A four-physician orthopedic group financed a $2.4 million build-out in 2023. The loan made sense on every measure the bank cared about. Then the return came back with roughly $50,000 of interest expense disallowed — carried forward, unusable until the numbers cooperated. Nobody had modeled it, because almost nobody had heard of the rule behind it.
That rule is Section 163(j), and in 2026 it works differently than it did when that loan was signed. The One Big Beautiful Bill permanently restored the more generous EBITDA-based method of computing the limit — one of the largest quiet tax changes of recent years for capital-intensive businesses. It also added an ordering rule that takes effect this year and cuts the other way.
The Rule in One Sentence
Businesses above the gross receipts threshold can deduct business interest expense only up to 30% of adjusted taxable income plus business interest income — and starting with 2025 tax years, adjusted taxable income is measured before depreciation and amortization again, permanently.
What Section 163(j) Actually Limits
Section 163(j) caps the deduction for business interest — loans, credit lines, equipment financing, seller notes, shareholder loans. Personal mortgage and investment interest live under separate rules.
The cap equals business interest income plus 30 percent of adjusted taxable income (ATI) plus floor plan financing interest. For most closely held companies the first and third are trivial, so the limit is effectively 30 percent of ATI. Interest above the cap is not lost — it carries forward indefinitely. But that is a deduction you paid cash for this year and realize at some unknown future date.
EBIT vs. EBITDA: The Same Loan, a Very Different Answer
ATI is roughly taxable income with certain items added back. The question that has whipsawed borrowers since 2018 is whether D&A is among them:
- 2018–2021: Added back. ATI approximated EBITDA. Generous.
- 2022–2024: The add-back expired. ATI approximated EBIT, shrinking the limit sharply for asset-heavy businesses — the ones most likely to borrow.
- 2025 forward: The EBITDA-based computation is restored, permanently.
The spread is not marginal. Three profiles at the same 30 percent limit:
| Business Profile | Cap Under EBIT Rules | Cap Under EBITDA Rules | Added Capacity |
|---|---|---|---|
| Medical practice: $700K EBIT, $500K D&A | $210,000 | $360,000 | +$150,000 |
| Light manufacturer: $2.2M EBIT, $1.8M D&A | $660,000 | $1,200,000 | +$540,000 |
| Equipment-heavy services: $300K EBIT, $900K D&A | $90,000 | $360,000 | +$270,000 |
Notice the third row: heavy depreciation and thin book earnings previously meant almost no deductible interest, while servicing the debt in cash every month.
A second effect: depreciation strategy and the interest limit now pull the same direction. Under EBIT rules, claiming bonus depreciation or Section 179 or running a cost segregation study reduced taxable income and therefore reduced interest capacity. With D&A added back, you can accelerate deductions without cannibalizing the limit.
Who Is Exempt — and the Trap That Catches Practices
The Small Business Exception
If average annual gross receipts for the prior three years fall at or below the inflation-indexed threshold — $31 million for tax years beginning in 2025, adjusting upward for 2026 — Section 163(j) does not apply at all.
Two cautions. The test aggregates receipts across commonly controlled entities, so a physician-owner with a practice entity, a real estate entity, and an ASC interest may be tested as one. And growth crosses the line quietly — on debt signed years earlier.
The Syndicate Rule
The exception is unavailable to a “tax shelter,” which includes a syndicate: an entity allocating more than 35 percent of its losses to owners who do not actively participate in management. That catches structures nobody thinks of as shelters — real estate partnerships, practices with passive investor physicians, any LLC with silent members. One loss year with the wrong allocation can subject a small entity to the full limit, so test it annually inside ongoing financial reporting.
The 2026 Ordering Rule Working Against You
The same legislation added a coordination rule effective for tax years beginning after 2025 — this year for calendar-year filers. Interest capitalized into an asset rather than expensed must now generally run through the Section 163(j) computation first, with narrow exceptions for long-production-period property. Capitalizing interest into inventory or construction no longer sidesteps the limit, which hits contractors, developers, and manufacturers hardest. A related change narrows ATI for companies with foreign subsidiaries. If either applies, your effective limit may be tighter in 2026 even though the headline rule got friendlier.
Partnerships Have the Harder Version
In a corporation or sole proprietorship, disallowed interest carries forward and gets used when ATI recovers. In a partnership it becomes excess business interest expense allocated to each partner — releasable only against future excess taxable income from that same partnership. Other income does not unlock it, so a partner can carry suspended interest for years while paying tax on everything else.
Interest is the only major business expense whose deductibility depends on how profitable you were that year. Model it before you borrow, not after you file.
The Real Estate Election You May Want to Revisit
Real property trades or businesses can elect out of Section 163(j) entirely. The price is depreciating real property under the alternative depreciation system — longer recovery periods, no bonus depreciation — and the election is generally irrevocable.
Many owners elected out between 2022 and 2024, when the EBIT-based limit made interest nearly undeductible and surrendering depreciation speed seemed a fair trade. That trade looks worse now: the limit has loosened, 100 percent bonus depreciation is back, and the ADS penalty runs for the life of the property. You cannot undo an election, but new entities and acquisitions are fresh decision points.
Your 2026 Section 163(j) Checklist
- Average three years of gross receipts across all commonly controlled entities.
- With passive owners, run the 35 percent syndicate test for any loss year.
- Recompute your limit on the EBITDA basis and compare it to what prior returns assumed.
- Confirm carryforwards are tracked — entity level for corporations, partner level for partnerships.
- Test capitalized interest in inventory or construction against the new ordering rule.
- Before signing new debt, model deductible versus non-deductible interest at projected ATI.
The Bottom Line
The after-tax cost of borrowing is not the rate on the term sheet. A 9 percent loan with fully deductible interest costs a top-bracket pass-through owner roughly 5.5 percent after tax; with disallowed interest it costs the full 9 percent until the carryforward releases. That gap should shape how much you borrow, whether you lease or buy, and how you time large purchases — the discipline behind loan preparation. It also means knowing your ATI before year-end, not in March: bookkeeping closed monthly, paired with real financial planning and analysis.
Section 163(j) got meaningfully more generous in 2026, and permanence means you can plan around it instead of guessing at expirations. But the exceptions are narrower than owners assume, and the ordering rule claws back part of the benefit. Schedule a free consultation and our tax strategy and CFO advisory teams will run your limit, test your exception status, and model the after-tax cost of the debt you carry. For practices, we handle it inside medical practice finance, where build-out debt makes this rule bite hardest.
