Property Owners Can Expedite the Recovery of More Capital Improvement Expenses UPDATED with Tax Reform News by John G. Ebenger, CPA
Posted on January 11, 2018
The Internal Revenue Code permits owners of business- and income-producing real estate to deduct from their taxable income an allowance for the wear and tear, deterioration or obsolescence of property over time. In addition, some businesses have been able to accelerate depreciation deductions to more quickly recover the cost and other basis of certain capital investments in property improvements. However, unbeknownst to many property owners, the laws changed in 2015 and extended the potential application of first-year bonus depreciation to a broader range of nonresidential property improvements. When real estate owners and investors miss out on these deductions, they may be leaving significant tax and cost savings on the table while also losing out on opportunities to improve the long-term value of their investments.
With the passage of the Tax Cuts and Jobs Act (TCJA) on Dec. 20, 2017, the technical implementation of bonus depreciation will change as the IRS issues guidance in 2018 to confirm to the provisions contained in the new tax reform law.
Then and Now
Under the U.S. tax code, businesses are typically allowed to deduct most “ordinary and necessary” business costs from their taxable income in the year they accrue those expenses. In contrast, a business’s capital investments in tangible property, including equipment, machinery and buildings, are deductible over several years of the property’s useful life, unless it qualifies for an immediate first-year bonus depreciation.
In 2002, Congress introduced the concept of bonus depreciation to apply to new property with a recovery period of 20 years or less, including off-the-shelf computer software, water utility property, and qualified leasehold improvement property (QLHI). This final category applied only to improvements businesses made to commercial property, excluding land, that they leased and made available for use at least three years after the building itself was placed in service. For the next 13 years, businesses were left in a state of uncertainty as Congress either allowed bonus depreciation to lapse or extended it temporarily to cover as much as 100 percent of expenses for qualifying assets, depending on the tax year for which the property was placed in service.
With the 2015 passage of the Protecting Americans from Tax Hikes (PATH) Act, 50 percent bonus depreciation was revived and extended to cover non-leased, qualified improvement property (QIP) acquired and placed in service after Dec. 31, 2015, and until Dec. 31, 2017, the impact of TCJA has not been addressed.
A Broader Range of Assets Now Qualify for Bonus Depreciation
Building improvements are typically very large expenditures that can stagnate a business’s cash flow. The logic behind bonus depreciation is that the quicker businesses are able to deduct and recover the costs of investments in real property improvements, the more money they will free up to invest in other assets that can expand their operations and improve their profit potential.
The PATH Act allowed property owners to apply bonus depreciation to a broader range of improvements to nonresidential property, regardless of whether or not the underlying property is leased. Moreover, the law lifted a prior restriction that limited the application of bonus depreciation to property that was at least three-years-old.
Under guidance issued in 2017, businesses received the ability to immediately write off a portion of QIP only when they made the improvements after the date the building was first placed in service. Therefore, deductions would apply to qualifying improvements that were made as soon as one day after a building was placed in service. The only exceptions to bonus-eligible property are 1) enlargements of an actual building, 2) changes to the internal structural framework of a building, or 3) any improvements to the building’s elevator or escalator.
Therefore, consider a taxpayer that completed construction on a new, 50,000-square-foot office building in January 2017 and subsequently expended $500,000 to build out 1,000 square-feet of a new tenant’s space in November 2017. Under this definition of QIP, the building owner could in 2017 deduct from taxable income 50 percent of the costs he or she incurred to build out the new tenant’s space, simply because the building predates the improvements.
If the building is 30-years old, and the owner completed a $1 million renovation to update the property’s common areas in 2017, 50 percent of those costs ($500,000) would qualify for bonus depreciation if the renovations maintained the structural integrity of the building and did not involve improvements to elevators or escalators. Not only would the building owner reduce 2017 tax liabilities, he or she will also be able to recover one-half of the costs incurred to improve the value and future marketability of the building.
The short-term certainty of these relaxed and less restrictive rules for bonus depreciation represents significant savings for owners of commercial real estate, businesses that invest heavily in equipment and machinery, such as manufacturers and distributors, as well as those entities that rely on frequent software updates. The only limit to the benefit of applying bonus depreciation is a business owner’s reluctance or failure to plan ahead with the guidance of experienced tax advisors.
Not only will property owners be able to use the immediate tax deductions to offset improvement costs in the current year, they will also free up cash flow to invest in other income-producing business activities. Moreover, because there is no spending or investment threshold on QIP used in a trade or business or for the production of income, some businesses may be able to create taxable losses to further reduce their tax liabilities
In some instances, businesses that failed to plan ahead or who put QIPs into service in 2016, may file amended tax returns to retroactively apply bonus depreciation to those activities they failed to report in that tax year. This assumes that businesses did not formally elect out of bonus depreciation on their 2016 income tax returns.
Businesses have an additional opportunity to qualify for both first-year bonus depreciation and Section 179 property deductions, especially when they make improvements to qualifying leasehold property, and/or retail or restaurant property. A cost segregation study is key to helping taxpayers identify all of the assets associated with the purchase, construction, repair and renovation of a property that may qualify for accelerated depreciation deductions and cost recovery.
About the Author: John G. Ebenger, CPA, is a director of Real Estate Tax Services with Berkowitz Pollack Brant, where he works closely with developers, landholders, investment funds and other real estate professionals, as well as high-net-worth entrepreneurs with complex holdings. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at email@example.com.