Scott Norquist, CPA
Senior tax manager, ACM
It seems like Congress changes the depreciation rules every year or so. Every time a jobs/economy/relief act of 20-something (fill in the year) is passed, we get new rules. More recently we have had the Economic Stimulus Act of 2008, the Small Business Jobs Act of 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010, Middle Class Tax Relief and Job Creation Act of 2012, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act), and a few more in between. We now have the Trump administration’s Tax Cuts and Jobs Act of 2017, which brings some major changes to the world of depreciation, many that benefit the real estate industry.
Assets consolidated into the “qualified improvement property” category. The Tax Cuts and Jobs Act of 2017, herein after referred to as the “Tax Act,” consolidated a few terms used under prior law. There were four different types of leasehold improvements with their own requirements. The four were:
• Qualified leasehold improvements,
• Qualified retail improvement property,
• Qualified restaurant property, and
• Qualified improvement property.
The first two required the asset to be made to the interior portion of the property and be placed into service three years after the building was placed into service. The qualified leasehold improvement had to be subject to a lease, and the qualified retail improvement had to be used in a retail business that sold tangible goods to the public. Qualified restaurant property was an improvement that at least 50 percent of the square footage of the building had to be used to serve food. Qualified improvement property did not have to be subject to a lease and did not have the three-year rule. These assets qualified for bonus depreciation and most had a 15-year depreciable life. The odd part of qualified improvement property, as it related to commercial real estate, was that in many cases it ended up being a 39-year asset because it still had to meet the definition of qualified leasehold improvement property for it to get the lower 15-year life. Taxpayers ended up having this odd 39-year asset that qualified for bonus depreciation.
With all the above-mentioned asset types now consolidated under the qualified improvement property category, one would think this aspect of depreciation would be easier to administer, and, in some cases, it will be. We will have one set of rules for leasehold improvements. Complications arise in that after the four asset types were consolidated, Congress did not insert language giving these assets a shorter 15-year life. That language was removed.
The code section that discusses bonus depreciation only mentions assets with lives less than 20 years. As mentioned earlier, unless qualified improvement property met the definition of qualified leasehold improvement property, it kept a 39-year life. This actually makes the situation worse now because the way the law was written, technically, these assets do not qualify for any bonus depreciation. There isn’t too much cause for concern because most believe it was just a misstep and it hopefully will get corrected when regulations are released this summer or, at least, before the end of the year.
Additional first-year depreciation deduction “bonus depreciation.” Bonus depreciation allows a taxpayer to write off, as a depreciation deduction, a certain percentage of the cost basis of a new capital asset.
Over the past 17 years, there have been varying percentages of bonus depreciation from 30 percent to a brief period of 100 percent. Prior to the passage of the Tax Act, bonus depreciation was set to gradually decrease from what was 50 percent at the time, down to 40 percent in 2018, 30 percent in 2019 and would be eliminated in 2020 under the PATH Act.
With the new Tax Act, bonus depreciation has increased to 100 percent and is available retroactively to Sept. 27, 2017, and forward, through the end of 2022. At this point, the percentage ratchets down until it is eliminated for any assets placed into service in 2026. This is great news for the real estate industry. Sub industries like hotel builders could see very large increases in depreciation deductions. Another big change for bonus depreciation is that it is now allowed for “used” assets. The requirement that it be original use property has gone away. This increases the immediate benefit of cost segregations studies. Now when a taxpayer hires a certified public accountant firm and engineer to perform one of these studies, all the assets that get segregated into the five-, seven-, 10- and 15-year lives will essentially get written off in full, assuming they were placed in service after Sept. 27, 2017.
One detail to keep track of regarding that 9/27/17 date is that for a new build property – an apartment building, for example – the construction contract needs to have been signed after this date. If not, you are regulated to the old bonus depreciation rules from the PATH Act, which is 40 percent for 2018.
The law has not changed regarding assets required to be depreciated using alternative depreciation system when it comes to bonus depreciation, they do not qualify. The real estate industry will need to plan around this rule. Part of the Tax Act puts a limit on the percentage of interest expense that is deductible based on net taxable income. This limit applies to “real property trades or business” and the limitation is 30 percent. The Tax Act does give an option to elect out of the interest limitation but forces depreciation of assets using ADS if the previous election is taken. The caveat here is even though the taxpayer would be denied bonus depreciation on the qualified improvement property (the way it’s written there is no bonus anyway) it would be retained on personal property like five- and seven-year assets (think lobby furniture, bathroom fixtures, cabinets and carpets). ADS also extends the depreciable lives of your other assets.
How to navigate these new rules? One critical piece of advice is to keep your CPA involved in conversations. The changes to qualified improvement property and bonus depreciation can provide some significant benefits to your project and your investors, if planned for accordingly.
