HR 1 Changes to Section 163(j) and Best Practices for Tax Shelters

By Andrew R. Barg, CPA, MST, CIRA-Fort Worth

HR 1, also known as the One Big Beautiful Bill Act (OBBBA), made permanent changes to Section 163(j). While most of the changes are positive for years beginning after Dec. 31, 2024, there are some negative provisions that become effective for tax years beginning after Dec. 31, 2025.

For tax years beginning after Dec. 31, 2024, HR 1 made permanent a more taxpayer friendly computation of adjusted taxable income (ATI) by calculating ATI without regard to depreciation, amortization or depletion. The legislation also makes permanent changes to the floor plan financing interest provisions by redefining “motor vehicle” to include: any self-propelled vehicle designed for transporting persons, a boat, farm machinery or equipment, and any trailer or camper designed to provide temporary living quarters designed to be towed by, or affixed to, a motor vehicle.

For tax years beginning after Dec. 31, 2025, an anti-abuse provision will generally prohibit companies from using elective interest capitalization strategies to deduct more interest as inventory or cost of goods sold. HR 1 also makes a change to modifications of ATI that will negatively affect companies with controlled foreign corporations (CFCs).

Tax firms will want to polish up on the new 163(j) rules and may consider adding new policies for reporting on previous tax shelters. Under 163(j), most small businesses qualify for an exception if they meet the gross receipts test of Section 448(c) and must not be a tax shelter as defined in Section 448(d)(3). The small business exception is an annual determination.

Syndicates are the most common tax shelter traps for small businesses and include any entity (other than a C Corp) where 35 percent or more of the losses are allocable to limited partners or limited entrepreneurs. Neither the statute nor the regulations address what happens to the interest expense carryover once a business meets the exception when, for example, a limited partnership turns a profit. When there is ambiguity in tax law, courts are generally required to construe in favor of taxpayers. I believe that once a former tax shelter partnership meets the small business exception, their interest expense is no longer limited and, thus, suspended 163(j) carryovers that exist can be fully utilized in the year the exception is met.

Unfortunately, when a tax shelter partnership qualifies for the small business exception, most tax software products will not inform the partner nor will they provide any numbers for excess taxable income to trigger the carryovers. In those situations, I recommend informing the partners that the partnership now qualifies for the small business exception under 163(j) so that other tax practitioners will have the information they need to utilize 163(j) carryovers.