The Interest Deduction Game Just Changed, and Most Real Estate Investors Missed It

TL;DR: The One Big Beautiful Bill Act made Section 163(j) more generous for 2025 tax returns by adding depreciation back into the interest limitation calculation. This means leveraged real estate investors lose less interest deductions to the cap, cost segregation works with interest deductions instead of against them, and prior elections to opt out may no longer make sense. If you made an RPTOB election in 2022-2024, the IRS is giving you until October 2026 to reverse it. If you already filed your 2025 return, you may want to review whether an amended return makes sense.

For 2025 tax returns, depreciation and amortization get added back when calculating your business interest expense limitation. This single change matters more than most investors realize because it means your interest deductions stop being artificially constrained by accelerated depreciation strategies. The after-tax cost of debt drops when you deduct more interest immediately instead of carrying it forward into future years.

Here's what changed and why it matters for anyone carrying debt on commercial property, whether you already filed your 2025 return or you are still on extension.

What Section 163(j) Actually Does

Section 163(j) limits how much business interest expense you deduct in a given year. The cap is based on a percentage of your Adjusted Taxable Income (ATI), which is a modified version of your taxable income that adds back certain deductions.

From 2018 through 2021, ATI was calculated like EBITDA. Depreciation and amortization were added back, which made your ATI larger and allowed more interest deductions. Then in 2022, the calculation shifted. Depreciation and amortization were no longer added back. Your ATI shrank. Your allowable interest deduction shrank with it.

For highly leveraged real estate investors, this created a problem. Interest expense that used to be fully deductible suddenly was not.

The One Big Beautiful Bill Act reversed this change. For 2025 tax returns, ATI once again includes depreciation and amortization, which means your limitation is higher and more interest becomes deductible in the current year.

Key Point: The interest limitation loosened for 2025 returns because depreciation now adds back to your ATI, which allows more interest deductions today instead of forcing carryforwards.

Why This Change Lowers Your After-Tax Cost of Debt

When interest rates climb, interest expense becomes one of the largest line items for leveraged businesses. If your deductions are limited, the after-tax cost of borrowing rises. You're paying interest with post-tax dollars instead of pre-tax dollars.

A more generous limitation formula lowers the effective cost of borrowing by allowing larger deductions today instead of forcing you to carry them forward into future years. The after-tax cost of debt drops when you deduct more interest immediately.

This is not theoretical. If you have been carrying forward disallowed interest from 2022, 2023, or 2024, the more favorable 2025 calculation may allow you to unlock those carryforwards sooner. This reduces taxable income without new borrowing, which improves cash flow without changing your capital structure. If you already filed your 2025 return without factoring this in, it may be worth reviewing whether an amended return makes sense.

Key Point: A larger ATI means more interest deductions today, which lowers your effective borrowing cost and may unlock prior-year carryforwards faster.

The 2026 Rule Change Developers Need to Know

There is a catch coming in 2026 that changes the game for developers and anyone capitalizing interest into inventory or construction costs.

Under prior rules, if you capitalized interest into the cost of inventory or a depreciable asset under construction, that interest was not subject to the Section 163(j) limitation. You could recharacterize interest expense as part of the asset's basis, which removed it from the limitation calculation entirely.

Starting in tax years beginning January 1, 2026, that workaround disappears. All business interest, regardless of whether it is capitalized or expensed, gets included in the 163(j) calculation.

This matters for developers who were using interest capitalization to avoid hitting the limitation. That strategy stops working in 2026. You will need to plan around the limitation directly instead of routing around it through capitalization.

Key Point: Interest capitalization stops helping you avoid the Section 163(j) limitation starting with 2026 tax returns, so 2025 was the last year to use this strategy.

Cost Segregation Now Works With Interest Deductions, Not Against Them

One of the concerns investors had when depreciation stopped being added back to ATI was that cost segregation studies might make the interest limitation worse. More depreciation means lower taxable income, which could mean a lower ATI and a tighter interest cap.

