Capitalizing interest to unlock deductions trapped by Section 163(j)

Interest capitalization can provide strategic tax planning opportunities that allow taxpayers to immediately deduct interest expense that would otherwise be denied by the limitation under Section 163(j).

This planning has become more powerful in recent years as high interest rates and increasing debt present organizations with growing interest expense challenges. Interest capitalization offers a wide range of opportunities to reduce disallowed interest deductions by capitalizing interest expense to assets with quick turnover, such as:

• Accounts receivable
• Inventory
• Fixed assets
• Customer contracts
• Other shorter recovery period assets

Once capitalized, the interest expense is fully recovered through another type of tax deduction, such as cost of goods sold, depreciation, amortization or losses. By strategically choosing which assets to capitalize interest to, businesses may recover the expenditures long before the otherwise disallowed interest expense becomes deductible under Section 163(j). Companies should carefully evaluate the potential planning options that interest capitalization provides by examining:

• Specific facts and available data
• Types of assets for which interest can be capitalized
• Which elective capitalization provisions may apply
• Available interest allocation methods

Background

Although business interest is generally deductible when paid or accrued within the taxable year of indebtedness, there are several limitations that restrict the ability to deduct such interest during the year. Section 163(j) limits the deduction for business interest in the current tax year to the sum of:

• The taxpayer’s business interest income for the taxable year
• 30% of the taxpayer’s adjusted taxable income (ATI) for the taxable year, and
• The taxpayer’s “floor plan financing interest expense” for the taxable year.¹

The term “business interest” means any interest paid or accrued on indebtedness properly allocable to a trade or business, excluding certain investment interest. Business interest not allowed as a deduction for any taxable year may be carried forward and deducted in subsequent taxable years, subject to the limitation in the carryforward year. ATI is generally taxable income without the deductions for interest, net operating losses, capital loss carrybacks or carryforwards or Section 199A. For tax years beginning after 2021, adjusted taxable income must include depreciation and amortization.

Consistent with the legislative history, the regulations under Section 163(j) provide that Section 163(j) limitations apply after the application of any other provisions that subject interest expense to disallowance, deferral, capitalization, or other limitations. 

Interest capitalization alternatives

There are several provisions that require or permit the capitalization of interest, including for example, Section 266, Section 263(a) and Section 263A. Interest that is capitalized is included in basis of the asset to which it is capitalized, and recovered through depreciation/amortization, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of, as applicable.

Section 263(a) provides optional capitalization elections for overhead costs that facilitate the acquisition of tangible or intangible property. Because interest is generally viewed as overhead, there is an opportunity to capitalize interest that facilitates the acquisition or creation of assets like inventory or contracts. These assets may provide for a quicker recovery of the capitalized interest than the types of assets under Section 263A, but the amount of time for which interest can attach to the items, and therefore the potential amount of interest capitalized, could be much shorter than under other provisions. The election is annual and, once made, is only revocable only with IRS consent.

Section 266 provides a different optional capitalization election for carrying charges, including interest, on personal property and certain unimproved or improved real property. In the case of personal property, the provision applies broadly, but the election is limited to specific types of interest and taxes incurred for specific purposes up until the property is first put into use. Case law and IRS guidance allow interest related to tangible property, including inventory and intangible assets like self-produced films, to fall under the election. As such, interest on debt incurred to purchase or produce any type of personal property, tangible or intangible, arguably should be eligible for elective capitalization. Capitalization of interest to personal property may provide for a quicker recovery than interest capitalized to assets under Section 263A. Further, the period of time for capitalization under Section 266 generally is longer than the period under Section 263(a), which typically means a higher amount of capitalized interest. The election is filed annually, but certain projects that carry over across years must continue to capitalize interest until the project is complete.

The most common provision requiring capitalization of interest is Section 263A. This section applies an avoided cost methodology, which is similar to the book accounting concept with some differences and options.  Applying some of these options can provide interest capitalization benefits, but it is generally a long-term solution to the extent the assets involved are not provided immediate expensing, like 100% bonus depreciation. This is because the types of property subject to the rules generally includes real property or tangible personal property that has (1) a class life of 20 years or more, (2) an estimated production period exceeding two years, or (3) an estimated production period exceeding one year and an estimated cost of production exceeding $1 million.