The 2026 Business Interest Expense Test for Leveraged Owners
Paying Interest Does Not Always Mean Deducting Interest
A real estate investor may pay $400,000 of mortgage interest during 2026. A closely held company may borrow to buy equipment or acquire another business. The lender’s statement shows what was paid, but it does not prove that the full amount is currently deductible.
Internal Revenue Code Section 163(j) limits business interest expense for certain taxpayers. The practical question is not simply, “How much interest did we pay?” It is, “What kind of interest is it, does an exemption or election apply, and how much deduction capacity does the business have for 2026?”
What the Business Interest Expense Limitation Is
Section 163(j) is generally a timing rule. It can defer a business interest deduction when interest is high relative to tax-defined income.
First, however, the interest must be classified correctly.
| Interest category | General federal treatment |
|---|---|
| Business interest expense | Interest properly allocable to a non-excepted trade or business. It may be limited by Section 163(j). |
| Business interest income | Taxable interest income allocable to a non-excepted trade or business. It increases deduction capacity. |
| Investment interest | For a noncorporate taxpayer, interest allocable to property held for investment. A separate rule generally limits it to net investment income. |
| Personal interest | Interest allocable to personal expenditures. It is generally nondeductible unless a specific exception applies. |
| Capitalized interest | Interest added to an asset’s tax basis and recovered later through depreciation, cost of goods sold, or disposition. |
C Corporations have special classification rules. The investment-interest distinction is particularly important for individuals and other noncorporate taxpayers.
The use of the money usually controls
Federal tracing rules generally follow the use of loan proceeds. Collateral is not the deciding factor.
Suppose you refinance a rental property and use the cash-out proceeds for a personal purchase. The related interest may be personal even though rental property secures the loan. Conversely, home-equity proceeds used to buy business equipment may produce business interest.
Refinancing, commingled accounts, transfers between entities, and debt-funded distributions can complicate the trail. Keep loan documents, closing statements, bank records, invoices, and wire details together.
Capitalization may apply first in limited cases
Construction and production projects may require interest capitalization. For tax years beginning after December 31, 2025, Section 163(j) generally applies before most interest-capitalization provisions. Important exceptions include production interest under Section 263A(f) and certain straddle interest under Section 263(g).
The ordering depends on the facts and should be reviewed project by project.
The 2026 Deduction Test
The maximum deduction is generally limited to:
+ 30% of adjusted taxable income
+ floor plan financing interest expense
The deduction cannot exceed the business interest expense available.
Floor plan financing mainly applies to dealers financing vehicles, boats, farm machinery, and certain trailers or campers held for sale or lease. Most real estate investors and ordinary operating companies will have no amount in this category.
Step 1: Classify and allocate the interest
Identify business, investment, personal, and capitalized interest. Allocate a mixed-use loan among its uses.
Step 2: Check exemptions and excepted trades
Determine whether the taxpayer qualifies for the small-business exemption or operates an excepted trade or business.
Step 3: Calculate adjusted taxable income
Adjusted taxable income, or ATI, begins with tentative taxable income computed as though Section 163(j) did not limit interest. Major 2026 adjustments include:
| ATI adjustment | General treatment |
|---|---|
| Business interest expense | Add back |
| Business interest income | Subtract |
| Net operating loss deduction | Add back |
| Section 199A qualified business income deduction | Add back |
| Business depreciation, amortization, and depletion | Add back for tax years beginning after 2024 |
| Nonbusiness income, gain, deduction, or loss | Generally remove |
| Other tax-specific items | Adjust under the Code, regulations, and guidance |
This is an EBITDA-like tax measure, not book EBITDA or lender covenant EBITDA. Tax allocations, disposition adjustments, and other rules can produce a different number.
Businesses with controlled foreign corporations also have special 2026 ATI exclusions.
Step 4: Apply the formula
Multiply ATI by 30%, add business interest income and qualifying floor plan interest, and compare the total with available business interest expense.
Step 5: Record the carryforward
Disallowed interest generally carries forward. Where it sits depends on whether the taxpayer is an individual, partnership, S Corporation, or C Corporation.
Who May Be Exempt
The 2026 gross-receipts test
For a tax year beginning in 2026, the inflation-adjusted threshold is $32 million.
A calendar-year business generally averages gross receipts for 2023, 2024, and 2025:
- Add the three years’ receipts.
- Divide by three.
- Compare the result with $32 million.
Short tax years, predecessors, new businesses, acquisitions, and dispositions can change the calculation.
Related businesses may have to aggregate
Controlled groups, businesses under common control, and affiliated service groups may have to combine receipts. An owner cannot assume that each LLC, partnership, or corporation receives a separate $32 million threshold.
The ownership tests vary by entity type and can include attribution among family members. After exemption status is determined, each taxpayer generally computes its own Section 163(j) result unless another rule requires consolidation.
Tax shelters do not qualify
A tax shelter cannot use the small-business exemption, even with receipts below $32 million.
This can affect a partnership or other non-C Corporation entity treated as a “syndicate.” In general, a syndicate can include an entity allocating more than 35% of its losses to limited partners or limited entrepreneurs.