That tension is gone. With depreciation added back to ATI, cost segregation studies no longer create a conflict with interest deductions. You get the benefit of accelerated depreciation without shrinking your ability to deduct interest.

The two strategies now reinforce each other. Cost segregation reclassifies building components into shorter-lived property, which increases depreciation deductions and reduces taxable income. With 100% bonus depreciation back, those deductions hit immediately. Because depreciation is added back when calculating your interest limitation, you are not penalized for taking the accelerated write-off.

This is the planning environment cost segregation was designed for. You are not choosing between depreciation and interest deductions. You are stacking them.

Key Point: Cost segregation and interest deductions now work together because depreciation adds back to ATI, eliminating the prior conflict between the two strategies.

The Real Property Trade or Business Election Dilemma

Real estate investors have the option to elect out of the Section 163(j) limitation entirely if they operate a Real Property Trade or Business (RPTOB). The election allows unlimited interest deductions, which sounds appealing if you are carrying significant debt.

The election comes with a cost. Once you opt out, you are required to depreciate certain property using the Alternative Depreciation System (ADS), which uses longer recovery periods. Qualified Improvement Property (QIP), for example, loses eligibility for bonus depreciation under an RPTOB election.

This trade-off made sense for some investors when the interest limitation was tight and depreciation was not adding back to ATI. With the more generous calculation in place, the election may no longer be worth the cost. The cost of losing accelerated depreciation often exceeds the benefit of unlimited interest deductions, especially when bonus depreciation is available at 100%.

The election is irrevocable. Once you make the election, you are locked in. That permanence is dangerous when the tax landscape shifts as dramatically as the past few years have shown.

Key Point: The RPTOB election may no longer make sense with the more generous interest limitation, and the irrevocable nature makes prior elections potentially costly.

The Rare IRS Do-Over You Need to Know About

Here is where things get interesting. The IRS released Revenue Procedure 2026-17, which gives taxpayers a limited-time opportunity to unwind certain Section 163(j) elections made in prior years.

If you elected out of the limitation in 2022, 2023, or 2024, when the calculation was less favorable and the trade-off seemed worth the cost, you now have the option to retroactively withdraw that election. The deadline to revoke is October 15, 2026, and the revocation allows you to reclaim accelerated depreciation that was previously disallowed.

This is not common. The IRS rarely offers do-overs on irrevocable elections. The legislative changes were significant enough that the IRS recognized taxpayers might be locked into positions that no longer serve them.

If you made the RPTOB election in the past three years, this is worth reviewing. The math may have flipped.

Key Point: The IRS is allowing revocation of certain Section 163(j) elections made in 2022-2024, with a deadline of October 15, 2026.

The Strategic Planning Window for 2025 vs. 2026

The shift in how interest capitalization is treated starting in 2026 created a planning opportunity for 2025. If you are a developer or you are capitalizing interest into construction projects, accelerating that capitalization into 2025 kept interest out of the Section 163(j) calculation. That opportunity has closed for future years.

For 2026 planning, once interest capitalization stops helping with the limitation, depreciation becomes more valuable in the ATI calculation because depreciation gets added back. The timing matters if you are planning capital expenditures that will generate depreciation.

The strategy depends on your specific situation. The point is this: the rules were different in 2025 than they are in 2026, and that difference created a timing window that has now closed for interest capitalization.

Key Point: 2025 was the last year interest capitalization helped avoid the limitation, creating a timing opportunity for developers that has now closed.

The Small Business Exemption Most Investors Miss

Not everyone is subject to the Section 163(j) limitation. If your business meets the gross receipts test under Section 448(c), you are exempt.

For 2025 returns, businesses with average annual gross receipts of $31 million or less over the prior three years are not subject to the limitation at all. You deduct all your business interest without worrying about ATI calculations or carryforwards.

