Favorable Changes to the Business Interest Deduction Rules

Under current law, the deduction for business interest expense is generally limited to 30% of adjusted taxable income (ATI) for the year. The One Big Beautiful Bill Act (OBBBA) modifies how ATI is calculated, starting in 2025. Specifically, depreciation, amortization and depletion are once again added back when computing ATI, increasing the limit on business interest deductions for many businesses. Here's what you need to know.

The Basics

Business interest expense is defined as interest on debt that's properly allocable to a trade or business. However, the term "trade or business" doesn't include the following:

• Services performed as an employee,
• Electing real property businesses,
• Electing farming businesses, and
• Businesses that sell electrical energy, water, sewage disposal services, gas or steam through a local distribution system, or transportation of gas or steam by pipeline, if the rates are established by a specified governing body.

The Tax Cuts and Jobs Act (TCJA) introduced a new limitation on business interest deductions, starting in 2018. Before that, business interest was generally deductible, but the deductions were subject to various other restrictions, such as the passive loss rules and the at-risk rules. Additionally, some corporations were subject to the so-called "earnings-stripping" rules. Those rules attempted to limit deductions by U.S. corporations for interest paid to related foreign entities that weren't subject to U.S. income tax.

Close-Up on the TCJA Limitation

Under the TCJA, for tax years beginning after 2017, a taxpayer's deduction for business interest expense for the year was limited to the sum of:

• Business interest income,
• 30% of ATI, and
• Floor plan financing interest paid by certain vehicle dealers. (See "What Qualifies as "Floor Plan" Financing Interest?" below.)

The 30%-of-ATI limit was a permanent change that affected many larger businesses. Interest expense that's disallowed under the limitation rules is carried forward to future tax years indefinitely and treated as business interest expense incurred in the carryforward year.

3 Key Exceptions

Many small and midsize businesses are exempt from the business interest deduction limitation. Three key exceptions are:

1. ‍Exception for small businesses. Under this exception, a taxpayer (other than a tax shelter) is exempt from the limitation if the taxpayer's average annual gross receipts are at or below an inflation-adjusted threshold for the three-tax-year period ending with the preceding tax year. For 2025, the average gross receipts threshold for the small business exception is $31 million. It's estimated that roughly 98% of U.S. businesses will be covered by this exception.‍
2. Exception for electing real property businesses. Businesses that develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease and/or broker real property can elect out of the interest expense limitation rules. But there's a cost: These businesses must use the Alternative Depreciation System (ADS) to depreciate their nonresidential real property, residential rental property and qualified improvement property.‍
3. Exception for electing farming businesses. Nurseries, sod farms, farms that raise or harvest crops or ornamental trees, certain agricultural and horticultural cooperatives, and other eligible farming businesses can elect out of the interest expense limitation rules. But, again, there's a cost: Those businesses that opt out of the limitation must use the ADS to depreciate assets used in the farming business that have Modified Accelerated Cost Recovery System (MACRS) depreciation periods of 10 years or more.

Important: Qualifying real estate and farming businesses that elect out of the interest expense limitation must use the ADS to depreciate certain assets. Using the ADS results in lower annual depreciation deductions, because the ADS depreciation periods are longer than the depreciation periods under the regular MACRS rules that usually apply. Before electing out of the business interest expense limitation, contact your tax advisor to discuss the pros and cons.

Calculating ATI

Under the TCJA, for tax years 2018 through 2021, the acronym "ATI" referred to taxable income adjusted to add back the following items:

• Any item of income, gain, deduction or loss that isn't allocable to a business,
• Any business interest income or business interest expense,
• Any net operating loss (NOL) deduction,
• The deduction for up to 20% of qualified business income from a pass-through business entity (such as a sole proprietorship, partnership, limited liability company or S corporation), and
• Any allowable deductions for depreciation, amortization and depletion.

Under the TCJA, for tax years 2022 through 2024, deductions for depreciation, amortization and depletion were no longer added back. This change significantly decreased many taxpayers' ATIs, reducing their allowable business interest deductions.

However, under the OBBBA, the formula for calculating ATI reverts to the pre-2022 methodology. That is, deductions for depreciation, amortization and depletion are once again added back to taxable income when calculating ATI. This favorable change is effective only for tax years beginning after 2024.

Bottom Line

Although the business interest expense limitation rules are complex, many small and midsize businesses are exempt. For those businesses subject to the limitation, the OBBBA generally realigns ATI with the accounting concept of earnings before interest, taxes, depreciation and amortization (EBITDA), rather than earnings before interest and taxes (EBIT). The bottom line? Starting in 2025, many affected businesses will be able to deduct more business interest expense than they could have deducted under the EBIT limitation that applied for tax years 2022 through 2024.

Proactive tax planning strategies can minimize the adverse effects of the business interest deduction limitation. Your tax advisor can help explain the rules, calculate your business interest deduction and provide supporting documentation if you qualify for an exception to the business interest expense limitation.

What Qualifies as "Floor Plan" Financing Interest?

Floor plan financing interest refers to interest on debt that's 1) used to finance motor vehicles that the taxpayer holds for sale or lease to customers, and 2) secured by a business's motor vehicle inventory. For this purpose, motor vehicles include:

• Any self-propelled vehicles designed for transporting people or property on public streets, highways or roads,
• Boats, and
• Farm machinery and equipment.

Because it's added back when calculating the business interest expense limitation, floor plan financing interest is effectively exempt from the limitation. However, property used in a business that has floor plan financing debt isn't eligible for first-year bonus depreciation.