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Cost Recovery Provisions in the Tax Cuts and Jobs Act

Michael Eagan, J.D., LL.M. 07.11.2018 | Client Alert

 

The Tax Cuts and Jobs Act (the “TCJA”), enacted in December 2017, made significant changes to various cost recovery provisions.  This alert discusses those provisions. 

Executive Summary

Cost recovery provisions in the TCJA focused on providing short-term writeoffs for asset purchases through enhanced immediate expensing and bonus depreciation.  As detailed below, the TCJA among other things:

  • Expanded bonus depreciation to certain used assets, increased the bonus percentage to 100% (from 50%), which phases down by annual 20% increments beginning in 2023, and extended bonus eligibility to property placed in service before January 1, 2027 (a seven year extension); and
  • Increased the limit on section 179 immediate expensing to $1 million (from $500 thousand) and the phase out limitation to $2.5 million (from $2 million), and expanded eligible property to include certain real property improvements.

In addition, the TCJA significantly altered the treatment of real estate improvements.  It eliminated the qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property categories of improvements, retaining the qualified improvement property (QIP) category.[1]  Though Congress intended for QIP to provide similar benefits to the three deleted categories – e.g. bonus eligibility and a 15 year life – a technical omission in the TCJA precludes those benefits.  Absent a legislative correction, QIP defaults to a 39 year MACRS life, thus making it ineligible for bonus depreciation.

Finally, the TCJA reduced the ADS life of residential rental property from 40 years to 30 years as well as the ADS life of QIP from 40 years to 20 years.  For QIP, this results in the unusual circumstance of a shorter ADS life (20 years) than MACRS life (39 years).

Following an overview of the US tax system’s cost recovery mechanisms, this alert details the TCJA provisions.  Taxpayers should understand the potential impact of these changes so they can work with their advisors to effectively plan as well as identify the opportunities and risks of the new legislation.

OVERVIEW

U.S. tax law provides various mechanisms for recovering costs invested in tangible property, including immediate expensing for certain assets (Code section 179) as well as depreciation and allowable first-year additional, or “bonus,” depreciation (Code sections 167 and 168).  While the TCJA focused primarily on providing short-term write-offs through enhanced immediate expensing and bonus depreciation, it also substantively changed the treatment of real estate improvements. 

U.S. Tax Depreciation & Cost Recovery

There are multiple depreciation “systems” under current U.S. tax law, including accelerated depreciation for certain assets—known as the Modified Accelerated Cost Recovery System or MACRS—and an alternative system—known as the Alternative Depreciation System or ADS—for specified assets.  ADS recovery periods tend to be longer and the depreciation method – e.g. accelerated vs. straight-line – slower than MACRS.  ADS must be used for certain property, including certain property used outside of the U.S., certain property financed by tax-exempt bonds, and certain property leased to a tax-exempt entity.[2]  Taxpayers may also elect to use ADS. 

Certain assets, including nonresidential real property and residential rental property must be depreciated using straight-line depreciation, regardless of whether MACRS or ADS applies, over relatively long recovery periods.  In addition, certain real property improvements must be depreciated using straight-line as well.

The amount of annual depreciation depends on the method the applicable system, whether MACRS or ADS, applies, as well as the asset’s recovery period,[3] which is generally prescribed by statute or in other IRS guidance.  Depreciation expense is taken annually until the cost is fully recovered or the asset is sold or otherwise disposed of. 

Bonus Depreciation & Section 179 Expensing

While depreciation is generally taken over time based on the required method and recovery period, “bonus depreciation,” or additional first year depreciation, is allowed for certain property under MACRS and, in certain circumstances, ADS.  Bonus depreciation is elective, though taxpayers must elect out of bonus if they don’t wish it to apply. 

Generally a percentage of total cost (50% prior to the TCJA), bonus depreciation dramatically speeds up the write-off of asset costs.  Eligible property includes – and included prior to the TCJA – new, depreciable property with a recovery period of 20 years or less, as well as certain water utility property and certain computer software.  Prior to the TCJA, bonus eligible property also specifically included a category of property improvements known as “qualified improvement property” (QIP).  QIP is discussed in more detail below.  

