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As Seen in Commercial Observer

Historically, depreciation has produced tax-advantaged returns for real estate owners and investors. Depreciation has shielded taxpayers from income taxes on properties that otherwise generate positive cash flow. In this article, we will explore the methods available for taxpayers to accelerate depreciation. There are several options and scenarios real estate businesses need to consider when assessing what is the most beneficial for them.

Additional First Year Depreciation
(Bonus Depreciation)

Currently, bonus depreciation enables taxpayers to depreciate 100% of the purchase price of “qualifying property” in the year it’s placed in service. To qualify, the property must have a recovery period of 20 years or less, be depreciated using the modified accelerated cost recovery system (MACRS), and placed in service after September 27, 2017 and before January 1, 2023. For real estate businesses, qualified property typically includes, but is not limited to, furniture, fixtures, land improvements, flooring, cabinets, and appliances.

Owners of nonresidential real estate can take bonus depreciation on qualified improvement property (QIP). QIP is defined as property that is an interior improvement placed in service after the date the building was first placed in service, made by the taxpayer, and placed in service after December 31, 2017. Although, it does not include elevators, escalators, internal structural framework, and improvements that relate to the enlargement of the building. Taxpayers that are considering offering tenant allowances should be aware that these costs could be deemed lease acquisition costs, instead of QIP, and therefore required to be amortized over the life of the lease. If bonus depreciation is deemed more beneficial, care must be taken when drafting lease agreements to ensure such allowances qualify as QIP.

Bonus depreciation will gradually be eliminated over the coming tax years. Any qualifying assets placed into service on or after January 1, 2023, will only be eligible for bonus depreciation equal to 80% of the purchase price. This will continue to drop by 20% per annum until bonus depreciation is completely phased out for assets placed in service on or after January 1, 2027.

When assessing bonus depreciation, real estate businesses should consider the state tax implications for their owners. Many states do not conform to federal bonus depreciation rules. At the state level, there is typically an addition and subsequent subtraction adjustment passed through to the owners that reverse the bonus depreciation enjoyed at the federal level. For taxpayers that can fully utilize federal depreciation, this usually does not present an issue. However, owners or investors that are deemed passive or subject to loss adjustments can be exposed to income tax from the depreciation adjustments at the state level. This unintended consequence can impact cash flows if distributions are required to cover the state income tax exposure for the owners and investors.

Section 179 Expensing

Under Internal Revenue Code Section 179, eligible taxpayers may elect to expense qualifying property up to certain dollar limitations. To be eligible, property must be purchased for use in a trade or business. Tangible personal property such as furniture, fixtures and carpets are eligible for this deduction. For real estate businesses, the cost of “qualified real property” is also eligible. This includes QIP as well as the following expenditures made to nonresidential real property after the property was originally placed in service: roofs, HVAC, fire protection and alarm systems, and security systems. Land improvements are not eligible.

For tax year 2022, the maximum deduction under Section 179 is $1,080,000. This is set to increase to $1,160,000 for tax year 2023. There is a dollar-for-dollar phase-out once the amount of qualified Section 179 property placed in service exceeds $2,700,000. For example, if a taxpayer has $3,000,000 of qualifying property, the maximum deduction they can claim for tax year 2022 is $780,000 ($1,080,000 reduced by the excess of $3,000,000 less $2,700,000 ceiling). The deduction is completely phased out if $3,780,000 of qualifying property is placed in service during 2022. Further note that this limitation is potentially calculated twice, once at the business-level and again at the owner-level if the business is a pass-through entity (i.e., partnership or S-Corporation).

In addition to the limitations discussed above, Section 179 expensing is limited to the trade or business income of an activity. Unlike bonus depreciation, it cannot create a net loss for the business. For purposes of this deduction, trade or business income is calculated before factoring in any deduction under Section 179.Businesses need to consider their owners or investor base before electing to utilize Section 179. Trusts and estates are ineligible to utilize the deduction (grantor trusts are eligible for the deduction). In addition, owners or investors that are considered passive are not entitled to the deduction even if the business is eligible since the income from the activity is not deemed trade or business income. Disallowed deductions due to trade or business income limitations are carried forward indefinitely and can potentially be utilized in a future tax year.

As with bonus depreciation, businesses also need to understand the state tax implications. For example, New York follows the federal treatment of Section 179, however New Jersey limits the deduction to $25,000. There could be a significant state tax impact on owners and investors depending on the location of the property.

Cost Segregation Studies

Cost segregation studies provide real estate businesses with a powerful depreciation accelerator. A cost segregation study identifies and quantifies the various components of both purchased and constructed assets. This quantification enables businesses to depreciate components of their building using shorter lives. If the assets are eligible, businesses can take bonus depreciation on the segregated building components.

Cost segregation studies do not need to be performed in the year the building was purchased or constructed. Businesses can implement studies in subsequent tax years. If a business chooses to implement a study in a future year, they must recalculate the depreciation that was in effect the year the building was placed in service. For example, a real estate business purchased and placed a property in service during 2022. A cost segregation study is performed in the tax year 2024. The business can still utilize a 100% bonus depreciation on any eligible property when the adjustment is made on the 2024 tax return since it relates to a 2022 purchase.

Tangible Property Regulations

The tangible property regulations or the “repair regulations” are often overlooked and underutilized by real estate businesses. Prior to the implementation of the repair regulations, taxpayers had to capitalize the cost of any asset that had a useful life in excess of one year and depreciate the cost of the asset over the said life. There was no clear definition of what a repair was, leading taxpayers to capitalize improvements that can now be expensed. The repair regulations issued in 2014 provided guidance as to what improvements could be considered a repair and expensed in the year incurred. These regulations have enabled taxpayers to deduct significant improvements which previously may have been capitalized.

One of the most beneficial aspects of the repair regulations is the expenditure is considered an expense, not a capitalized fixed asset with additional rules and limitations on its depreciation. There are no state tax adjustments that need to be made. Additionally, there is no potential for the recapture of gain attributable to prior depreciation taken on the asset upon disposition. Lastly, there is no phase-out or dollar limitation on the qualifying improvements that can be expensed.

Conclusion

This discussion highlights many items that real estate businesses should analyze when strategizing on how to maximize their depreciation expense. It is important for businesses to carefully plan their future projects to ensure depreciation is utilized in an effective and efficient manner.