How IRC Section 163(j) Affects Real Estate Investors: What You Need to Know

If you're investing in real estate or running a business with leveraged assets, you’ve likely encountered IRC Section 163(j) the IRS provision that limits the deductibility of business interest expense. This rule has far-reaching implications for your bottom line, particularly when combined with the power of cost segregation. Here's what you need to know.

Important Insights

• IRC Section 163(j) limits business interest deductions to 30% of adjusted taxable income, potentially increasing taxable income for highly leveraged real estate investors.
• Real estate businesses can elect out of this limitation but must switch to slower ADS depreciation and forfeit bonus depreciation benefits.
• Cost segregation studies remain valuable, even under ADS, by accelerating depreciation on components with shorter recovery periods.

Table of Content

• Important Insights
• What Is IRC Section 163(j)?
• Who’s Affected?
• The Real Estate Investor’s Trade-Off: Electing Out of IRC 163(j)
• Cost Segregation to the Rescue
• What Should You Do?
• Final Thoughts

What Is IRC Section 163(j)?

Originally expanded under the Tax Cuts and Jobs Act (TCJA) of 2017, IRC §163(j) limits the amount of business interest expense that can be deducted in a given year. The general cap is 30% of adjusted taxable income (ATI), which is essentially EBITDA through 2021 and EBIT from 2022 onward.

In simple terms: If your interest expenses exceed this threshold, the excess is disallowed and carried forward to future years.

Who’s Affected?

Most businesses are subject to this limitation. However, certain real estate businesses can elect out but there’s a catch.

To opt out of §163(j), a real estate business must:

• Make an irrevocable election to be treated as an “electing real property trade or business.”
• Agree to use Alternative Depreciation System (ADS) instead of the standard MACRS on certain property classes.

The Real Estate Investor’s Trade-Off: Electing Out of IRC 163(j)

Real estate investors face a strategic decision when considering the election out of IRC Section 163(j). While the election can provide immediate tax relief, it comes with long-term implications.

Advantages of Electing Out:

• Full Deductibility of Interest: All business interest expense becomes deductible—no 30% cap.

• Lower Taxable Income: Greater deductions can significantly reduce taxable income, especially for highly leveraged investments.

Trade-Offs to Consider:

• Mandatory Use of ADS: Electing out requires switching to the Alternative Depreciation System (ADS), which uses longer recovery periods (e.g., 40 years instead of 39 for commercial property).

• Loss of Bonus Depreciation: ADS rules prohibit the use of 100% bonus depreciation on certain asset classes, delaying valuable tax write-offs.

This is where cost segregation proves invaluable. By identifying and reclassifying shorter-life assets even under ADS investors can still accelerate depreciation and recapture some of the benefits lost by forgoing bonus depreciation.

Cost Segregation to the Rescue

A cost segregation study breaks your property down into its component parts, allowing investors to accelerate depreciation on certain asset categories, including:

• Land improvements (typically depreciated over 15 years)

• Personal property (depreciated over 5 or 7 years)

Even if you elect out of IRC §163(j) and are required to use the slower Alternative Depreciation System (ADS), cost segregation still delivers significant value. While bonus depreciation is no longer available under ADS, you can still capture accelerated depreciation through reclassification into shorter-lived assets.

Strategic Insight:
Some investors opt against the §163(j) election to retain bonus depreciation benefits—especially valuable in the early years of ownership. Others elect out when the ability to deduct full interest expense outweighs the loss of bonus depreciation, particularly in highly leveraged transactions.

The right choice depends on your financing structure, cash flow strategy, and long-term tax planning. Cost segregation helps you make that decision with clarity—and maximize tax savings either way.

What Should You Do?

Your decision should be driven by a detailed analysis of your:

• Debt structure
• Projected interest expense
• Depreciation strategy
• Long-term investment goals

Partnering with a qualified Cost Segregation Specialist and your CPA ensures that you’re not leaving money on the table—whether you elect out of 163(j) or not.

Final Thoughts

IRC §163(j) adds a layer of complexity, but also opportunity. With the right planning especially with the help of cost segregation you can optimize both your interest expense and depreciation deductions. Need help running the numbers or deciding if the election makes sense for your next acquisition? Schedule a call with CostSegRx.