What Is the Business Interest Expense Limitation and Which Businesses Does It Hit?

What Is the Business Interest Expense Limitation and Which Businesses Does It Hit?

The short answer: the business interest expense limitation, found in Section 163(j) of the tax code, caps how much business interest a business can deduct in a year. The cap equals business interest income, plus 30% of adjusted taxable income, plus floor plan financing interest. Anything above that is disallowed for the year and carried forward indefinitely.

Most small businesses never encounter it, because there is a size-based exemption. Most businesses that do encounter it find out from a preparer in March, after a year of borrowing decisions that were made on the assumption interest was fully deductible.

Here is how it works, who is out, and what changed recently enough that stale advice is now wrong.

The Formula, In Plain Terms

Three components make up the ceiling on your interest deduction.

Business interest income. Interest the business earned. Most operating companies have very little of this, so it usually rounds to nothing.

Thirty percent of adjusted taxable income. This is the whole ballgame. Adjusted taxable income, usually written as ATI, is taxable income with several items added back.

Floor plan financing interest. Interest on debt used to finance inventory of motor vehicles held for sale or lease. This is fully deductible and sits outside the 30% cap. It applies to a narrow set of dealerships, and the definition of motor vehicle was expanded for tax years beginning after December 31, 2024 to include trailers and campers designed to provide temporary living quarters, which brought RV and camper dealers inside it.

Disallowed interest becomes a disallowed business interest expense carryforward. It carries forward with no expiration, which is genuine relief, though a deduction deferred to a year with the same problem is a deduction that keeps being deferred.

Who Is Exempt: The Gross Receipts Test

The exemption is the first thing to check, because it settles the question for most businesses in one calculation.

A business is exempt from Section 163(j) if it meets the gross receipts test in Section 448(c) and is not a tax shelter as defined in Section 448(d)(3). The test looks at average annual gross receipts for the three tax years preceding the current one, measured against an inflation-adjusted threshold.

The current figures, updated by the IRS in Fact Sheet FS-2026-14 released on August 19, 2026:

Tax year	Gross receipts threshold
2024	$30 million
2025	$31 million
2026	$32 million

Two features of this test matter more than the numbers. It is a rolling three-year average, so a business can be subject to the limitation one year and exempt the next, and vice versa, without any deliberate change on its part. And the threshold rises every year, which means a business that just crossed it may fall back under.

For a business sitting close to the line, Treasury regulations allow a protective election to be treated as an excepted trade or business, which removes the need to run the three-year computation when the answer is uncertain. That is a real practical convenience, and it has a cost discussed below.

The Change That Matters Most: Depreciation Is Back in ATI

If you read anything about this limitation written between 2022 and 2024, the most important part of it is now wrong.

For tax years beginning after December 31, 2021 and before January 1, 2025, depreciation, amortization, and depletion were not added back when computing ATI. That was brutal for capital-intensive businesses, because those deductions depressed ATI, which depressed 30% of ATI, which depressed the interest deduction. A manufacturer with heavy equipment could lose interest deductions purely because of how much depreciation it was claiming.

The One Big Beautiful Bill Act reversed that. For tax years beginning after December 31, 2024, taxpayers add depreciation, amortization, and depletion back to taxable income in computing ATI. Higher ATI, higher cap, more deductible interest.

For anyone with real fixed assets, this is the single largest favorable change to the provision since it was written, and it is the reason the next section exists.

The Real Property Election, and the New Way Out of It

Certain trades or businesses are carved out of the limitation entirely under Section 163(j)(7), including an electing real property trade or business and an electing farming business. An election gets you an unlimited interest deduction.

It also costs you bonus depreciation. An electing real property business has to depreciate nonresidential real property, residential rental property, and qualified improvement property under the Alternative Depreciation System, which makes those assets ineligible for bonus depreciation. Electing farming businesses take the same treatment on assets with recovery periods of ten years or more.

That was an acceptable trade when depreciation was suppressing ATI. Now that depreciation is added back, many taxpayers who elected years ago would be better off not having elected. The problem was that the election was irrevocable and binding on all succeeding years.