Similar to bonus depreciation, section 179 provides for the elective immediate expensing for certain asset purchase costs that would otherwise have to be capitalized and depreciated for U.S. tax purposes.  A dollar limit applies to the aggregate cost that taxpayers can expense ($500K prior to the TCJA), and above a statutory threshold amount ($2M prior to the TCJA), the allowable deduction is reduced.  Property eligible for section 179 expensing includes depreciable tangible property as well as, at the taxpayer’s election, certain real property and real property improvements.

Real Estate Improvements

Improvements to real property assets are generally depreciable using the same useful life and method as the underlying real property.  Prior to the TCJA, exceptions were provided for:

  • Qualified leasehold improvement property: interior improvements made to a nonsesidential building pursuant to a lease;
  • Qualified restaurant property: improvements made to buildings (as well as the buildings themselves) to the extent used as restaurants; and
  • Qualified retail improvement property: interior improvements made generally to a nonresidential building used as, generally, retail space.

While certain conditions applied to each category,[4] each was statutorily defined as 15-year property, making property in each category generally eligible for bonus depreciation.[5]  Additionally, each improvement category was eligible for section 179 expensing.

Qualified Improvement Property

A relatively new category (added for taxable years beginning in 2016), QIP includes certain non-structural improvements to the interior of a nonresidential building and does not have the restrictions the other categories imposed.  Not limited to improvements made pursuant to a lease, or to restaurants or retail establishments, QIP is limited only to the extent that improvements enlarging the building, or attributable to an elevator/escalator or to the internal structural framework of the building are excluded.  Thus, QIP generally captures interior, non-structural improvements.

Prior to the TCJA, QIP qualified for bonus depreciation; QIP was specifically included in bonus-eligible “qualified property” under section 168(k)(1).  Because of a technical omission in the Act’s statutory language discussed below, however, bonus for QIP is, generally, not allowed forany QIP placed in service in 2018 or beyond.

THE TCJA’S PROVISIONS AFFECTING COST RECOVERY

The significant changes the TCJA made to the provisions affecting cost recovery include:

  • Increased section 179 expensing;
  • Reductions in ADS lives of certain real property;
  • The elimination of categories of qualified leasehold improvements; and
  • Expansion of bonus depreciation to include used property and increase in bonus-eligibility to 100% for certain property.

The changes affecting bonus depreciation and, specifically, the impact on certain improvements to real property are discussed in more detail below.

Consolidation of Real Property Improvements to QIP

The TCJA eliminated the separate real property improvement categories of qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.  As noted above, each was defined statutorily as 15-year property, and thus were exceptions to the general principle that improvements to real property are depreciable using the same recovery period as the improved property.  Moreover, as 15 year property, improvements qualifying under these categories generally qualified for bonus depreciation. 

The apparent intent was to simplify the law by having a single definition for real property improvements eligible for bonus: QIP.  Enacted for 2016 and forward, QIP, as mentioned previously, includes improvements to the interior of a nonresidential building, but not including elevators/escalators, improvements that relate to the internal framework of the building, or improvements that enlarge the building.

Technical Legislative Oversight in the TCJA

By oversight, however, the TCJA does not specify a reduced recovery period for QIP.  The legislative history clearly indicates an intended 15 year MACRS recovery period, but the TCJA statute does not provide for it.  Therefore the MACRS recovery period for QIP remains at the pre-TCJA 39 years.  This technical oversight is significant in that it disqualifies QIP from bonus depreciation.

Prior to the TCJA, QIP was defined in section 168(k), which as mentioned above, also provides for bonus depreciation.  Section 168(k)(1) specifically authorized QIP, as defined elsewhere (prior to the Act) in section 168(k), for bonus depreciation.  The TCJA, however, moved the QIP definition to another subsection (section 168(e)) and removed the specific qualification of QIP for bonus depreciation from section 168(k)(1). 

Following the passage of the TCJA, only depreciable property with a recovery period of 20 years or less, and certain computer software, water utility property, and property related to film, television or live theatrical performances qualifies for bonus.  As such, much of what would constitute QIP defaults to 39 years, and no bonus is generally allowed.  This will require a legislative fix.

Bonus Depreciation

The TCJA also made several changes to bonus depreciation, including the:

  • Extension of bonus availability to property placed in service before January 1, 2027 (a seven year extension);
  • Increase of the bonus depreciation percentage on eligible property to 100% (from 50%),[6] which phases down by annual 20% increments beginning in 2023; 
  • Expansion of property eligible for bonus depreciation to include certain used assets (provided they are new to the taxpayer); and 
  • Elimination of ability to use AMT credits.

