How Does the Interest Deductibility Cap Work?

The Tax Cuts and Jobs Act of 2017 (TCJA) introduced a rule that caps the amount of business interest expense a taxpayer can deduct in a single year. This regulation, found in Section 163(j) of the Internal Revenue Code, was implemented to limit how much interest companies could deduct. The limitation establishes a ceiling on the annual interest deduction based on a formula that considers the business’s income and other financial metrics for the year.

Determining Applicability of the Cap

Many businesses are exempt from the interest deduction limitation under the small business exemption. This exemption applies if a business has average annual gross receipts of $25 million or less for the three preceding tax years, a threshold that is adjusted for inflation. To determine the average, a business adds its total gross receipts from the prior three years and divides by three.

For example, if a company’s gross receipts for the three preceding years were $26 million, $27 million, and $28 million, its average would be $27 million. Because this exceeds the inflation-adjusted threshold, the business would be subject to the interest limitation. This calculation must be performed annually, as revenue fluctuations can change a business’s status.

Certain types of businesses, such as some regulated public utilities, are also not subject to the limitation. Businesses that do not qualify for an exemption must calculate their allowable deduction.

Calculating the Allowable Interest Deduction

For businesses subject to the interest deduction cap, the allowable deduction is the sum of the taxpayer’s business interest income, 30% of the taxpayer’s adjusted taxable income (ATI), and the taxpayer’s floor plan financing interest. Floor plan financing is an interest expense common in dealerships that finance inventory like automobiles.

The calculation of ATI is a central part of the limitation. For tax years beginning in 2022 and later, the ATI formula became more restrictive because it no longer allows for add-backs of depreciation and amortization deductions. This change, which aligns ATI more with earnings before interest and taxes (EBIT), results in a lower ATI. This in turn reduces the amount of interest a business can deduct and can increase its tax liability.

This is a departure from the pre-2022 calculation, which was similar to earnings before interest, taxes, depreciation, and amortization (EBITDA) and was more favorable to capital-intensive businesses.

For example, consider a business with $500,000 in taxable income before interest and depreciation, $100,000 in business interest expense, and $150,000 in depreciation. Its ATI would be $350,000 ($500,000 minus $150,000 depreciation). The limit would be $105,000 (30% of $350,000), allowing a full deduction of its $100,000 interest expense in this case. All calculations are reported on Form 8990.

Electing Out for Real Property and Farming Businesses

Certain real property and farming businesses can elect out of the interest limitation, even if they do not qualify for the small business exemption. This election is irrevocable and applies to businesses in real estate development, construction, management, or brokerage.

Making this election comes with a trade-off. In exchange for deducting business interest without limitation, these businesses must use the Alternative Depreciation System (ADS) for certain property. ADS requires assets to be depreciated over a longer period compared to the standard General Depreciation System (GDS).

For example, residential rental property must be depreciated over 30 years under ADS instead of 27.5 years, and nonresidential real property is depreciated over 40 years instead of 39. This results in smaller annual depreciation deductions. The decision requires a careful analysis of whether the benefit of unlimited interest deductibility outweighs the negative impact of slower depreciation. Businesses with high leverage may find the election advantageous.

Treatment of Disallowed Interest Carryforwards

When a business’s interest expense exceeds its deduction limit for a given year, the excess amount is not permanently lost. The disallowed business interest expense is carried forward and treated as an interest expense incurred in the following tax year.

This carryforward amount is combined with the new year’s interest expense, and the total is subject to the new year’s limitation calculation. The deductibility of the carried-forward interest depends on the business’s financial performance and resulting limitation in that future year. This process can continue indefinitely until the interest is fully deducted.

For example, if a business has $40,000 of disallowed interest from a prior year, that amount is carried forward. If the business incurs an additional $150,000 of interest expense in the current year, the total interest expense subject to the limitation would be $190,000. If the current year’s deduction limit is $200,000, it can deduct the full $190,000. If the limit is only $120,000, it would deduct that amount and carry forward the remaining $70,000.