This exemption often gets overlooked because the conversation around Section 163(j) focuses on large, leveraged businesses. If you are operating below the threshold, the limitation does not apply to you, and that is worth confirming with your tax advisor.

Key Point: Businesses with average annual gross receipts under $31 million are exempt from Section 163(j) entirely.

What This Means for Your 2025 Strategy

The return of the more generous ATI calculation for 2025 does not mean Section 163(j) stops mattering. The limitation is less restrictive, which changes how you think about leverage, depreciation, and timing.

If you have been carrying forward disallowed interest, the new rules applied to 2025 returns may let you unlock those deductions sooner. If you made an RPTOB election in the past three years, the IRS is giving you until October 15, 2026 to reconsider. If you filed your 2025 return and missed opportunities related to these changes, an amended return might be worth reviewing with your tax advisor.

If you are a developer who capitalized interest in 2025, that was the last year that strategy helped with the limitation. Starting with 2026 tax returns, the rules changed, and you will need a different approach.

This is not the kind of shift that announces itself. Your CPA may have applied the new rules to your 2025 return without flagging the implications. The implications are real, and they affect how much tax you pay, how much cash flow you keep, and whether prior elections still make sense. If you are still on extension for 2025, this is worth addressing before you file.

Frequently Asked Questions

What is Section 163(j) and why does the limitation exist?

Section 163(j) limits business interest expense deductions to prevent companies from overleveraging and creating excessive tax deductions through debt financing. The cap is based on a percentage of your Adjusted Taxable Income (ATI).

How did the One Big Beautiful Bill Act change the interest limitation?

The Act restored the pre-2022 calculation method by adding depreciation and amortization back to ATI for 2025 tax returns. This makes your ATI larger, which increases the amount of interest you deduct in the current year.

Should I revoke my RPTOB election if I made one in 2022 or 2023?

The answer depends on your specific situation. With the more generous limitation now in place, the trade-off of losing accelerated depreciation may no longer be worth unlimited interest deductions. Review the math with your tax advisor before the October 15, 2026 deadline.

Does cost segregation still make sense with Section 163(j)?

Yes. With depreciation now added back to ATI, cost segregation no longer conflicts with interest deductions. The two strategies reinforce each other instead of competing.

What happens to my disallowed interest carryforwards from prior years?

Carryforwards from 2022-2024 may now be deductible sooner under the more generous ATI calculation applied to 2025 returns. These carryforwards reduce taxable income without requiring new borrowing. If you already filed your 2025 return, review whether you maximized the use of these carryforwards.

What changes in 2026 for developers capitalizing interest?

Starting with 2026 tax returns, all business interest gets included in the Section 163(j) calculation, even if capitalized into inventory or construction costs. The workaround of capitalizing interest to avoid the limitation stopped working after 2025.

Who is exempt from Section 163(j)?

Businesses with average annual gross receipts of $31 million or less over the prior three years are exempt from the limitation entirely.

When is the deadline to revoke a Section 163(j) election?

The IRS set the deadline for October 15, 2026 under Revenue Procedure 2026-17. This applies to certain elections made in 2022, 2023, or 2024.

Key Takeaways

• For 2025 tax returns, depreciation and amortization get added back to ATI, which loosens the Section 163(j) interest limitation and lowers the after-tax cost of debt.

• Cost segregation studies now work with interest deductions instead of against them because depreciation adds back to the limitation calculation.

• The RPTOB election to opt out of Section 163(j) may no longer make sense with the more generous limitation, and the IRS is allowing revocations through October 15, 2026.

• Starting with 2026 tax returns, interest capitalization stops helping you avoid the limitation, so 2025 was the last year to use this strategy for developers.

• Businesses with average annual gross receipts under $31 million are exempt from Section 163(j) entirely.

• Disallowed interest carryforwards from 2022-2024 may now be unlocked sooner under the new calculation applied to 2025 returns.

• The timing difference between 2025 and 2026 rules created a planning window for capitalization and depreciation strategies that has now closed.