Earlier this year, the Coronavirus Aid, Relief, and Economic Security (CARES) Act corrected a drafting error related to real estate qualified improvement property (QIP). This retroactive correction, which accelerates the tax depreciation deduction for certain improvements to real estate, is of particular benefit to: Landlords and tenants who make improvements to leased space; restaurant, hotel and retail businesses revamping the interiors of their properties; and taxpayers who make improvements to their owner-occupied business premises. When considered together with other pro-taxpayer provisions in the CARES Act and related IRS guidance, this change has the potential to generate substantial cash flow opportunities.
Congress’ “Retail Glitch”
QIP is defined as an improvement to an interior portion of a nonresidential building that is placed in service after the date the building was first placed in service. However, QIP does not include any expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.
The legislative history for the 2017 Tax Cuts and Jobs Act (TCJA) indicates that Congress intended for QIP to have a 15-year recovery period and thus, continue to meet the requirements for qualified property eligible for bonus depreciation. The final statute, due to a drafting error, did not reflect this intent and QIP, as 39-year property, became ineligible for bonus depreciation after Dec. 31, 2017. Therefore, taxpayers were losing out on depreciation deductions for which the law intended.
CARES Act provides the fix
The CARES Act corrects the error. QIP is now included in the Internal Revenue Code’s definition of 15-year property and once again qualifies for bonus depreciation.
The technical correction has a retroactive effect for QIP that was placed in service in 2018 and 2019. Before the correction, QIP placed in service in those years generally had to be treated as nonresidential real property and depreciated over 39 years using the straight-line method.
As mentioned above, the “retail glitch fix” allows business owners to take 100% bonus depreciation on the QIP assets placed in service 2018-2022. This will provide income tax and cash flow relief for many business owners, in restaurants, retail and real estate, by allowing larger immediate depreciation deductions.
The CARES Act allows real estate owners to accelerate depreciation deductions on qualified improvement property, which is great for the short term. Keep in mind, there are additional considerations when the property is sold. When you sell a property for which you have claimed 100% bonus depreciation for QIP expenditures, any taxable gain on QIP, up to the amount of the bonus depreciation previously deducted, is treated as ordinary income rather than long-term capital gain. Currently, ordinary income recognized by an individual taxpayer can be taxed at rates as high as 37%.
In contrast, if you depreciate QIP over 15 years using the straight-line method, the current maximum individual federal rate on long-term gain attributable to that depreciation is 25%. The gain is the so-called “unrecaptured Section 1250 gain,” which is basically a special category of long-term capital gain.
Be aware that claiming 100% bonus depreciation may affect other items on your tax return, such as the qualified business income deduction and various credits. In addition, different states have different rules on how bonus depreciation affects state income tax liabilities. It is important that taxpayers work with their tax advisors to understand the other impacts of taking bonus depreciation on the federal and state levels.
Time to act
The retail glitch fix provided valuable (and long-awaited) relief to many small business owners. The IRS has since come out with guidance on how taxpayers can fix the retail glitch. It is important for taxpayers to contact their tax professional to see what steps must be taken to fix prior years’ tax returns and how to ensure maximum tax benefits going forward.
For more information, contact Justin Sylvan at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.