, and may need to explore alternative financing options.

Restrictions On Deducting Business Interest Expenses

Section 163(j) puts limitations on how much business interest expense (BIE) a company can deduct. Interest expenses are defined as:

  • Interest on indebtedness
  • Substitute interest payments on securities lending or sale-repurchase transactions
  • Premium on debt instruments
  • OID
  • Repurchase premiums

The BIE deduction is limited to the sum of 30 percent of adjusted taxable income (ATI), business interest income, and floor plan financing interest. Excess BIE can be carried forward indefinitely either at the entity level or partner level (for partnerships).

There are exceptions for real property trade or business taxpayers, a farming trade or business, and small businesses with annual average gross receipts that don’t exceed $27 million. Certain eligible businesses that fall into these categories can elect out of Section 163(j) treatment. While most eligible businesses have already made this election, it bears another look for businesses that may be affected.

This particular section of the tax code has gone through several changes between the Tax Cuts and Jobs Act in 2017 and the CARES Act in 2020. Our previous article on pre- and post-TCJA Section 163(j) changes help to define its tax treatment and role in overall tax planning.

Section 163(j) In 2022 and Beyond

For taxable years beginning with 2022, addbacks for depreciation, depletion, and amortization are no longer allowed. In years past, allowances for deprecation allowed capital-intensive businesses like real estate to add back a large deduction without impacting the overall ATI.

So while the deduction is still in place for 30 percent of the taxpayer’s ATI, how the income is calculated has changed, resulting in a more restrictive tax strategy.

Because of an automatic change in tax law dating back to TCJA rules, Section 163(j) is now computed without regard to interest and income tax, much like EBIT versus EBITDA. A lower ATI means a lower limitation on the business interest expense deduction. And that means that real estate investors may lose out on their full ability to capitalize assets and leverage debt.

Now, other strategies may be needed.

Other Strategies for Real Estate Transactions

Losing a valuable tax deduction on top of dealing with rising costs and interest rates give real estate investors an opportunity to explore other scenarios for transactions. Which solution might work best depends on the industry and preferred or available financing methods. These are two of the more common alternatives.

First, investors and owners may want to consider preferred equity financing over debt financing. Because debt financing is more expensive now with less of a return, this option can be favorable for larger projects with active investors. Preferred equity financing opens the door to family office investors, other real estate partnerships or hedge funds, or institutional investors with a fixed rate of return.

A sale leaseback is another option that can be beneficial for long-term leases, especially with multi-family, office, and retail properties.

In a sale leaseback transaction, the seller pays lease payments to the buyer after the sale is completed. The lease payments would be treated as tax-deductible rent and therefore not subject to the limitations under Section 163(j).

For tax purposes, this transaction is treated as a sale, even though it’s still financing under GAAP. The seller benefits from an income-producing property they don’t own. Often, sale leasebacks are used to finance expansions and generate immediate cash flow. For the buyer, they benefit from the tax advantages of property ownership plus the option to lease the property to other tenants once the sale leaseback period is over.

Considerations for a sale leaseback strategy might include lease terms and lengths, property value, market risk, the impact of new lease accounting rules, and sale price.

Section 163(j) Considerations

One factor that real estate investors and partnerships need to look at is accelerated depreciation. Now that Section 163(j) is more limited without the depreciation addback, accelerated depreciation may be less favorable. Prior to 2022, depreciation was allowed as an “add-back” to ATI which allows business interest expense to be deducted up to 30% of ATI.  For 2022 and subsequent years, the ATI will no longer be increased by the depreciation deduction which now limits the amount of deductible interest expense.

PBMares clients with questions about how tax planning, forecasting, and modeling can better manage the effects of a lower Section 163(j) deduction can contact Construction and Real Estate Partner Ryan Paul, CPA.