Business Interest Expense Limitation — Section 163(j)

Before 2018, businesses could deduct nearly all their interest expense on business debt. The Tax Cuts and Jobs Act of 2017 changed that by adding § 163(j) to the Code, capping the business interest deduction at 30% of "adjusted taxable income" (ATI) — regardless of how much interest was actually paid. Any interest that can't be deducted in the current year carries forward indefinitely as a future deduction. As of 2022, the definition of ATI tightened significantly: depreciation and amortization are no longer added back when calculating ATI, making the limitation more restrictive for capital-intensive businesses. Small businesses with average annual gross receipts of $30 million or less (as of 2026) are exempt from this rule entirely, and real estate businesses can elect out — but only by giving up accelerated depreciation.

Current Law (2026)

Legal Authority

• 26 U.S.C. § 163(j)(1) — The limit: business interest deductions for any year cannot exceed (A) business interest income, plus (B) 30% of ATI for the year, plus (C) floor plan financing interest; any excess is carried forward
• 26 U.S.C. § 163(j)(2) — Carryforward: disallowed business interest is treated as if paid or accrued in the following year, subject to the same 30% test; it carries forward indefinitely (unlike NOLs, there is no expiration)
• 26 U.S.C. § 163(j)(3) — Small business exemption: taxpayers that satisfy the § 448(c) gross receipts test (average annual gross receipts ≤ inflation-adjusted threshold, which is $30 million for 2026 tax years) are exempt from § 163(j) entirely; the three-year average is key — a temporarily large year could cause a business to lose the exemption
• 26 U.S.C. § 163(j)(4) — Partnership rules: the limitation is calculated at the partnership entity level, not the partner level; excess business interest is allocated to partners as "excess business interest" (EBI), which the partner can only deduct in future years to the extent the partnership allocates "excess taxable income" back to that partner; this creates complex tracking requirements for private equity funds and other partnerships
• 26 U.S.C. § 163(j)(7) — Elections out: real estate trades or businesses may elect to be exempt from § 163(j) if they use the Alternative Depreciation System (ADS) for applicable residential and nonresidential real property; farming businesses similarly may elect out but must apply ADS to farm property
• 26 U.S.C. § 163(j)(8) — ATI defined: adjusted taxable income starts with taxable income, adds back business interest expense, deductions for depreciation, amortization, and depletion were added back under pre-2022 rules (EBITDA-like), but Congress did not extend that treatment — since January 1, 2022, ATI is computed without the D&A addback (EBIT-like), significantly reducing ATI and therefore the amount deductible
• 26 U.S.C. § 163(j)(9) — Anti-abuse for tax shelters: any taxpayer that is a tax shelter (as defined in § 448(a)(3), including certain partnerships structured as tax shelters) cannot use the small business exemption regardless of gross receipts

How the Limitation Works

The § 163(j) calculation follows a simple formula: your deductible business interest cannot exceed business interest income (interest received from your business activities) plus 30% of ATI plus floor plan financing interest.

Example: A manufacturing company has $0 of business interest income, $5 million of ATI (which, post-2021, does not add back depreciation), and pays $2 million of interest on its bank debt. The § 163(j) limit is 30% × $5M = $1.5M. Of the $2M interest paid, $1.5M is deductible; $500,000 carries forward to next year as potential future deduction.

The pre-2022 vs. post-2022 shift: Before 2022, ATI was calculated on an EBITDA basis — depreciation and amortization were added back, making ATI (and therefore the deduction limit) larger. Congress allowed this EBITDA treatment to expire on December 31, 2021. Since 2022, ATI is EBIT-based. For capital-intensive businesses that take large depreciation deductions (manufacturers, real estate companies, infrastructure businesses), this change significantly reduced the deductible amount. Congress has repeatedly considered extending the EBITDA addback but has not done so as of 2026.

The Partnership Complexity

For partnerships — including private equity fund portfolio companies, real estate partnerships, and operating partnerships — § 163(j) is notably complex:

1. Entity-level calculation: The partnership calculates its § 163(j) limitation at the entity level and takes whatever interest deduction is allowed on the partnership return
2. Excess business interest allocation: Any disallowed interest (excess business interest, or "EBI") is allocated to the partners on the K-1 — but the partners cannot immediately deduct it on their own returns
3. Suspension at the partner level: The partner's EBI carries forward, suspended, until the same partnership allocates "excess taxable income" to that partner in a future year — essentially, the partner gets to deduct prior EBI only when the partnership has "room" under its 30% limit
4. Basis reduction: Receiving EBI reduces the partner's outside basis in the partnership interest by the EBI amount — even though no deduction has been taken yet

This creates a mismatch: a partner who receives EBI takes a basis hit today but gets the deduction later. For investors who sell their partnership interests, the timing mismatch can be costly — they may have reduced basis (higher gain on sale) before ever deducting the suspended interest.

The Real Estate Election

Real estate businesses face a difficult choice under § 163(j). Most real estate investment is debt-financed, and interest expense is often the largest operating deduction. Making the § 163(j) election out preserves full interest deductibility — but the price is using the Alternative Depreciation System (ADS) for residential real property (ADS 30-year life vs. MACRS 27.5 years) and nonresidential real property (ADS 40-year life vs. MACRS 39 years). The slower ADS depreciation means smaller annual depreciation deductions — the question is whether the interest deduction preserved is worth more than the depreciation deductions deferred.

