Lost in Translation: Technical Issues Create Confusion Over New Depreciation RulesAnchin’s Real Estate UpdateJuly 12, 2018
The new tax law — popularly known as the Tax Cuts and Jobs Act (TCJA) — makes significant changes to the way real estate improvements and other business assets are depreciated for tax purposes. Unfortunately, in the rush to pass tax reform before Christmas, critical provisions were omitted, creating a disconnect between what Congress intended and the language of the act.
One of the TCJA’s key changes is to reduce the number of categories of nonresidential real property improvements eligible for accelerated depreciation from four to one. The act eliminates references in the tax code to qualified leasehold, retail, and restaurant improvements — all of which were depreciable over 15 years — in favor of a single classification: Qualified improvement property (QIP). But the act neglects to provide a 15-year depreciation period for QIP, which is what Congress meant to do. Until lawmakers address this oversight through a technical corrections bill, QIP will not be entitled to accelerated depreciation, nor will it be eligible for 100% bonus depreciation.
Another drafting error involves the alternative depreciation system (ADS). Congress intended to provide QIP with a 20-year depreciation life for ADS purposes, but the act fails to do so. As discussed below, this oversight, if not corrected, will have significant implications for larger real estate businesses.
Review of Prior Law
To fully grasp the TCJA’s changes, it’s necessary to understand how nonresidential real property was treated under prior law. Here’s a quick review:
Ordinarily, nonresidential buildings — as well as tenant buildouts and other improvements to those buildings — are depreciable over 39 years. But the tax code provided a 15-year depreciation period for three types of property:
Qualified leasehold improvement property — An improvement to the interior portion of a building, made pursuant to a lease between unrelated parties, occupied exclusively by the lessee or any sublessee, and placed in service more than three years after the building was first placed in service. It did not include improvement expenditures attributable to enlargement of the building, elevators or escalators, structural components benefitting common areas, or the building’s internal structural framework.
Qualified retail improvement property — An improvement to the interior portion of a building, provided such portion is open to the general public, used in a retail sales business, and made more than three years after the building was first placed in service. Like qualified leasehold improvements, it did not include building enlargements, elevators or escalators, structural components benefitting common areas, or the building’s internal structural framework.
Qualified restaurant property — A building or improvement to a building, provided more than 50% of the building’s square footage was devoted to preparing or serving meals.
Legislation enacted in 2015 added a fourth category: QIP. This type of improvement did not have to be made pursuant to a lease, did not have to be made more than three years after the building was first placed in service, and was not restricted to a particular type of business. The only requirements were that the improvement be made to the interior portion of a nonresidential building (including common areas) and that it be placed in service after the building was first placed in service. QIP did not include improvement expenditures attributable to enlargement of the building, elevators or escalators, or the building’s internal structural framework.
Under prior law, QIP was not entitled to a 15-year depreciation period. But it was eligible for 50% bonus depreciation, allowing the owner to deduct 50% of the property’s adjusted basis for the taxable year in which it was placed in service.
The New Law
The TCJA eliminates qualified leasehold and retail improvements, as well as restaurant buildings and improvements, from the property categories entitled to 15-year depreciation, effective for property placed in service after 2017. The idea was to designate a single category of property — QIP — eligible for depreciation over 15 years. This change is particularly significant for restaurants, because restaurant buildings, as opposed to improvements, are no longer eligible for accelerated depreciation.
As written, however, the act does not provide a 15-year depreciation period for QIP. So, as things stand now, there is no authority in the tax code for depreciating improvements to nonresidential real property over 15 years.
Congress also inadvertently eliminated bonus depreciation for QIP. The TCJA provides for 100% bonus depreciation of qualified property placed in service after September 27, 2017, and before January 1, 2023. (After that, bonus depreciation is phased out and eventually eliminated by the end of 2026.) But the act removes QIP from the list of assets eligible for bonus depreciation. The intent was that this property would be eligible under a separate provision that allows bonus depreciation for property with a depreciable life of 20 years or less. Had the act been drafted as intended, qualified improvement property would have a 15-year depreciable life. Under the act as written, however, such property is depreciable over 39 years, so technically it’s no longer eligible for bonus depreciation.
Another gap between congressional intent and the final legislation is the bill’s failure to provide QIP with a 20-year depreciation life for ADS purposes. The ADS method, which is required for certain assets, generally involves straight-line depreciation over a longer recovery period. For example, the lives of nonresidential and residential real estate — ordinarily 39 years and 27.5 years, respectively — are 40 years and 30 years, respectively, under ADS. Congress intended to reduce the ADS life of QIP from 39 years to 20 years, but a new tax code section designed to accomplish that goal was omitted from the final legislation.
Unless corrected, this error will have significant implications for real estate businesses. That’s because the TCJA limits the deductibility of net business interest expense (that is, the excess of interest expense over interest income) to 30% of adjusted taxable income, which can place a considerable burden on real estate businesses with substantial mortgage debt. The limit does not apply to “smaller” businesses — that is, those whose average annual gross receipts do not exceed $25 million. In addition, “real property” businesses — including development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and brokerage — may opt out of the interest expense limitation. The catch? In exchange for avoiding the limitation, a business must depreciate all of its real estate and QIP using the ADS method.
For many real estate businesses, exchanging higher interest deductions for lower depreciation deductions will make sense. But it will be difficult to evaluate the benefits of this strategy until there’s greater certainty over the ADS life of QIP.
The TCJA, as originally conceived, creates significant benefits and tax-planning opportunities for many real estate businesses — particularly 100% bonus depreciation for QIP. Unfortunately, the availability of these benefits will remain uncertain unless and until Congress fixes the act’s drafting errors. Contact your Anchin Relationship Partner to discuss how this might impact your business.