What Is the Limitation on Business Interest Expense Deductions?

What is the current IRC §163(j) deduction limitation?

The TCJA significantly expanded IRC §163(j) by limiting the IRC §163 deduction for net business interest expense to 30% of any taxpayer’s adjusted taxable income (ATI), with an exemption for small businesses and an option for real estate and farming businesses to elect out of the limitation. The OBBBA impacts the limitation by increasing a taxpayer’s ATI to include amounts deducted for depreciation, amortization, or depletion for tax years beginning after 2024, which permits a taxpayer to deduct more business interest.

How is the business interest deduction calculated?

IRC §163(j) provides that the amount of deductible business interest expense in a tax year is limited to the sum of the following:

• The taxpayer’s business interest income for the year
• 30% of the taxpayer’s ATI for the year
• The taxpayer’s floor plan financing interest expense for the year

What qualifies as a business interest expense?

According to IRC §163(j), “business interest” is defined as “any interest paid or accrued on indebtedness properly allocable to a trade or business.” It does not include investment income or (for taxable years beginning after 2025) interest capitalized under IRC §263(g) or IRC §263A(f).

“Business interest income” is defined as the amount of interest includible in the gross income of the taxpayer for the taxable year that is properly allocable to a nonexcepted trade or business.

“Business interest expense” is defined as interest expense that is properly allocable to a nonexcepted trade or business or that is floor plan financing interest expense. Both terms exclude investment income.

The current iteration of IRC §163(j) is considerably more encompassing than its predecessor; it applies regardless of whether:

• The debt is between related parties
• The debt is incurred by a sole proprietor, a corporation, a pass-through entity, or an entity subject to tax under IRC §511
• The taxpayer is thinly capitalized

For purposes of the IRC §163(j) limitation on the deductibility of business interest expense, the definition of “interest” is broader than the definition of “interest” for federal income tax purposes more generally. “Interest” includes amounts paid or accrued as compensation for the use or forbearance of money, but also includes amounts associated with arrangements that create debt in substance but not in form.

The regulations characterize myriad items as “interest,” including:

• Substitute interest payments, but only if the payment relates to a sale-repurchase agreement or a securities lending transaction that isn’t entered into by the payor in the ordinary course of the payor’s business
• Acquisition discount
• Deductible repurchase premium
• Deductible bond premium
• §163(j) interest dividends
• Ordinary income or loss on contingent payment debt instruments and inflation-indexed debt instruments
• §1258 gain
• Amounts treated as interest under other provisions of the tax law
• A portion of the payments on over-the-counter interest rate swaps (subject to an exception)

The regulations don’t expressly characterize debt issuance costs, loan commitment fees, guaranteed payments for the use of capital, or hedging income and expense as interest. However, the anti-avoidance rule contained in the regulations’ definition of interest clarifies circumstances under which hedging transactions and guaranteed payments for the use of capital are treated as interest for purposes of IRC §163(j). Note, that regulatory guidance has not yet been updated for changes made by the OBBBA.