An annual election may permit use of the prior year’s allocations, but it must be made on a timely original return. A loss-generating real estate partnership with passive investors should therefore test tax-shelter status before claiming the exemption.
Other excepted businesses
Interest properly allocable to an electing real property trade or business, an electing farming business, or certain regulated utilities is outside the limitation.
A taxpayer with both excepted and non-excepted activities must allocate interest and other tax items between them.
Special Considerations for Real Estate Investors
A qualifying real property trade or business may elect out of Section 163(j). Eligible activities can include development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, and brokerage.
The election may accelerate interest deductions, but specified property in the electing business must use the alternative depreciation system, or ADS, and cannot receive bonus depreciation.
| Property | General system | After real property election |
|---|---|---|
| Residential rental property | Generally 27.5-year GDS | Generally 30-year ADS |
| Nonresidential real property | Generally 39-year GDS | Generally 40-year ADS |
| Qualified improvement property | Generally 15-year GDS and potentially 100% bonus depreciation | 20-year ADS and no bonus depreciation |
For buildings, the recovery-period difference may be modest. For qualified improvement property, losing bonus depreciation can be significant.
The election does not automatically force every short-lived cost-segregation asset into ADS, but property classification still matters.
The election is generally irrevocable. Narrow relief for certain prior-year elections should not be treated as a general right to reverse a 2026 election.
Model the election using projected interest, depreciation, holding period, capital expenditures, passive-loss capacity, state treatment, and the time value of money. It should not be selected automatically because current interest is limited.
How the Rules Affect Partnerships and S Corporations
The entity may pay the interest, but the owner may not receive an immediate deduction.
| Taxpayer | Where calculated | Treatment of disallowed interest |
|---|---|---|
| Partnership | Partnership level | Allocated to partners as excess business interest expense, or EBIE. |
| S Corporation | S Corporation level | Carried by the S Corporation; not allocated as EBIE to shareholders. |
| Sole proprietorship or disregarded entity | Generally on the owner’s return | Carried by the owner and tested in later years. |
| C Corporation | Corporation level | Carried by the corporation, subject to future capacity and possible ownership-change rules. |
Partnerships
Deductible interest reduces the partnership’s nonseparately stated taxable income or increases its loss. Disallowed interest becomes EBIE and is allocated under detailed partnership rules.
A partner generally cannot deduct EBIE until the same partnership later allocates excess taxable income or excess business interest income, or becomes exempt. Once released, the interest may still enter the partner’s own Section 163(j) calculation.
EBIE can reduce the partner’s outside basis before the deduction is used. Dispositions of partnership interests have special basis rules, so suspended interest should not be assumed deductible merely because ownership changes.
S Corporations
An S Corporation’s disallowed interest remains at the entity. Shareholders do not receive a separate EBIE carryforward.
The S Corporation may use the amount in a later year if it has sufficient limitation capacity or becomes exempt. Excess taxable income and excess business interest income may be reported to shareholders on a pro rata basis for their own Section 163(j) calculations.
Other loss limitations remain separate
Section 163(j) does not replace basis, at-risk, passive activity, or excess business loss rules.
Interest that survives Section 163(j) can still be deferred under another limitation. Maintain separate schedules for each test.
Carryforwards and Future Deductions
For taxpayers other than partnerships, disallowed interest generally carries to later years and is tested again. Use depends on future business interest income, ATI, exemptions, and other limitations.
Partnership carryforwards are source-specific. EBIE from Partnership A is generally released by excess taxable income or excess business interest income from Partnership A, not by earnings from Partnership B.
Mergers, reorganizations, entity conversions, ownership changes, partnership-interest dispositions, property sales, and business sales may affect who owns the carryforward, whether it is released, and which basis or loss rules apply.
A sale does not automatically free all suspended interest.
Five Practical Examples
All examples are simplified illustrations and assume no other limitations unless stated.
Leveraged rental acquisition
Assume a rental is a trade or business, is not exempt, and has not made the real property election.
- Income before interest and depreciation: $900,000
- Depreciation: $500,000
- Business interest expense: $420,000
- Business interest income and floor plan interest: $0
1. Tentative taxable income: $900,000 − $500,000 − $420,000 = $(20,000)
2. ATI: $(20,000) + $500,000 + $420,000 = $900,000
3. Limit: $900,000 × 30% = $270,000
4. Current interest deduction: $270,000
5. Carryforward: $150,000
The depreciation addback helps, but it does not make the deduction unlimited.
Operating company acquisition debt
- Operating income before interest, depreciation, and interest income: $3,000,000
- Business interest income: $100,000
- Depreciation: $1,200,000
- Business interest expense: $1,300,000
1. Tentative taxable income: $3,000,000 + $100,000 − $1,200,000 − $1,300,000 = $600,000
2. ATI: $600,000 + $1,300,000 + $1,200,000 − $100,000 = $3,000,000
3. Limit: $100,000 + ($3,000,000 × 30%) = $1,000,000
4. Carryforward: $1,300,000 − $1,000,000 = $300,000
Partnership with two owners
A partnership has $1,200,000 of ATI and $500,000 of business interest expense.