For heavily leveraged real estate (where interest expense is very large relative to net income), the election is usually worthwhile. For modestly leveraged real estate, the TCJA bonus depreciation and § 179 immediate expensing may be more valuable than unlimited interest deductions. Note: the real estate election cannot be "un-made" — it's permanent for the business once elected.

How It Affects You

If you're a closely-held business owner with significant debt: First, confirm whether the $30 million gross receipts exemption applies — if your average annual gross receipts for the prior 3 years are below $30 million (indexed for inflation), § 163(j) doesn't apply to your business at all. Above that threshold, your annual interest deduction is capped at 30% of adjusted taxable income (ATI). For a business with $5 million ATI and $2.5 million of interest expense, you can deduct $1.5 million (30% × $5M) and carry forward $1 million of excess business interest (EBI). Before year-end, assess whether accelerating income recognition (to increase ATI) or deferring interest payments (to reduce the limitation's bite) makes sense — the answer depends on whether you expect to have ATI capacity in future years to absorb the carryforward.

If you're in a private equity or leveraged buyout structure: § 163(j) was explicitly designed to limit leveraged structures where interest deductions offset all operating income. LBO acquisition financings now routinely include multi-year § 163(j) models showing when accumulated EBI carryforwards can be absorbed as operating ATI grows. Also critical: after the TCJA's 2022 change, depreciation and amortization are no longer added back to ATI (the pre-2022 EBITDA-based calculation is gone — it's now EBIT-based). This significantly reduced ATI for capital-intensive businesses and made § 163(j) more binding than before. Model the change-of-control impact as well — § 382 ownership changes can affect EBI carryforward usability in some structures.

If you're a real estate investor deciding whether to elect out of § 163(j): The real estate election out of § 163(j) is a permanent, irrevocable election that trades unlimited interest deductibility for the loss of bonus depreciation (you must use ADS straight-line depreciation on residential and nonresidential property, which is slower). Before electing, model the tradeoff over your expected holding period: for short-hold properties where front-loaded bonus depreciation is valuable, staying in § 163(j) and accepting some interest limitation may be better than giving up bonus depreciation permanently. For properties with moderate leverage and long hold periods, the election may be clearly beneficial. The election is made separately for each real property trade or business.

If you're a partner or S corporation shareholder receiving a § 163(j)-limited entity's K-1: For partnerships, disallowed interest is allocated to partners as excess business interest expense (EBIE) — it can only be deducted when the partner receives excess taxable income or excess business interest income from that same partnership in a future year. EBIE allocated from one partnership cannot be used against income from another entity, and basis is reduced by EBIE at allocation (creating phantom basis loss). For S corporations, the § 163(j) limitation applies at the corporate level and the EBI carryforward stays at the S-corp — it does not pass through to shareholders — which is simpler to track but means shareholders can't accelerate the deduction at the individual level.

State Variations

State conformity to § 163(j) is inconsistent:

• States decoupled from § 163(j): Several states, including California, New York, and Illinois, allow the full interest deduction without the 30% cap; in these states, the business pays lower state tax even if the federal deduction is limited
• States conforming to EBITDA treatment: Some states that do conform to § 163(j) continue to use the more favorable EBITDA-based ATI calculation even after the federal switch to EBIT, providing a state-level deduction uplift
• Impact on state taxable income: Because § 163(j) is a timing rule (deductions defer, not disappear), the long-term state impact depends on the carryforward: states that don't conform to the carryforward can create permanent state/federal differences

Pending Legislation

The restoration of the EBITDA-based ATI calculation has been included in multiple legislative proposals, including as part of various reconciliation bills and as a standalone bipartisan measure. The argument for restoration: the original TCJA intent was to allow a reasonable interest deduction, and the switch to EBIT-based ATI significantly tightened the rule beyond what was debated when TCJA passed. As of 2026, no legislation restoring EBITDA treatment has been enacted, but the issue remains active in tax policy discussions.

Recent Developments

The IRS issued comprehensive final regulations under § 163(j) in 2020 and supplemental regulations in 2021, addressing partnership EBI allocation mechanics, the definition of "business interest," anti-avoidance rules for interest-stripping transactions, and the treatment of regulated utilities (which received a 100% deduction under a separate regulatory elective). The regulations confirmed that consolidated group members calculate § 163(j) on a consolidated basis, not member-by-member — an important simplification for corporate groups. Treasury has also issued guidance on the interaction of § 163(j) with the new corporate alternative minimum tax (CAMT) enacted in the Inflation Reduction Act.

• OBBBA (2025) proposes restoring EBITDA-based § 163(j) limitation: one of the most significant business tax provisions in the reconciliation bill would restore the pre-2022 EBITDA (earnings before interest, taxes, depreciation and amortization) standard retroactively to 2022, substantially expanding the deductible interest base for capital-intensive businesses and reducing their tax burden.
• CAMT interaction remains complex: Treasury's 2024 final regulations on the 15% corporate AMT enacted in the IRA addressed § 163(j) carryforward treatment but left open questions about partnership-level allocations; further guidance is expected in 2025 but may be delayed by the Trump Treasury's regulatory freeze.
• Loper Bright exposure for § 163(j) regulations: the IRS's broad reading of "floor plan financing" and partnership aggregation rules under § 163(j) now face heightened judicial scrutiny without Chevron deference; taxpayers in ongoing Tax Court § 163(j) disputes are filing supplemental briefs arguing courts must independently construe the statute.