Electing out of the §163(j) interest limit — what it does to cost seg math
3 Replies
- 4dAaron WeikleBusiness MemberMember since 2026 · 82 posts · 23 votes
Ran this exact comparison on a 32 unit deal last year, so the numbers are fresh. The break even depends almost entirely on your marginal rate, how much 5, 7, or 15 year property the cost segregation identifies, and what your interest expense actually looks like relative to ATI. On that deal, the cost segregation pulled about twenty eight percent of purchase price into short life components. At one hundred percent bonus (under GDS), that's a massive Year 1 deduction. Switching to ADS spreads those same components over 5, 7, and 15 years with no bonus. This means the NPV of the depreciation benefit drops by roughly 40-50% depending on your discount rate. Meanwhile, the interest at stake was around $180k annually against an ATI that limited the deduction to $140k under §163(j). So electing out freed up $40k of deductions per year. Run that at a 37% rate and you're recovering $14.8k a year in tax. The lost bonus depreciation NPV on the short life assets was north of $90k at a 7% discount rate. The math wasn't close at all. You will end up keeping the bonus, eating the interest limitation, and carrying the disallowed interest forward under the §163(j) carryforward rules. The carryforward part matters and often gets ignored. Disallowed interest doesn't disappear, it carries indefinitely. If your ATI grows or you sell then it releases. That changes the calculus considerably versus treating the limitation as a permanent loss. Where electing out wins is low cost segregation benefit (older building, mostly structure), very high leverage relative to income, and a short intended hold where the carryforward never releases anyway. The irrevocability is the real constraint. Model a 10 year cash flow with realistic ATI growth before committing.
- 3dJason MalabuteBusiness MemberAccountant · Los Angeles, CA · Member since 2016 · 2k+ posts · 905 votes
This one is easy to get backwards, so it's worth slowing down. The election to skip the interest limit is permanent, so you can't undo it later if your income or interest rates change. In exchange, the building itself has to be depreciated the slow way, 30 years for residential rentals and 40 for commercial, and it can't get bonus depreciation. If you don't elect, interest that gets limited isn't lost, it generally carries forward to future years. One thing worth checking is how it hits the shorter-life pieces from a cost seg study, because the election doesn't automatically put every one of those on the slow schedule.
Before you file, I'd run both versions side by side using your actual interest expense, your income, how long you plan to hold, and how much a study would really reclassify. Is your interest expense high enough right now that the limit is actually cutting into your deductions? The exact answer depends on your facts, so talk it through with your own CPA or tax advisor.
Malabute & Company CPAs525 Reviews - 19hAshish AcharyaBusiness MemberCPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
Sagiv, this is exactly the kind of comparison I’d want to model before making the §163(j) election. The interest deduction can be extremely valuable on a highly leveraged property, but I’d be careful about assuming that electing out means all of the cost-seg benefit disappears. The ADS requirement applies to specific categories of property, including residential rental property, nonresidential real property, and QIP. Some shorter-life cost-seg components can have different treatment depending on what they actually are.
So I’d run the two scenarios side by side:
§163(j) election -> more interest deduction capacity -> slower depreciation on the affected property
versus
No election -> potential interest limitation -> greater depreciation/bonus opportunity where available.
And I’d look at more than the first-year deduction. The investor’s leverage, taxable income, expected holding period, future interest expense, and ability to actually use the depreciation all matter.
One other nuance: while the election is generally irrevocable, there are now limited circumstances under the IRS’s 2026 guidance where an election can be withdrawn for the year it was made, so I wouldn’t treat “irrevocable” as meaning there are absolutely no exceptions. This is a great example of why I prefer modeling the after-tax result over the entire hold period rather than choosing whichever strategy produces the biggest deduction in year one. IRS
Feel free to DM me, I’d be happy to send over a few resources that might be helpful.
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