How to Optimize Your Business Interest Deductions

27 Mar 2025 How to Optimize Your Business Interest Deductions

For business owners, interest expense is often a major line item—and an important tax deduction. But, due to evolving tax rules, deducting interest isn’t as straightforward as it once was.

These rules have changed significantly over the past several years, particularly with the Tax Cuts and Jobs Act (TCJA) and its aftermath. The deduction limits tightened in 2022, and with key TCJA provisions expiring after 2025, businesses need to plan ahead.

So, how do you maximize your deductions while staying compliant? Let’s walk through how business interest deductions under §163(j) work, who it affects, and what you can do to optimize your business’s interest expense deductions.

The business interest deduction has had many changes

Before the TCJA, business interest expense was generally deductible in the year it was paid or accrued, with relatively few restrictions. The old version of IRC §163(j), which existed before 2018, was narrow in scope—it only limited interest deductions for certain highly leveraged corporations, particularly when the interest was paid on tax-exempt debt to a related party. For most businesses, interest deductions weren’t much of a concern.

That changed with the TCJA. Starting in 2018, §163(j) was expanded. The new rules capped deductible business interest at 30% of a business’s adjusted taxable income (ATI). ATI was initially intended to approximate earnings before interest, taxes, depreciation, and amortization (EBITDA) for deduction limitation purposes. While not identical to EBITDA in a financial reporting sense, it functionally mimicked it for tax purposes. This gave businesses a higher ATI base, allowing a larger interest deduction under the 30% cap.

Starting in 2022, the depreciation, amortization, and depletion add-backs expired, per the TCJA’s original design. This shifted ATI to an earnings before interest and taxes (EBIT) -like calculation, making the limitation more restrictive. So, while ATI remains its own defined term under §163(j), it now effectively behaves more like EBIT.

The distinction matters because a business with significant depreciation or amortization deductions now has a much lower ATI, reducing how much it can deduct – even if its overall financial performance hasn’t changed.

Who’s subject to §163(j)?

The short answer is that most businesses with interest expense could be subject to §163(j)—but there are notable exceptions. If your business qualifies for one of these exceptions, you might not have to deal with the interest limitation rules at all.

Small business exception

One of the most common exemptions is the small business exception, which is based on a three-year average gross receipts test under IRC §448(c).

If your business’s average annual gross receipts for the prior three years are below a certain threshold—approximately $30 million as of 2024 (adjusted annually for inflation)—you’re not subject to §163(j). But it’s not just last year’s revenue that matters. It’s a rolling average, and you must consider aggregation rules.

Under the aggregation rules, multiple related entities—like commonly controlled LLCs or subsidiaries—must combine their gross receipts for purposes of the test. That’s where some businesses get tripped up. On paper, a single entity may fall below the threshold, but if it’s part of a broader business group, it may still be subject to §163(j) after aggregation.

Also important: even if you qualify one year, you may not qualify the next. Your status can change annually depending on your three-year average, so it’s something you have to monitor over time, especially if you’re close to the threshold.

Other exceptions

Beyond the gross receipts test, there are a few additional carve-outs:

• Real property trades or businesses can elect out of §163(j), but they must then use the Alternative Depreciation System (ADS), which typically means longer depreciation periods and no bonus depreciation on certain assets.
• Farming businesses can also elect out, but they too must follow ADS rules for some property.
• Regulated public utility businesses are automatically excluded from §163(j).

Could these exceptions change if §163(j) reverts post-2025?

If Congress lets §163(j) revert to its pre-TCJA form, the business interest limitation would again apply only in narrow related-party contexts, and many current exceptions would simply become irrelevant, because they wouldn’t be needed under the narrower rule.

That said, it’s unclear whether lawmakers would fully roll back the expanded scope or adopt some hybrid version with modified thresholds or exemptions.

Business interest expense: what counts and what doesn’t?

Not all interest qualifies for a deduction under §163(j). Business interest expense generally means any interest charged on debt that a company incurs to acquire assets, fund business operations, or pay for other expenses related to generating business income. However, if a portion of a loan is set aside for personal or investment use, the associated interest on that portion is typically carved out and not treated as business interest expense.

This definition extends beyond conventional bank loans or bond interest. The regulations can sweep in various arrangements that effectively serve as financing, including certain swaps or factoring agreements. However, the rules also specifically exclude purely investment-type interest from the definition.

Business interest income

If your business earns interest income, it can help offset your interest expense limitation under §163(j).

To qualify, the interest must be effectively connected to your trade or business. If you generate a lot of business-related interest income, it can reduce the amount of interest expense subject to the 30% limitation—which can be an important planning tool for businesses with substantial interest earnings.

Floor plan financing interest

Some businesses, particularly dealerships that sell vehicles, boats, or farm machinery, rely on floor plan financing—a type of loan used to purchase inventory. The loans used to acquire and hold inventory on a dealership’s lot typically incur interest and are termed “floor plan financing interest.”

Although this interest is still counted as business interest expense, it has a unique place within §163(j); under certain circumstances, it can allow an additional deduction that is not capped by the ordinary computation. However, this deduction may come at the cost of forfeiting 100% bonus depreciation under §168(k)(9) for other eligible property.

