Tax benefits from cost segregation studies remain a valuable planning strategy for many taxpayers and business owners. The overriding benefit of this strategy is the creation of accelerated depreciation deductions during a single tax year. While the benefits of cost segregation studies are likely to remain appealing in any case, there is potentially an added wrinkle to consider for studies that are completed during 2022 and beyond.

Without Congressional intervention, starting in 2022 taxpayers subject to the business interest limitation under Section 163(j) may find interest deductions curtailed or eliminated. This is because deductions for depreciation, amortization and depletion are no longer added to the adjusted taxable income (ATI) calculation that is used to derive the Section 163(j) limitation. Taxpayers and business owners should be aware of these changes in order to eliminate surprises and effectively plan for 2022 and beyond.

In this article, we will discuss:

• An overview of the Section 163(j) business interest limitation
• The ATI calculation
• 2022 ATI calculation changes
• The effects of a 2022 or future cost segregation study on the business interest limitation.

Section 163(j) Overview

The business interest limitation applies to all businesses, including sole proprietorships, even if the lender is a related party. However, taxpayers that are not tax shelters are exempt from the limitation when their average annual gross receipts for the prior three tax years are equal to or less than $26 million (for 2020 and 2021) or $27 million (for 2022). Real property trades or businesses also may elect out of the limitation, with certain trade-offs required in depreciation benefits.

In general, Section 163(j) limits the taxpayer's business interest deduction to the sum of:

1. The taxpayer's business interest income for the tax year,
2. 30% of the taxpayer's ATI for the tax year, and
3. The taxpayer's floor plan financing interest expense for the tax year.

A taxpayer’s business interest expense that is in excess of the limitation is generally carried forward to the following year, but partnerships must allocate excess business interest expense to their partners who then maintain those carryforwards in their separate capacities.

As can easily be seen, a taxpayer’s calculation of ATI is paramount to the business interest limitation.

ATI Calculation

Because a taxpayer's business interest expense deduction is limited to 30% of the taxpayer's ATI, it is important to take a closer look at the ATI calculation.

The ATI calculation is computed without regard to the application of the business interest expense limitation, or any disallowed business interest expense carryforwards. In that respect, ATI is defined as the taxpayer's taxable income for the year, increased by the following items:

• Any loss or deduction that is not properly allocable to a non-excepted trade or business
• Any business interest expense, other than disallowed business interest expense carryforwards
• Any net operating loss deduction under Section 172
• Any qualified business income deduction allowed under Section 199A
• For tax years 2018 to 2021, any depreciation (including bonus depreciation), amortization or depletion
• Any loss or deduction from a pass-through entity
• Any deduction for a capital loss carryback or carryover.

Next, the ATI computation is decreased by the following items:

• Any income or gain that is not properly allocable to a non-excepted trade or business
• Any business interest income
• Any floor plan financing interest expense
• Any income or gain from a pass-through entity
• For tax years 2018 to 2021, the greater of the allowed or allowable depreciation, amortization or depletion with respect to property sold or otherwise disposed of (including the allocable amount of such items from a partnership interest when such partnership interest is sold or otherwise disposed of).

2022 ATI Calculation Changes

As stated above, some of the items are applicable only for tax years 2018 to 2021. Moreover, for taxable years beginning before Jan. 1, 2022, ATI is increased by a taxpayer’s deductions for depreciation, amortization or depletion. The resulting calculation of ATI generally corresponds with the financial accounting concept of EBITDA (but unlike true EBITDA, deductible taxes are within the ATI calculation).

For taxable years beginning on or after Jan. 1, 2022, ATI will include deductions for depreciation, amortization and depletion. Correspondingly, ATI is no longer increased by these items. This resulting calculation of ATI generally corresponds with the financial accounting concept of earnings before interest and taxes (EBIT, with the same caveat for deductible taxes).

As a result, for taxpayers with deductions for depreciation, amortization or depletion, the business interest limitation becomes more stringent, because ATI is now lower due to the inclusion of these deductions. This may ultimately reduce the taxpayer’s amount of deductible business interest expense for taxable years beginning on or after Jan. 1, 2022.

The Impact of Cost Segregation Studies

For many taxpayers, a cost segregation study can accelerate depreciation deductions into earlier years for a recently constructed, renovated or acquired real estate building project by identifying and reclassifying the cost of building assets into their appropriate asset classifications. Because the appropriate asset classifications have recovery periods that are shorter than the recovery period for the building, cost segregation studies result in accelerated depreciation benefits. To the extent a cost segregation study is performed during a tax year that is subsequent to the one when the building was placed in service, the cumulative amount of accelerated depreciation on account of all previous tax years (in excess of what was originally deducted) is claimed as a Section 481(a) adjustment during the year of the cost segregation study (as part of a request for change in method of accounting).

Notably, the IRS clarified in CCA 202123007 that this type of Section 481(a) adjustment is treated as though it is depreciation for purposes of the ATI calculation. Therefore, with the 2022 changes in the ATI calculation, a  Section 481(a) depreciation adjustment identified in a cost segregation study performed for the 2022 tax year (and later) will have a deleterious effect on the ATI calculation by lowering it substantially during one tax year. This may consequently limit a taxpayer’s deductible amount of business interest expense for the affected tax year.

Summary

To recap, 2022 brings changes to the Section 163(j) business interest limitation. More specifically, ATI is no longer increased by depreciation, amortization and depletion deductions, which means the limitation will be more stringent. Because ATI is the overriding determinant of the limitation, this may reduce the amount of business interest expense deductible in 2022 and beyond.

For those who conducted a cost segregation study in 2022 or beyond, the study can bring positive benefits by accelerating depreciation deductions for building assets related to new construction, renovations or recently acquired buildings. While this is likely to remain attractive in any case, note that the accelerated depreciation deductions will be aggregated in a year where the ATI calculation changes, which may cause a limitation to your business interest expense deduction.

As you engage in tax planning activities, remember to take a look at the 2022 business interest limitation changes to determine its effect on your business. If you need assistance or more information, please contact us.

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