The IRS addressed exactly this. Revenue Procedure 2026-17 provides transition guidance for taxpayers who previously made one of these elections and now want to withdraw it in light of the changes to Sections 163(j)(8) and 168(k). If your business made a real property election in 2019 or 2020 and has been living with ADS ever since, that decision is worth revisiting rather than treating as settled.

How It Flows Through a Partnership or S Corporation

The limitation is applied at the entity level, not on your personal return, and the two entity types behave differently in a way that surprises partners.

For an S corporation, disallowed interest stays at the corporate level and carries forward there. It is not pushed out to shareholders. What does get allocated pro rata is excess taxable income and excess business interest income.

For a partnership, disallowed interest is allocated out to each partner as excess business interest expense, and it is carried forward at the partner level. A partner can only deduct it in a later year to the extent that same partnership allocates them excess taxable income or excess business interest income. Not any partnership. That one.

There is also an ordering rule with partner basis under Section 704(d) that most partners will never see but which determines whether the deduction is available at all in a given year. If a K-1 shows excess business interest expense, that is a line to ask about rather than ignore.

One more item for anyone with foreign subsidiaries: for tax years beginning after December 31, 2025, controlled foreign corporation inclusions under Subpart F and GILTI, and the associated Section 78 gross-up, are excluded from ATI. The IRS has stated that the September 2020 proposed regulations under Treas. Reg. 1.163(j)-7(j) are no longer consistent with current law and cannot be relied on for those years.

Who Does This Kind of Work

This is planning work, and the useful version of it happens before the borrowing rather than after.

Purewater Financial is a New York firm founded in 2020, a three-person practice holding a CPA credential, offering tax planning and preparation, accounting, tax strategy, and cryptocurrency and web3 work, and serving clients nationwide. It publishes minimums of $100,000 in income and $1 million in revenue, which points it at established businesses rather than early-stage ones.

A small practice with a planning orientation is a reasonable fit for a question like this, because 163(j) rewards someone who models the ATI computation in advance and knows whether a protective election makes sense. The trade-off is capacity: a three-person firm has real constraints in filing season, and a business with foreign subsidiaries or a complicated real property election history may need a larger bench.

Two honest limits on the topic itself. The threshold test depends on facts that change every year, so an exemption is not a permanent status. And the carryforward means disallowed interest is deferred rather than destroyed, which is better than losing it and worse than deducting it.

For the depreciation side of this interaction, see What Is Bonus Depreciation and How It Works in 2026, or compare firms in the Sam's List accountant directory.

Frequently Asked Questions

What is the Section 163(j) gross receipts threshold for 2026? $32 million, up from $31 million for 2025 and $30 million for 2024, per IRS Fact Sheet FS-2026-14. A business meeting the Section 448(c) gross receipts test on a rolling three-year average, and that is not a tax shelter, is exempt from the business interest expense limitation for that year.

How is adjusted taxable income calculated? It is taxable income with specified items added back. For tax years beginning after December 31, 2024, that includes depreciation, amortization, and depletion, which were excluded from the addback for 2022 through 2024. The higher the adjusted taxable income, the higher the 30% cap on deductible business interest.

What happens to interest I cannot deduct this year? It becomes a disallowed business interest expense carryforward with no expiration date. Partnerships allocate it out to partners as excess business interest expense, deductible only against excess taxable income or excess business interest income from that same partnership. S corporations carry it at the entity level instead.

Should a real estate business make the electing real property trade or business election? It is worth re-examining rather than assuming. The election removes the interest limitation but requires the Alternative Depreciation System on real property, which forfeits bonus depreciation. Because depreciation is added back to adjusted taxable income again for years beginning after 2024, the trade-off has shifted, and Revenue Procedure 2026-17 provides a path for some taxpayers to withdraw a prior election.

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About the author: Kimberly Green is the cofounder of Sam's List, where business owners and high earners find vetted CPAs, financial advisors, and fractional CFOs. She's met one-on-one with 400+ financial professionals and writes from the real data behind thousands of client-advisor matches. Ask her anything about finding an accountant - she's heard it all, including the questions people are afraid to ask.