How the Section 163(j) Election Reshapes Real Estate Tax Strategy

For real estate investors, the ability to fully deduct interest expense can materially affect the economics of a project.

Section 163(j) of the Internal Revenue Code limits business interest deductions to 30% of adjusted taxable income, imposing a significant tax burden on highly leveraged investments. To mitigate this, Real Property Trades or Businesses (RPTOBs) may elect to opt out of the limitation.

While this election can offer immediate tax relief, it is irrevocable and can introduce long-term consequences that extend well beyond the current tax year.

This blog examines both the advantages of making the election and the lasting implications it has on depreciation methods, future acquisitions, and broader portfolio strategy, particularly in light of the One Big Beautiful Bill Act (OBBBA).

Understanding the trade-off: ADS and the loss of bonus depreciation

By electing out of the Section 163(j) limitation, a RPTOB gains the ability to fully deduct all business interest expense. In exchange, the business must adopt the Alternative Depreciation System (ADS) for all qualified real property assets. ADS extends the recovery periods for depreciation, resulting in slower annual deductions compared to the General Depreciation System (GDS).

For example, residential rental property shifts from a 27.5-year recovery period under GDS to 30 years under ADS; nonresidential real property moves from 39 to 40 years; and qualified improvement property extends from 15 to 20 years.

More critically, the election permanently disqualifies the business from claiming bonus depreciation on any new qualified improvement property or other eligible assets. This change is not temporary; it constitutes a permanent modification to the entity’s tax accounting method.

Implications for future property exchanges

The RPTOB election applies at the entity level and affects all qualifying properties, including those acquired in the future. This has particular relevance in the context of Section 1031 exchanges.

When a property is exchanged for a replacement asset, the ADS rules and the prohibition on bonus depreciation continue to apply. The business cannot reverse the election or selectively apply different depreciation methods to new acquisitions. Whether the asset is acquired through exchange, purchase, or new construction, the original election governs its treatment.

This permanence means that the tax strategy of the business is effectively locked in. Investors must recognize that the election’s impact might extend to the entire lifecycle of the portfolio.

Tax legislation impact on Section 163(j)

OBBBA reintroduces a critical change to the calculation of adjusted taxable income (ATI) under Section 163(j). Specifically, it restores the ability to add back depreciation, amortization, and depletion when computing ATI. This change effectively reverts ATI to a tax basis EBITDA model, which had previously expired for tax years beginning after 2021.

For highly leveraged real estate investments, this restoration increases the amount of deductible interest expense without requiring the RPTOB election. As a result, the strategic calculus behind making the election has changed. Businesses may now find they can achieve sufficient interest deductibility while preserving eligibility for bonus depreciation and avoiding the slower ADS recovery periods.

However, it is important to note that the RPTOB election remains irrevocable. For businesses that have already made the election, the restored addbacks under OBBBA do not reverse the ADS requirement or reinstate eligibility for bonus depreciation. Therefore, going forward, the decision to elect out of Section 163(j) must be made with full awareness of both current and future tax implications.

Additional considerations before making the election

Given its irrevocable nature, the RPTOB election should not be viewed as a short-term tax planning fix. Before proceeding, real estate investors should carefully evaluate the following: 

• Does the immediate benefit of fully deducting interest expense outweigh the long-term cost of slower depreciation across current and future assets? 
• Are the business’s growth plans, particularly those involving acquisitions or exchanges, compatible with the limitations imposed by ADS? 
• Is the potential to claim bonus depreciation in future years more valuable than the present need for interest deductibility? 
• How do the restored addbacks under OBBBA affect the business’s ability to deduct interest without making the RPTOB election?

Because this election alters the tax treatment of real property assets permanently, it is essential to consult with a qualified tax advisor who can model the long-term effects based on the specific facts and objectives of the business. The decision should be grounded in a comprehensive understanding of both current tax exposure and future strategic direction.

How CLA can help with Section 163(j) elections

At CLA, we recognize the complexity and permanence of the Section 163(j) election and its impact on long-term tax strategy. Our experienced tax advisors, backed by deep specialization in the real estate industry, can provide comprehensive modeling and analysis to help you evaluate the implications across your portfolio