Adjusted Taxable Income For a typical affordable housing partnership, 30% of the taxpayer’s Adjusted Taxable Income would be the largest factor in determining the deductibility of interest expense. Adjusted Taxable Income is defined as taxable income of the taxpayer without regard to the following:

• any items not properly allocated to a trade or business
• any business interest or interest income
• any NOL
• any section 199A
• any depreciation, amortization, or depletion*

*For tax years beginning after December 31, 2017 and before January 1, 2022

Let’s see an example.

For the tax period December 31, 2017, ABC partnership has business interest income of $100, taxable income before limitation of $0.  Included in this taxable income is $5,000 of interest expense, and $5,000 of depreciation expense. In 2017, under prior law the taxable income would be $0, as there would be no limitation on business interest expense. Assuming the same facts in 2018, ABC’s taxable income before limitation is $0. However ABC’s Adjusted Taxable Income is $9,900 ($0 + $5,000 interest expense – $100 interest income + $5,000 depreciation expense). ABC’s business interest expense is then limited to 30% of adjusted taxable income ($2,970) plus its business interest income of $100 for a total interest deduction of $3,070. As ABC’s total business interest expense is $5,000, ABC will have $1,930 of nondeductible interest expense. ABC’s taxable income will then be $0 + $1,930. Using the same facts in 2022, ABC will not get the benefit of the $5,000 depreciation expense. ABC’s adjusted taxable income will be $4,900.  ABC’s nondeductible interest, and taxable income will be $3,430.

As you can see in the example above, where historically this partnership would not have taxable income, the taxpayer now would have taxable income due to the interest limitation. Although the nondeductible interest expense is carried forward, if the taxpayer’s taxable income is consistent from year to year, it would be a number of years before the suspended deductions could be realized. As stated before however, the limitation applies to all taxpayers except for those that meet the gross receipts test, or those that are in certain trades or businesses.

What does this have to do with depreciation? We are getting closer. First let’s look at the exemptions.

Gross Receipts test. An exemption from these rules applies for certain small business taxpayers (other than tax shelters) with average annual gross receipts for the three-tax year period ending with the prior tax year that do not exceed $25 Million. Tax Shelters for the purposes of this definition includes any syndicate, defined as any partnership if more than 35 percent of the losses of such entity during the taxable year are allocable to limited partners. A typical affordable housing ownership structure would fall under this definition, and as such would not receive the benefit of the exemption for certain small businesses.

Certain Trades or Businesses. For purposes of the business interest limitation, the trade or business definition does not include any electing real property trade or businesses. If ABC were to make this election, they would not be subject to the business interest limitation.

However this irrevocable election comes with some consequences. Making the election requires the electing real property trade or business to use the Alternative Depreciation System (ADS) to depreciate any of its non-residential real property, residential rental property, and qualified improvement property. ABC’s residential rental property which normally would be depreciated over 27.5 years using the Modified Accelerated Cost Recovery System (MACRS), under ADS would now be depreciated over 30 years.

Finally, we made it to depreciation.

Affordable housing partnerships have an interesting decision regarding depreciation. If the partnership elects to be a real property trade or business for purposes of the interest income limitation, they will not be subject to potential nondeductible interest. The cost of this is extending the depreciable life of the building by 2.5 years. If the partnership foregoes the election, they will be able to depreciate their residential rental property over 27.5 years but will be subject to the business interest limitation. Let’s compare this to our initial calculation.

For purposes of our example above, let’s assume the depreciable property value is $137,500. The annual depreciation using MACRS over 27.5 years would be $5,000. If ABC were to depreciate that property using ADS over 30 years, the annual depreciation would be $4,583. The deferred depreciation by making the election would be $417. Compare the $417 deferred depreciation using ADS to the interest no longer disallowed of $1,930 and in 2018 they will increase their deductions by $1,513 with the election. In 2022 and beyond, without the benefit of the depreciation addback in the adjusted taxable income, the benefit would be $3,013.

As you can see in 2018, the election allows ABC to deduct the full $5,000 of interest expense, providing additional interest expense of $1,930. However depreciating the property over 30 years reduces their annual depreciation expense in 2018 by $417. The net benefit of this election in 2018 is $1930 - $417 = $1,513. In 2022 and beyond, the election allows ABC to deduct the full $5,000 of interest expense, providing additional interest expense of $3,430. The deferred depreciation expense remains $417. The net benefit of this election in 2022 and beyond is $3,430 - $417 = $3,013.

However, what if ABC's rental real estate was $2,750,000 and their interest expense is now $50,000? In that case, ABC’s annual depreciation would be $100,000 per year under MACRS, and ABC’s interest expense is would be $50,000. In 2017, $50,000 would be deductible. In 2018, $45,070 would be deductible, and $4,930 would be carried forward. The same property under ADS would have depreciation expense of $91,667. A difference from MACRS of $8,333. If ABC were to make the election, ABC would gain the $4,930 of interest expense, but defer $8,333 in depreciation for a net loss of deductions of $3,403. In 2022, once ABC loses the benefit of depreciation for purposes of adjusted gross income, if they were to make the election, they would gain the $34,930 of interest limitation and continue to defer the $8,333 for an increase in deductions of $26,597.

In this scenario the benefit of the election would only occur after depreciation is no longer added back after 1/1/2022.

As we can see with this example, the cost of the property, the period the property is in service, and the amount of interest income and expense all play a part in determining whether ABC should elect out of the business interest limitation.  Although the election is for the deductibility of interest expense, close consideration should be made regarding how this will affect the depreciation throughout the life of the property.  The cost of the residential rental property, in relation to the interest expense will determine whether to make the election and when the benefit will be realized. If you have any questions regarding the new limitations on business interest expense please feel free to contact us at [email protected].