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The Tax Cuts and Jobs Act (TCJA) has reformed business taxation with many changes to depreciation and the expensing rules for business assets. Little attention has been drawn to depreciation changes, but the new rules offer new opportunities for additional tax savings especially when applied with cost segregation.
Bonus depreciation has been around since September 11, 2001, with various enactment periods and percentages. Never has it applied to used property. As long as the qualified property began with the taxpayer, meaning it was the first use for the taxpayer and it was not acquired from a related party, it may qualify for 100 percent bonus if contracted after September 27, 2017. There are special transition rules. When acquiring property, the written binding contract rules, generally, will use the date of the binding contract as the determining factor to qualify for 100 percent bonus depreciation. For new construction, less than 10 percent of the hard costs can be spent prior to September 28, 2018, for the property to qualify for 100 percent bonus. If not, bonus defaults to the old rules of 50 percent for 2017 and 40 percent for 2019 in-service dates. Qualified property is tangible personal property with a recovery period of 20 years or less. Cost segregation is the IRS accepted tax planning tool to accelerate depreciation and applying 100 percent bonus depreciation to all the 5, 7, and 15-year recovery periods. Often the depreciation deduction in the first year is greater than income and the taxpayer can then carry forward the benefit for several years, as much as 20 years.
Example: Taxpayer acquires a limited service hotel for $5,000,000 on December 1, 2017, with a purchase sales agreement dated October 1, 2017. There is no written binding contract prior to September 28, 2017, hence, taxpayer’s acquisition will qualify for 100 percent bonus. A cost segregation study is completed and assigns 25 percent of the acquisition depreciable basis to 5 and 15-year recovery periods. The taxpayer will claim $1,250,000 as depreciation expense. Assuming a 35 percent tax rate, the taxpayer will reduce tax liability by $437,500.
The changes to qualified improvement property (QIP) made a simple provision very complicated. QIP was first introduced with the PATH Act of 2015, as a 39-year asset for interior improvements that qualified for the bonus. Because of a drafting error, the TCJA final language did not reflect the intent of Congress. Congress meant to assign a 15-year recovery period for all QIP and remove the separate 15-year straight line provisions for qualified leasehold improvement, qualified restaurant and qualified retail improvement property, all of which were eliminated. With this exclusion of the separate types of improvement property, it also removed the requirements that property would be subject to a lease, building was at least three years old, or use as a restaurant or retail space. However, without a technical corrections bill, QIP remains at 39-year recovery period and does not qualify for bonus depreciation, effective January 1, 2018. QIP placed in service after September 27, 2017 and before January 1, 2018, is eligible for 100 percent bonus depreciation. In general, the term ‘qualified improvement property’ means any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. QIP does not include any improvement related to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. A cost segregation study will be necessary to identify 5 and 7-year recovery periods for any interior improvements to avoid a 39-year recovery period and no application for bonus depreciation.
And what about § 179 expensing? The TCJA introduced a new term, Qualified Real Property, and expanded the § 179 eligibility. It includes qualified improvement property. It has expanded the definition to include other items such as roofs, fire protection or alarm systems, security systems, and HVAC property. In addition, an increase to both the annual cap and phase out limitation was introduced. The annual cap is raised to $1,000,000, with limitation phase out increased to $2,500,000. The danger comes in taxpayers thinking they can expense $1,000,000, without thought to the expanded definition of qualified real property that is now included in the phase-out limitation. Often the taxpayer will phase out and not be able to claim § 179 expensing. Also, this provision cannot create a net operating loss. This provision although expanded still has many limitations compared to bonus depreciation. Planning is required to be able to take advantage of expensing and bonus. And don’t forget about evaluating the capital investment under the Tangible Property Regulations. There is possible expense treatment under the routine maintenance and unit of property materiality rules.
All this and more will be the topics of discussion for tax planning considerations at the KyCPA Commercial Real Estate Conference on November 9. The agenda includes a broad spectrum of presentations with subject matter experts beginning with a deep dive into Federal and Kentucky Tax Reform, Depreciation, 1031 Exchanges and Opportunity Zones, Financial Reporting, Grouping Elections, Historical Credits, and regional real estate trends showcasing green space. Click here to register.
About the author: Karen J. Koch, CPA, MT is a partner at Bedford Cost Segregation, LLC and a founding partner of Bedford Energy Consulting, LLC. She can be reached at firstname.lastname@example.org.
Originally published in The Kentucky CPA Journal, Issue 4, 2018. Click here to read additional articles.