In what is likely a legislative error, depreciation of qualified improvement property is uncertain under the new tax reform law. Given the Sept. 27, 2017 effective date for bonus depreciation, this issue will have an immediate impact on 2017 tax returns filed this year.
Building improvements are generally depreciable over 39 years, but certain types of qualified real property, including qualified leasehold improvements, qualified restaurant property and qualified retail improvement property, had historically been eligible for a 15-year cost recovery period and Section 179 expensing. Each of these three categories of qualified real property has unique criteria, with qualified restaurant property having the fewest limitations. Property that did not meet the definition of any of these three categories was subject to a class life of 39 years.
Bonus depreciation allows faster depreciation of assets with class lives of 20 years or less. The class life definition is important to understanding the Congressional oversight in the new law. Bonus depreciation allowed businesses to immediately deduct an increased percentage of the cost basis of qualifying property placed in service during that tax year. The bonus percentage, initially set at 50 percent, was set to drop to 40 percent in 2018, 30 percent in 2019, and expire in 2020.
Qualified improvement property, as historically defined, was eligible for bonus depreciation. The original definition for qualified improvement property provided that the improvement must be to the interior portion of a building that is nonresidential real property and placed in service after the date the associated building was first placed in service. Such property did not need to be made pursuant to a lease, nor was the associated building required to be at least three years old when the improvement was placed in service (these criteria were once required for bonus depreciation). While the definition of qualified improvement property was similar to definitions of qualified real property, the qualified improvement property definition was relevant only to determine eligibility for bonus depreciation. For example, not all types of qualified restaurant property were eligible for bonus depreciation (such as the restaurant building itself).
The new law introduced as the Tax Cuts and Jobs Act (TCJA) consolidated all three categories of qualified real property into one: qualified improvement property (QIP). The new law was intended to describe the class lives of QIP, which would in turn determine its bonus depreciation eligibility. Although it is clear that Congress intended to make QIP eligible for a 15-year MACRS class life and 20-year ADS class life, the omission of a provision linking QIP to these class lives makes its depreciation uncertain.
Under TCJA, the enhanced bonus depreciation percentage is 100 percent – full expensing – for property with class lives of 20 years or less that are placed in service after Sept. 27, 2017, and before Jan. 1, 2023. The enhanced bonus depreciation under TCJA phases out starting in 2023 and expires in 2027. The available bonus depreciation during that time is:
- 80 percent in 2023
- 60 percent in 2024
- 40 percent in 2025
- 20 percent in 2026
The enhanced bonus depreciation should be a significant benefit for business planning expansion and improvements projects, and other new purchases, but currently its application to QIP is unclear.
One of the stated goals of the new tax reform law was simplification, and in that vein, the new law consolidated the separate definitions of qualified leasehold improvements, qualified restaurant property and qualified retail improvement property under the QIP banner. Hence, it is no longer necessary to maintain a category of qualified real property that is separate from qualified improvement property. This consolidation of definitions only applies to property placed in service after Dec. 31, 2017; however, the new rules on increased bonus depreciation apply to property placed in service after Sept. 27, 2017. In the Joint Explanatory Statement released in conjunction with the final tax reform bill, the Conference Committee stated that QIP placed in service after Dec. 31, 2017, would be eligible for 15-year MACRS depreciation (“the conference agreement provides a general 15-year MACRS recovery period for qualified improvement property”), but the language within the bill itself does not include the reference necessary to include QIP among the property eligible to use the 15-year MACRS cost recovery nor the 20-year ADS class life.
This is a major oversight that will need to be addressed in a technical corrections bill. In the meantime, it has important consequences for businesses making qualified improvements to real property because it eliminates QIP from eligibility for 100 percent bonus depreciation.
The uncertainty of the class life of QIP directly affects anyone in a real property trade or business (RPTB) with average annual gross receipts in excess of $25 million over the prior three years because of the interplay between 100 percent bonus depreciation and the new rules limiting business interest. An RPTB includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. For any type of entity, including an RPTB, business interest deductions after Dec. 31, 2017 will be limited to the sum of business interest income plus 30 percent of adjusted taxable income (computed without regard to deductions allowable for interest, depreciation, amortization, depletion, net operating losses, and the pass-through entity deduction). An RPTB has the option to elect out of the business interest limitation rules and deduct all of its business interest expenses. If the business elects out, it will be REQUIRED to depreciate any residential rental property, nonresidential rental property, and QIP using the ADS method, and with lives of 30 years, 40 years, and 20 years respectively. The ADS method prohibits the use of bonus depreciation.
Under the bonus depreciation rules intended by Congress, an RPTB could then determine whether it makes more economic sense to elect out of the business interest rules (and thereby deduct all of its business interest and depreciate its assets using the longer ADS methods), or submit to the business interest limitations (and take 100 percent bonus depreciation on its QIP plus land improvements or other personal property building components (MACRS property with recovery periods of 20 years or less)).
Because of the Congressional oversight in failing to define QIP as property qualifying for 15-year MACRS class life and 20-year ADS class life, QIP is currently not available for 100 percent bonus depreciation, and must be depreciated over 39 years. Furthermore, for property placed in service between Sept. 27, 2017, and Dec. 31. 2017, every business will have to use the prior definitions of qualified leasehold improvements, qualified restaurant property, qualified retail improvement property, and qualified improvement property to determine what methods of depreciation apply. For instance, such prior definitions may avail property of 50% bonus depreciation and a 15-year depreciation period pursuant to pre-TCJA law during this time span, but after Dec. 31, 2017, such property is classified as QIP under TCJA and would be subject to the 39 year depreciation period with no bonus depreciation available.
What Businesses Can Do Now
Based upon the seemingly clear Congressional intent to include the appropriate class lives of QIP as expressed in the Joint Explanatory Statement to the final bill, Congress is likely to pass a technical corrections bill that will be retroactive to at least Jan. 1, 2018 (the effective date combining all four prior classes of improvement property discussed above into QIP). Hopefully, Congress will also cure the issue relating to QIP placed in service after Sept. 27, 2017 (the effective date for 100 percent bonus depreciation). This is not certain, however, especially in light of the budget reconciliation rule restraints that allowed the Senate to pass the law with a simple majority. RPTBs cannot count on being able to claim 100 percent bonus depreciation for QIP placed into service in 2018 if they elect out of the business interest limitation rules. We recommend that you work with your tax advisor to analyze how a 39-year depreciation schedule would affect your taxes moving forward.
CBIZ will keep you-up-to-date as more developments on this matter emerge. If you have any comments, questions or concerns about qualified improvement property, please contact your local tax professional.
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