How Change in 163(j) Affects Depreciation
With all the attention being put on the amortization requirements of 174 some of the other expiring provisions of the TCJA are being overlooked. This includes the changes to the calculation of Adjusted Taxable Income (ATI) as it relates to the interest limitation under 163(j). Prior to the end of 2021 the calculation for ATI closely followed EBITDA, however starting in 2022 the calculation follows EBIT. This could have drastic affects on the tax liability for affected businesses.
For most businesses, the effect of this change is easy to see. For a business with $50 million in EBITDA income and $20 million in depreciation, the limitation in interest drops from $15 million under the old calculation to $9 million under the new calculation. This may cause some companies to revisit the Real Property Trade or Business election. However, companies need to be careful with that election as it requires qualified improvement property to be depreciated using ADS, eliminating access to bonus for certain capital expenditures.
The issue gets worse for companies utilizing floor plan interest financing. Under 163(j) floor plan interest is not limited. However, for companies with floor plan financing indebtedness bonus depreciation may be limited. Under regulation 1.168(k)-2(b)(2)(ii)(G) companies compare their total interest, including floor plan interest, to the 163(j) limitation. If they exceed the 30% threshold, they cannot take bonus on any assets. This can drastically change the tax liability for car dealerships. Take a dealership with $2 million in EBITDA income and $500,000 in floor plan financing interest. For this example, let’s assume that the dealership put in service $1 million in interior renovations in 2022. Under the old rules the taxpayer could have deducted both their floor plan interest, and taken bonus for all of the interior renovations as QIP. This would mean their taxable income would have been $500,000 ($2 million, less $1 million in depreciation, less $500k in interest). However, under the new rules the calculation for 163(j) is based on EBIT, this means the $500,000 now exceeds their $300,000 limit. The taxpayer now loses bonus on the $1 million in improvements. Since QIP is a straight line 15-year asset the taxpayer will only get a depreciation deduction of $33,000. This will increase their taxable income by almost $1 million.
Similar to the 174-amortization requirement, the change to the 163(j) limitation was a budgetary move under the TCJA. While no one expected these changes to come to fruition taxpayers now need to wrestle with how to deal with these changes on their 2022 taxes. If you have any questions about this or any other expiring provisions of the TCJA, please reach out to your McGuire Sponsel representative.
David McGuire is a leading expert on cost segregation, fixed assets and depreciation law and a co-founder of McGuire Sponsel.
McGuire is an expert on for how tax law affects depreciation. His knowledge in determining asset costs and classifications has held up against IRS scrutiny and has built the firm into a trusted industry partner.