The new bonus provisions apply to qualified property that is both acquired and placed in service after September 27, 2017.  The statute provides that qualifying property acquired before September 28, 2017 is generally eligible for lower percentages of bonus depreciation, depending on when actually placed in service.  As under prior law, bonus depreciation is elective, though the taxpayer must elect out.  If made, the election cannot be revoked without IRS consent.

For real estate improvements, however,  this benefit is unclear, given the technical oversight in the legislation.  As discussed above, QIP placed in service beyond 2017 is not, without a technical correction, qualifying property for bonus depreciation purposes.

Bonus Depreciation – Used Assets

Under prior law, bonus depreciation applied only to new assets; significantly however, the extends eligibility to used assets.  Qualifying used assets include assets not previously used by the taxpayer that are acquired from an unrelated person in a purchase transaction.  The expansion of bonus eligibility to used assets (but new to the taxpayer) is a significant feature of the TCJA and can be particularly beneficial to hotel acquisitions where a material component of the assets acquired is bonus-eligible personal property.  This expansion also creates additional opportunities for cost segregation studies to isolate bonus-eligible property in a property acquisition.

Note with respect to bonus depreciation that certain states (including New York) do not allow for bonus depreciation, and taking bonus depreciation federally may not be optimal when state tax rules are considered.  Additionally, the bonus depreciation rules apply after application of the tangible property capitalization regulations (TPCR), which themselves often provide beneficial expensing of improvement costs; only costs required to be capitalized under the TPCR are bonus eligible.

OTHER TCJA PROVISIONS AFFECTING COST RECOVERY

Section 179 Expensing

As part of its small business reforms, the TCJA made several changes affecting section 179’s immediate expensing provisions, including:

  • An increased limit on section 179 immediate expensing from $500K to $1M;
  • An increased phase out limitation from $2M to $2.5M; and
  • Expanded eligibility for certain real property improvements.

Eligible property continues to include “qualified real property,” including QIP (discussed above) and certain specified improvements to nonresidential real property, including roofs, HVAC, fire protection and alarm systems, and security systems placed in service after the taxpayer placed the nonresidential real property in service.  Moreover, the TCJA removed the restriction that section 179 did not apply to property used to furnish lodging.

ADS Recovery Periods

The TCJA reduces the recovery period on certain real property for purposes of the ADS.  Specifically, the TCJA reduces the ADS life for residential rental property to 30 years (from 40 years).  The ADS life for QIP was also reduced to 20 years (from 40 years).  Given the legislative oversight discussed above regarding QIP, creating the unusual situation of these assets having a shorter recovery period under ADS as compared to MACRS.  For reference:

                                         MACRS                                                    ADS

 

Before

After

Before

After

Nonresidential

39 Years

39 years

40 years

40 years

Residential

27.5 Years

27.5 years

40 years

30 years

QIP

39 Years

39 years

40 years

20 years

 

In summary, the changes the TCJA made to the cost recovery provisions will impact taxpayer decisions, making proper planning essential to ensure that cost recovery elections properly align with overall tax strategy. 

Questions? Contact Michael Eagan at 212.699.8831 | meagan@berdonllp.com or Thea Kruger at 212.699.8865| tkruger@berdonllp.com, or reach out to your Berdon tax advisor.

 

Berdon LLP New York Accountants



[1] QIP generally captures interior, non-structural improvements to real property.

[2] Additionally, certain real estate taxpayers electing out of the new interest limitation provisions must use ADS.  For more on the interest limitation and opt-out election, see [link to Thea’s article].

[3] US tax law also provides certain “conventions” for determining when an asset is placed in service for tax purposes.  Examples include the mid-month convention, applicable generally to real property and pursuant to which assets are considered placed in service at the midpoint of the month actually placed in service.  Other conventions include the half-year and mid-quarter conventions.

[4] Qualified leasehold improvements, for example, included only improvements made pursuant to a lease and placed in service more than three years after the building itself was placed in service.

[5] Only certain qualified restaurant property qualified for bonus depreciation.

[6] The TCJA also allowed taxpayers to elect 50% bonus with respect to property placed in service in, generally, 2017.

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