Strategic approaches to maximize your business interest deductions

Consider the real estate trade or business election

If a company is primarily involved in real estate activities — from development to management and beyond — it may opt out of the §163(j) limitation. Doing so eliminates the interest deduction cap but requires the use of the ADS for certain property, precluding eligibility for bonus depreciation. In practice, accepting slower depreciation methods in favor of an unlimited interest deduction can still be beneficial, especially for real estate companies that rely heavily on financing. The financial benefit hinges on modeling which scenario yields the best overall tax outcome given a particular project’s horizon, debt levels, and projected revenue.

It’s worth noting that the real estate trade or business election is irrevocable. If the §163(j) limitation expires you would still be required to use ADS unless Congress provides some form of related relief.

Capitalize interest instead of expensing

Certain tax rules allow businesses to capitalize interest expense, meaning it gets added to the cost of an asset instead of being deducted in the current year. Under §263A, interest related to self-constructed or produced property must be capitalized in many cases and is not optional. Under §266, businesses can elect to capitalize certain carrying costs, including mortgage interest on unimproved real estate.

This approach can be useful for companies facing §163(j) limitations, as it effectively removes interest from the 30% ATI cap. By capitalizing, businesses increase the asset’s cost basis, which can lead to larger depreciation deductions over time or reduce taxable gain upon sale. It also aligns costs with revenue, making it particularly useful for long-term construction or development projects.

However, the downside is a delayed deduction—rather than an immediate expense, the interest is recovered gradually through depreciation or when the asset is sold. This strategy also adds complexity, requiring careful tracking to ensure compliance. It may not be ideal for businesses needing current tax relief, especially if the asset is subject to a long depreciation schedule.

Rethink debt vs. equity financing

The tax code traditionally allows businesses to deduct interest on debt but not dividends paid to equity investors. This difference can introduce a bias in favor of debt financing.

But, if your interest expense is getting disallowed under §163(j), it might make sense to consider raising capital through equity financing or restructuring debt to lower interest costs. This approach, however, is more complex to structure and has other ramifications for control and ownership. So, it’s best to weigh both current and future cost-of-capital implications before deciding.

Adjust lease vs. buy decisions

Beyond the choice of debt versus equity, the decision to buy or lease assets can also change your interest expense profile. Under a finance (capital) lease, you effectively purchase the asset, incur interest on the “loan portion,” and claim depreciation. In an operating lease, you won’t typically record an explicit interest deduction for tax purposes, as payments are generally deductible as rent.

Where business interest might be disallowed under §163(j), you could consider structuring more transactions as operating leases, although you must also professionalize your approach to deciding whether a given arrangement meets the criteria of a “true” lease. Coupled with evolving financial reporting standards, this is a complex area, but one that can yield important tax savings.

Optimize partnership and S corp interest handling

If you operate through a partnership or S corporation, §163(j) applies at the entity level. This means the maximum amount of currently deductible interest is determined before any income or expense passes through to the partners or shareholders. When a partnership’s year-end numbers show more interest expense than is allowed, that disallowed portion (termed “excess business interest expense” or EBIE) passes through to the partners, who must carry it forward in their personal capacity.

The rules provide intricate mechanisms for tracking carryforward amounts and applying them to subsequent years, and these calculations can turn into complicated exercises in partnership tax accounting. In simple terms, a partner can only utilize the disallowed interest in a future year if the same partnership allocates “excess taxable income” or “excess business interest income” to them. S corporations generally handle the interest limit in a similar fashion, but the disallowed interest remains trapped at the entity level indefinitely until there’s sufficient ATI.

A noteworthy wrinkle arises from “self-charged interest,” where a partner lends money directly to the partnership. This transaction creates interest income for the partner and interest expense for the partnership. Certain regulatory rules allow that interest to be partially recharacterized in order to align the ultimate economic reality with how the §163(j) limit is applied. While specialized, it can be a tool for partners who use self-financing to support business expansions.

Compliance and reporting considerations

If your business is subject to §163(j), you must file IRS Form 8990 to report the limitation.

Many taxpayers also have to attach statements when they make elections, such as opting out for real property trades or businesses, or when capitalizing certain expenditures under §266. The requirements, including the specific language and details needed, tend to be very precise. If any of these elections are missing or incorrectly prepared, you could find yourself in unnecessary disputes or dealing with an irrevocable election that’s been improperly executed. Thorough recordkeeping for the cost and disposition of assets is likewise essential, particularly if you opt to capitalize interest or handle partnership-level interest carryforwards. Considering the layering effect that §263A, §266, or CARES Act elections might add, staying organized is vital to ensure compliance and maintain the ability to support any deductions claimed.

Planning for 2025 and beyond

Several TCJA provisions expire at the end of 2025 if Congress does not step in to extend them.

Given this uncertainty, it makes sense to revisit decisions on annual elections, partnership structures, and significant debt financing arrangements with an eye toward potential future changes.

If you’re unsure how these rules apply to your business, a CPA or tax advisor can help you identify the best strategies and avoid potential pitfalls. To discuss your options, please contact our office.

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