1. Limit: $1,200,000 × 30% = $360,000
2. Deductible interest: $360,000
3. EBIE: $140,000
Assume the detailed allocation rules produce 60% to Partner A and 40% to Partner B:
- Partner A tracks $84,000.
- Partner B tracks $56,000.
Neither automatically deducts the amount in 2026. Actual allocations can require an 11-step computation and may not match ownership percentages.
Related entities exceed the threshold
Three commonly controlled entities have three-year average receipts of:
- Entity 1: $14 million
- Entity 2: $11 million
- Entity 3: $10 million
Each is below $32 million, but the combined $35 million exceeds the threshold.
Assuming aggregation applies, the small-business exemption is unavailable, and each entity analyzes its own limitation.
Real estate election tradeoff
A qualifying real property business has:
- ATI of $1,400,000
- Business interest of $600,000
- No business interest income
- $2,000,000 of otherwise eligible qualified improvement property
Without the election, the interest limit is $420,000, leaving $180,000 deferred. The qualified improvement property may be 15-year property eligible for 100% bonus depreciation.
With the election, interest allocable to the electing activity may avoid Section 163(j), but the qualified improvement property becomes 20-year ADS property with no bonus depreciation.
The correct choice depends on the value of the $180,000 current interest deduction compared with the depreciation timing cost and the owner’s ability to use any resulting loss.
Common Mistakes
- Assuming all interest on a lender statement is currently deductible.
- Testing only the borrowing entity and ignoring related-business aggregation.
- Confusing business interest with investment interest.
- Failing to trace cash-out refinancing or commingled proceeds.
- Making the real property election without modeling ADS and bonus-depreciation consequences.
- Reviewing only the owner’s return when the calculation belongs at the partnership or S Corporation.
- Treating Section 163(j), basis, at-risk, and passive-loss rules as one test.
- Using the 2022–2024 ATI rules instead of the 2026 depreciation addback.
- Failing to track taxpayer-level, partnership, S Corporation, and state carryforwards separately.
Frequently Asked Questions
Is all mortgage interest on rental property business interest?
No. The use of the proceeds and whether the rental rises to a trade or business both matter. Cash-out proceeds used personally can produce personal interest.
Does the 2026 depreciation addback permit a full deduction?
Not necessarily. It can increase ATI, but the percentage remains 30%, and other tax adjustments may reduce ATI.
Can a growing owner split operations among entities to stay below $32 million?
Not automatically. Aggregation rules combine certain controlled and related businesses.
Can the real property election be revoked?
Generally, no. It is generally irrevocable, and narrow transition relief for earlier elections is not a normal revocation right for 2026.
Does a property or business sale release all disallowed interest?
No. The answer depends on the taxpayer, entity, transaction structure, carryforward type, and basis rules.
2026 Planning Checklist
- Debt inventory: Collect loan agreements, statements, and amortization schedules.
- Proceeds tracing: Match closing statements, bank records, invoices, and wires to the use of funds.
- Entity map: Document ownership and attribution details for related businesses.
- 2023–2025 receipts: Gather returns and workpapers for all potentially related entities.
- 2026 projection: Estimate ATI using the trial balance, depreciation, NOL, and Section 199A information.
- Interest income: Review notes receivable and intercompany-loan schedules.
- Capital structure: Compare debt and equity terms, covenants, and cash-flow forecasts.
- Election model: Compare the interest benefit with ADS and bonus-depreciation costs.
- Pass-through schedules: Track Form 8990, K-1 data, EBIE, ETI, EBII, and owner basis.
- Related-party debt: Confirm written terms, rate support, payment history, and business purpose.
- Planned transactions: Review borrowing, refinancing, distributions, acquisitions, and sales before closing.
- Other limitations: Coordinate Section 163(j) with basis, at-risk, passive activity, and other loss rules.
Virginia treatment may differ
Virginia currently allows a subtraction equal to 20% of federally disallowed business interest for tax years beginning on or after January 1, 2025. That does not eliminate the federal carryforward, and state tracking may not mirror federal timing.
Financing should be selected for sound business and economic reasons. Tax modeling can inform the structure and timing, but it should not be used to justify a transaction that lacks a legitimate non-tax purpose.
When to Request Professional Assistance
A proactive review may be appropriate when:
- interest is material compared with income;
- receipts approach $32 million;
- several entities share owners, employees, services, or management;
- a partnership allocates losses to passive investors;
- a real estate election is under consideration;
- EBIE appears on a Schedule K-1; or
- a refinancing, recapitalization, acquisition, merger, or sale is planned.
The best time to model the rule is before the financing or election is finalized. After closing, documentation and calculation are still necessary, but the range of planning choices may be smaller.
Debt Can Build Wealth, but Interest Deductions Have Rules
For 2026, work through the issue in order: trace the proceeds, identify exemptions and elections, calculate tax ATI using the current depreciation addback, apply the limit at the correct entity or taxpayer, and coordinate the result with other loss limitations and state rules.
The goal is not to avoid useful financing. It is to understand the tax timing before a financing decision becomes a return-preparation surprise.