Special Tax Alert
On January 5, the Treasury Department and the IRS released final regulations providing additional guidance on the section 163(j) interest expense limitation for passthrough entities, regulated investment companies, and controlled foreign corporations. The new final regulations (the 2021 Final Regulations) generally adopt the regulations proposed in 2020 (the 2020 Proposed Regulations). However, there are a few noteworthy modifications that taxpayers should be aware of. Additionally, the 2021 Final Regulations modify some of the rules that were previously finalized in 2020 (the 2020 Final Regulations).
As discussed in greater detail in our prior alert on the 2020 Proposed Regulations and the 2020 Final Regulations, the TCJA limited a taxpayer’s ability to deduct business interest expense (BIE), which is interest expense that is properly allocable to a trade or business, by subjecting it to a new annual deduction limitation (the section 163(j) limitation). This alert highlights several significant changes in the 2021 Final Regulations and discusses open questions and areas where the final regulations reserve.
Specifically, this alert covers the following topics:
Recapture of Prior Depreciation, Amortization, and Depletion Deductions
The section 163(j) limitation is equal to the sum of the taxpayer’s business interest income (BII), 30% (or 50%, if the CARES Act applies) of the taxpayer’s adjusted taxable income (ATI), and the taxpayer’s floor plan financing interest for the taxable year. For taxable years beginning before 2022, a taxpayer’s ATI is equal to the taxpayer’s tentative taxable income (TTI) with certain adjustments, including adding back depreciation, amortization, and depletion deductions (collectively, “depreciation”). The 2020 Final Regulations provided a recapture rule, not found in the statute, that required depreciation attributable to 2018 through 2021 be to be subtracted from TTI on the sale of the property (or the direct or indirect sale of the stock of the consolidated group member or interest in the partnership that took the depreciation deductions), even if such amounts had not been added to TTI (the recapture rule). Additionally, as discussed previously, the 2020 Proposed Regulations allowed taxpayers to elect to apply the recapture rule to the lesser of the depreciation deductions and the gain that was recognized on the sale.
Reversal on Policy and Rules for Recapture for Prior Depreciation, Amortization and Depletion Deduction
In discussing the recapture rule, the preamble to the 2020 Final Regulations stressed that the recapture rule is merely a timing provision, and not a rule intended to prevent a double benefit (i.e., recapture applied even if the add back of the depreciation did not result in an increased business interest expense deduction).
However, the 2021 Final Regulations reverse course with respect to the underlying policy and application of the recapture rule. Under the 2021 Final Regulations, the recapture rule only applies to the extent the taxpayer benefited from an addition of the depreciation to TTI by way of an increased business interest expense deduction.
A&M Insight: The limitation on the application of the recapture rule is a welcome change that taxpayers can choose to apply retroactively, so long as they apply all of the 2021 Final Regulations retroactively. However, it is important to note that the rule entails some administrative complexity.
Taxpayers will need to track the extent to which the add back of depreciation increased the BIE deduction each year and the amount of depreciation each property generated in that particular year. For example, if the depreciation addback did not increase the amount of a taxpayer’s BIE that was deducted in 2018 and 2020, but it did impact its BIE deduction in 2019, then the recapture will apply to the depreciation added back to TTI in 2019. This analysis becomes even more complicated if only part of the addback increased the amount of BIE deduction. For example, assume in 2019, the taxpayer’s TTI is $400x (including $180x of depreciation deductions). As a result, the taxpayer’s ATI is $580x ($400x + $180x), resulting in a section 163(j) limitation of $174x ($580x * 30%). The taxpayer’s BIE for 2019 is $141x. Without the addback of depreciation, the taxpayer’s section 163(j) limitation would be $120x ($400x * 30%). Therefore, an additional $21x of BIE was deducted due to the depreciation addback, which represents the impact of $70x of depreciation ($21x/30%). As a result, it appears that only $70x of the total $180x depreciation is subject to recapture when a property that was held in 2019 is disposed of in a subsequent year…