[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 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 it may have caused some complications.
For example, not all bonus-depreciation-eligible improvements will qualify for a 15-year writeoff of the remainder of the costs. And some expenses eligible for bonus first-year depreciation under the liberalized rules may not be eligible for expensing under Section 179 of the tax code.
This article examines the bonus first-year depreciation allowance and the fast 15-year writeoff for qualifying building improvements. To read Part I of this discussion, click here.
Bonus First-Year Depreciation Allowance
For property placed in service before 2016, a bonus 50 percent first-year depreciation allowance is available for "qualified leasehold improvement property," defined the same way as it is for Section 179 purposes, except for the special rules that apply for expensing purposes to lessors that make a qualified leasehold improvement and then the property is transferred to a subsequent owner. The allowance is equal to 50 percent of the adjusted basis of the property.
Liberalized rules after 2015. Effective for property placed in service after Dec. 31, 2015, in tax years ending after that date, the term for real estate improvements eligible for bonus depreciation is "qualified improvement property," a vastly more expansive category than the prior law's "qualified leasehold improvement property" category.
Qualified improvement property is any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building was first placed in service. But qualified improvement property doesn't include any improvement for which the expense is attributable to:
• The enlargement of the building;
• Any elevator or escalator; or
• The internal structural framework of the building.
Thus, the PATH Act liberalizes the rules for bonus-depreciation-eligible building improvements in a number of important ways:
1. Building improvements are eligible for bonus depreciation regardless of whether the improvements are property subject to a lease. Thus, a business that improves its own realty will be newly eligible for bonus depreciation.
2. The improvement need not be placed in service more than three years after the date the building was first placed in service.
3. Structural components of a building that benefit a common area are no longer excluded from the definition of qualified improvements.
Qualified leasehold improvement property or qualified retail improvement property eligible for bonus depreciation under prior law automatically qualifies for bonus depreciation under the PATH Act changes because those terms are more restrictive than qualified improvement property. However, under Code Sec. 168(e)(7)(B), expenditures for qualified restaurant property are eligible for bonus depreciation only if they also meet the definition of qualified improvement property.
An expenditure that qualifies for bonus depreciation because it is qualified improvement property won't qualify for Section 179 expensing unless it meets the more restrictive requirements for qualified real property.
Phase down of bonus depreciation. For qualified improvement property placed in service after Dec. 31, 2017, 50 percent bonus depreciation won't be available. Instead, bonus first-year depreciation for such property will be:
1. 40 percent, for property placed in service in calendar year 2018 (or in calendar year 2019 for property described in Code Sec. 168(k)(2)(B), i.e., certain long-production-period property); and
2. 30 percent, for property placed in service in calendar year 2019 (or in calendar year 2020 for certain long-production-period property).
Bonus depreciation won't be available at all for qualified improvement property placed in service after 2019 (after 2020 for certain long-production-period property).
Fast 15-Year Writeoff for Qualifying Building Improvements
Under the General Depreciation System (GDS) of MACRS, nonresidential realty is depreciated over 39 years using straight line depreciation and the mid-month convention (which treats property as placed in service in the mid-point of the month in which it is actually placed in service).
Under pre-PATH Act law, for property placed in service before 2015, assets were eligible for far-more-favorable GDS recovery over 15 years via straight line if they met the requirements for qualified leasehold improvement property, qualified restaurant property or qualified leasehold improvement property.
The PATH Act retroactively restored and made permanent the advantageous 15-year recovery period for qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property.
From a functional standpoint, these three categories of property are defined for 15-year recovery purposes in the same way as they were under pre-PATH Act law, although the definition of qualified leasehold improvement property now is stated in Code Sec. 168(e)(6), instead of being covered at former Code Sec. 168(e)(6) and former Code Sec. 168(k)(3).
These three categories of property also are automatically eligible for Code Sec. 179 expensing. Qualified leasehold improvement property and qualified retail improvement property also are eligible for bonus depreciation under Code Sec. 168(k), and so is qualified restaurant property that also meets the technical definition of qualified improvement property.
A realty improvement that is eligible for 50 percent bonus depreciation because it is qualified improvement property may not qualify for a 15-year writeoff for the balance of the depreciable basis because it doesn't meet the more stringent tests required for qualified leasehold improvement property, qualified restaurant property or qualified retail improvement property. As a result, that part of the improvement cost that isn't recovered via 50 percent bonus depreciation may have to be recovered over a period of 39 years instead of 15.
In some cases, a portion of the improvement cost that isn't recovered via 50 percent bonus depreciation may have to be recovered over a period of 15 years, and the rest may have to be recovered over 39 years.
Businesses and contractors may be required to compile detailed cost segregation studies to determine the proper recovery period for improvement costs after subtracting bonus depreciation.
Robert Trinz is a senior analyst with Thomson Reuters Checkpoint within the Tax & Accounting business of Thomson Reuters.
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