IMGCAP(1)]As a general rule, the cost of commercial real estate improvements is recovered over a painfully long period of 39 years via straight-line depreciation only.
However, for specially defined categories of realty improvements, taxpayers may be entitled to the hat-trick of tax breaks: expensing under Code Section 179 of part of the cost of the improvements; bonus first-year depreciation deductions of the portion of the cost that isn't (or can't be) expensed; and a relatively short 15-year recovery period of the cost that isn't (or can't be) expensed or recovered via bonus first-year depreciation. Larger businesses may not qualify for expensing, but they still may be able to score bonus depreciation and a short 15-year recovery period.
The PATH Act substantially liberalized the expensing break for qualifying real estate improvements. It also made it easier for improvements to qualify for bonus first-year depreciation, but in the process may have caused some complications.
This article takes a closer look at the expensing of realty improvements under Section 179. Part II will examine the bonus first-year depreciation allowance and the fast 15-year writeoff for qualifying building improvements.
Taxpayers, except trusts, estates and certain noncorporate lessors can elect on Form 4562 to expense (deduct in lieu of depreciation) the cost (subject to dollar limits) of "Section 179 property."
Under pre-PATH Act law, for tax years beginning in calendar years before 2015, the maximum expensing amount was $500,000, reduced dollar-for-dollar by the amount of Section 179 property placed in service during the tax year in excess of $2,000,000 (the investment ceiling).
The deduction amount was further limited to the amount of taxable income from any of taxpayer's active trades or businesses, computed without regard to the cost of qualified expense property, the deduction for one-half of self-employment tax, NOL carrybacks or carryforwards, and deductions suspended under other Code sections (Code Sec. 179(b)(3); Reg. § 1.179-2(c)(1)), e.g., the passive activity rules.
Generally, Section 179 property is tangible depreciable property, other than buildings or their structural components, and "off the shelf" computer software that is acquired by purchase and used in an active trade or business. However, under pre-2015 PATH Act law, for tax years beginning before calendar year 2015, a taxpayer could elect to treat "qualified real property" as Section 179 property. But the aggregate amount of the cost of qualified real property that a taxpayer could elect to treat as an expense was subject to both an annual limit of $250,000 and the $500,000 annual per taxpayer overall limit on Section 179 expensing (which, as mentioned above, was itself subject to reduction if the investment ceiling was exceeded).
The PATH Act retroactively extended and made permanent the $500,000 expensing limitation and $2 million phase-out amount. These dollar limits had been scheduled to drop, respectively, to $25,000 and $200,000 respectively. Additionally, both dollar limits are inflation adjusted after 2015. For 2016, the expensing limitation remains unchanged, but the phaseout amount rises to $2,010,000.
The PATH Act also:
• Permanently extended the elective treatment of qualified real property as Section 179 property, effective for tax years beginning after Dec. 31, 2014.
• Removed the annual $250,000 limitation under former Section 179(f)(3) on the amount of qualified real property that can be treated as Section 179 property, effective for tax years beginning after Dec. 31, 2015.
Thus, for property placed in service in tax years beginning after Dec. 31, 2015, the PATH Act can double the maximum amount of qualifying realty improvements that can be expensed—from $250,000 to $500,000. This change will be a boon to smaller businesses that need to make improvements to their properties.
What is qualified real property? Qualified real property is property that is classified as:
1. Qualified leasehold improvement property as defined in Code Sec. 168(e)(6);
2. Qualified retail improvement property as defined in Code Sec. 168(e)(7); and
3. Qualified restaurant property as defined in Code Sec. 168(e)(8).
For expensing purposes, these three classes of property are defined the same way as they were under prior law, although the placement of some of the definitions within the Code has been changed.
The qualified property must be depreciable, acquired by purchase for use in the active conduct of a trade or business, and can't be certain ineligible property (i.e., used for lodging; used outside the U.S.; used by governmental units, foreign persons or entities, and certain tax-exempt organizations).
What is qualified leasehold improvement property? In general, qualified leasehold improvement property is any improvement to an interior portion of a building which is nonresidential realty if:
1. The improvement is Code Sec. 1250 property.
2. The improvement is made "under or pursuant to a lease" (as defined in Code Sec. 168(h)(7), namely any grant of a right to use property), either by the lessee, sublessee or lessor of the building portion. Leases between certain related persons aren't treated as leases.
3. The portion of the building is to be occupied exclusively by the lessee (or any sublessee) of the portion.
4. The improvement is placed in service more than three years after the date the building was first placed in service.
If a lessor makes an improvement that is a qualified leasehold improvement, it can't be qualified leasehold improvement property to any subsequent owner, subject to exceptions for nonrecognition and death transfers.
The Code doesn't define what types of building improvements are eligible to be treated as qualified leasehold improvement property. Rather, it lists the types of property that can't be so treated. Under Code Sec. 168(e)(6)(B), qualified leasehold improvement property does not include any improvement for which the expense is attributable to:
• The enlargement of the building,
• Any elevator or escalator,
• Any structural component benefiting a common area, and
• The internal structural framework of the building.
What kinds of improvements are qualified leasehold improvements after eliminating those that are ineligible? The following types of improvements would appear to qualify, if they benefit the tenant's space only and not a common area:
1. Electrical or plumbing systems (including a sprinkler system);
2. Permanently installed lighting fixtures;
3. Ceilings and doors; and
4. Non-load-bearing walls.
What is qualified retail improvement property? Qualified retail improvement property is any improvement to a building which is nonresidential real property if:
• That portion is open to the general public and is used in the retail trade or business of selling tangible personal property to the general public, and
• The improvement is placed in service more than three years after the date the building was first placed in service.
An improvement made by the owner of that improvement will be qualified retail improvement property, if at all, only so long as the improvement is held by that owner. Exceptions similar to the exceptions under Code Sec. 168(e)(6)(B) (e.g., for death, or like-kind exchange transactions) apply for purposes of this provision.
As is the case with qualified leasehold improvement property, qualified retail improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefitting a common area, or the internal structural framework of the building.
The Joint Committee on Taxation says retail establishments that are qualified retail improvement property include those primarily engaged in the sale of goods, such as grocery stores, clothing stores, hardware stores, and convenience stores.
Establishments primarily engaged in providing services, such as professional services, financial services, personal services, health services, and entertainment, aren't qualified retail improvement property. The JCT adds that "it is generally intended" that a business that is defined as a store retailer under the North American Industry Classification System (NAICS)will qualify, while those in other industry classes won't. (Note that the current NAICS lists categories 44-45 as "Retail Trade.")
What is qualified restaurant property? Property is qualified restaurant property if it is any Code Sec. 1250 property which is a building or an improvement to a building, if more than 50 percent of the building's square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals.
The definition of qualified restaurant property is unique in that it allows a building (rather than an improvement to one) to qualify for expensing. Additionally, an otherwise qualifying improvement need not have been placed in service more than three years after the date the building was first placed in service, as is the case with qualified leasehold improvement and qualified retail improvement property.
Robert Trinz is a senior analyst with Thomson Reuters
