Articles & Alerts
QIP vs. Repair Regulations – Decisions, Decisions, Decisions…
Has your business been hit hard by the COVID-19 pandemic? While many business’s operations have been greatly affected by the pandemic, the good news is that much needed relief is now accessible to many. The Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law on March 27, 2020, providing widespread economic relief, including some significant tax law changes. The new CARES Act provision on qualified improvement property (QIP) tax treatment is particularly noteworthy for taxpayers in the real estate, restaurant, retail, and hospitality industries as these businesses have been hit hard by the COVID-19 pandemic.
The CARES Act: Before the enactment of the CARES Act, QIP placed in service after Dec. 31, 2017 had to use a 39-year tax life and was not eligible for bonus depreciation. The CARES Act passed in 2020 retroactively changed QIP to a 15-year tax life, allowing taxpayers to claim 100% bonus depreciation. The change is retroactive to January 1, 2018. This is great news as real estate property owners can now depreciate QIP over a shorter 15-year tax life or take an immediate write off of 100% of the cost of the asset using bonus depreciation.
What is Qualified Improvement Property (QIP)? QIP is an internal improvement made to nonresidential real property after the real property is first placed in service by any taxpayer. The definition of QIP does not include expenditures attributable to the enlargement of a building, an elevator or escalator, or the internal structural framework of a building. The CARES Act clarifies that the improvement must be “made by the taxpayer.” This means that a taxpayer may not purchase real estate and treat improvements previously made by the seller as QIP.
Additional Considerations: Although the immediate write off of bonus depreciation sounds like a great tax saving strategy, it does have downsides, as outlined below.
- Depreciation recaptured: Bonus depreciation is subject to depreciation recapture in the year of sale. When you sell property for which you’ve claimed 100% bonus depreciation, any taxable gain up to the amount of the bonus depreciation is treated as higher-taxed ordinary income rather than the lower long-term capital gain tax rate. Under the current federal income tax regime, ordinary income recognized by an individual taxpayer can be taxed at a rate almost double, if not more, of that of capital gains tax rates.
- State Addback: Another item to consider is the state income tax treatment of bonus depreciation. Most states do not allow bonus depreciation and require a state addback to the extent of the bonus depreciation claimed on the federal tax return. Depending on the amount of the bonus depreciation, the state addback could put you in a higher state tax bracket. Due to the interplay with the business interest limitations, a real estate trade or business may want to forgo bonus depreciation on 15-year property in order to fully deduct interest expense.
- Bonus Phase Out: The bonus depreciation is not permanent. Under current law, it is subject to be phased out for property placed in service in calendar year 2023 and will be completely eliminated in 2027. An 80% rate will apply to property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026, and a 0% rate will apply in 2027 and later years.
Repair Regulations Analysis May be the Better Choice: If you are looking for a tax saving strategy similar to the immediate write off benefit of bonus depreciation, but would like to eliminate the negative effect of the depreciation recapture and state addback, you may want to consider a Repair Regulations analysis as an alternative.
The Repair Regulations analysis is applicable to businesses in all industries that acquire, produce, replace, or improve tangible property. The process involves going back to review your depreciation schedule to make sure you have treated costs correctly in the past. Prior to the issuance of the repair regulations in 2014, any time a taxpayer purchased an asset with a useful life that went beyond one year, the taxpayer needed to capitalize the cost of such asset and depreciate it over its tax life. However, it was not made clear as to how to treat costs made to repair an asset. For example, due to water leaking from the roof, you hired a contractor to replace 100% of your old roof membrane for a brand new similar quality roof membrane. Is this a cost that must be capitalized or should it be deducted as a repair cost? Due to the lack of guidance in this area, you may have capitalized it to be conservative. In 2014, Congress finally came out with repair regulations providing guidance as to what costs must be capitalized and what costs could be deducted as repair costs. Surprisingly, it turns out that the cost to replace the whole roof membrane may be deducted as a repair cost under the repair regulations and under the proper circumstances.
The Repair Regulations analysis could be an opportunity for huge tax savings particularly when you are a lessor making tenant improvements. For example, a landlord owns a commercial office building with 6 floors. A tenant that occupied the second floor moved out in 2012 and a new one moved in to that unit in the same year. To get it ready for the new tenant, the landlord spent $2 million to renovate the space. Under the old regulations, the landlord would have capitalized and depreciated the cost over 15 years. However, based on the Repair Regulations, these costs can now be deducted. In this situation, the landlord can file a Form 3115 to formally adopt the regulations to expense the remaining basis of the $2 million asset, garnering a significant deduction in the current year. Furthermore, we can apply the rules back to any undepreciated basis in property, and may be able to create large deductions in the current year.
Going back and reviewing depreciable assets could be an opportunity to save taxes, but you don’t necessarily have to go back to apply the Repair Regulations analysis. You can also apply the Repair Regulations analysis to all construction and repair work going forward. However, if you haven’t formally adopted the regulations in the past, you do have to change your method of accounting to formally adopt the regulations first.