The Section 163(j) Interest Limitation Tightens Back to 30% for 2021 — and a Harder Change Looms for 2022

Key takeaways

• IRC § 163(j) limits the deduction for business interest expense to the sum of business interest income, 30% of adjusted taxable income (ATI), and floor plan financing interest. Disallowed interest carries forward indefinitely.
• The CARES Act (§ 2306) raised the 30% figure to 50% for tax years beginning in 2019 and 2020 only. For 2021, the limitation reverts to 30%.
• A bigger change is built into the statute for 2022: for tax years beginning after December 31, 2021, ATI is computed without adding back depreciation, amortization, and depletion — shrinking ATI and the deductible amount.
• Businesses meeting the small-business gross-receipts test ($26 million for 2021) are exempt, and real property and farming businesses can elect out at the cost of slower depreciation.

How the limitation works

Since the 2017 tax law rewrote it, IRC § 163(j) caps the deduction for business interest expense at the sum of three items: the taxpayer's business interest income, 30% of its adjusted taxable income, and any floor plan financing interest. Interest disallowed in a year is not lost — it carries forward indefinitely and is treated as business interest paid in the next year, subject again to the limit.

For most leveraged businesses, the binding component is the second one: 30% of ATI. ATI is a tax-based measure of earnings, and how it is computed — in particular, what gets added back to it — determines how much interest a business can deduct. That computation is where both the 2021 reversion and the 2022 cliff live.

The 50% cushion was for 2019 and 2020 only

When the pandemic hit, Congress loosened the cap. CARES Act § 2306 raised the 30%-of-ATI figure to 50% for tax years beginning in 2019 and 2020, and let taxpayers elect to use their (generally higher) 2019 ATI in computing the 2020 limitation. For leveraged businesses whose earnings fell in 2020, that combination meaningfully increased deductible interest at exactly the moment cash was tight.

It was explicitly temporary. The 50% figure applied only to 2019 and 2020. For tax years beginning in 2021, the limitation reverts to 30% of ATI. There is no transition and no phase-down — the cap simply drops back to where the 2017 law set it. A business that deducted interest comfortably under the 50% ceiling in 2020 may find a meaningful slice of the same interest disallowed in 2021 on otherwise similar facts.

This is the first of two tightenings, and it is the smaller one.

The 2022 cliff: EBITDA becomes EBIT

The change scheduled for 2022 is structural, and it is worth understanding now because it cannot be undone later. For tax years beginning before January 1, 2022 — which includes 2021 — ATI is computed *without regard to* deductions for depreciation, amortization, and depletion. In other words, those deductions are added back, producing an EBITDA-like measure of earnings. That add-back inflates ATI, and a larger ATI means a larger 30% cap and more deductible interest.

For tax years beginning after December 31, 2021, that add-back disappears. ATI is then computed on an EBIT-like basis, with depreciation, amortization, and depletion reducing it. For a capital-intensive business with large depreciation, the effect is significant: ATI falls, and with it the 30% ceiling on deductible interest. Two businesses with identical interest expense and identical economics will get different answers in 2021 and 2022 solely because of this definitional shift.

So the 2021 taxpayer still gets the depreciation add-back; the 2022 taxpayer will not. A business that is comfortably inside the limit in 2021 on the strength of its add-backs should not assume it stays there in 2022. The combination — a 30% cap with no depreciation add-back, arriving as borrowing costs are a live concern — is exactly the kind of change that should be modeled before year-end, not discovered on the 2022 return.

Who is exempt, and who can elect out

Two important exceptions soften the picture for some taxpayers:

Small businesses. Section 163(j) does not apply to a taxpayer that meets the gross-receipts test of IRC § 448(c) — average annual gross receipts of $26 million or less for 2021, per the inflation adjustments. A genuinely small business is simply outside the limitation. The exception does not extend to tax shelters, which cannot use it even if under the threshold.

Real property and farming businesses. An electing real property trade or business, or an electing farming business, may elect out of § 163(j) entirely under § 163(j)(7). The election removes the interest limitation — but it has a price: electing real property businesses must depreciate certain property under the Alternative Depreciation System, which means longer recovery periods and no bonus depreciation on the affected assets. The election is also irrevocable. For a leveraged real estate business, that trade-off — uncapped interest deductions in exchange for slower cost recovery — is a real modeling exercise, not an automatic yes, and it should be evaluated against the coming 2022 ATI change rather than in isolation.

Partnerships add their own complexity: § 163(j) applies at the partnership level, and interest disallowed there becomes "excess business interest expense" allocated to partners under special carryforward rules. Partners cannot simply deduct their share; they carry it forward against future allocations from the same partnership.

What to do now

The right posture this year is to look at both tightenings together. For 2021, recompute the limitation at 30% of ATI — not 50% — and identify whether the reversion alone disallows interest the business deducted in 2020. Then model 2022 on the EBIT basis, removing the depreciation add-back, to see how much further the cap falls; for a capital-intensive borrower, that second step usually matters more than the first. Confirm whether the small-business exception applies. And for real estate and farming businesses, weigh the § 163(j)(7) election deliberately, because it is irrevocable and trades faster cost recovery for uncapped interest — a trade whose value depends heavily on the 2022 ATI change.

Interest deductibility is not a filing-season problem; it is a structuring and timing problem. The businesses that manage it well are the ones that see the 2022 cliff coming while there is still time to adjust capital structure, fixed-asset timing, and elections around it.

FAQ

What is the § 163(j) limit for 2021? 30% of adjusted taxable income, plus business interest income and floor plan financing interest. The 50% figure available under the CARES Act applied only to 2019 and 2020.

What changes in 2022? For tax years beginning after December 31, 2021, ATI is computed without adding back depreciation, amortization, and depletion. That lowers ATI and the 30% cap — a meaningful tightening for capital-intensive businesses.

Is my business exempt? If your average annual gross receipts are $26 million or less for 2021 and you are not a tax shelter, § 163(j) does not apply. Real property and farming businesses can also elect out, at the cost of slower (ADS) depreciation.

What happens to interest I can't deduct this year? It carries forward indefinitely and is treated as business interest in the next year, where it is subject to the limitation again.