Tax Considerations for Real Estate Investors Mini Series: How Do I Maximize My Depreciation Deductions?

The recently enacted Tax Cuts and Jobs Act (the Act) is a sweeping tax package that has transformed the way we think about taxation and how it affects our decision making process. When looking at the new law, one of the biggest takeaways to note is the amount of available opportunities to save taxes. The media’s headlines have focused on the lower corporate and individual tax rates, the changes to itemized deductions, and the deduction for qualified business income. However, there are other opportunities that haven’t received as much traction in the news but can be very important to your business. Today we’ll examine four changes in the code that impact the way property is depreciated and see how this can relate to the Construction and Real Estate industry.

Section 179 Deduction and Bonus Depreciation

In recent years, operating businesses in the Construction and Real Estate industry have grown accustomed to utilizing the Section 179 deduction and bonus depreciation as valuable planning tools in determining taxable income. Under prior law, a taxpayer’s annually allowable Section 179 expense could not exceed $500,000 as adjusted for inflation. The dollar limit had to be reduced by the amount of Section 179 property placed in service during the tax year that exceeded $2 million. The new law raises the annual dollar limit from $500,000 to $1 million and increases the beginning of the phase down threshold from $2 million to $2.5 million.

When it comes to bonus depreciation, the old rules allowed an additional depreciation deduction for 50 percent of new (not used) property placed in service during the year. The Act now raises the bonus depreciation rate to 100 percent for all qualified property, which includes both new and used property.

These increases create an environment that provides a great deal of flexibility in determining taxable income, but there are some very important matters to consider when taking these deductions. For example, the 179 deduction cannot create a loss, while bonus depreciation can. In addition, each state treats bonus and 179 differently for tax purposes, which causes increased complication in managing your overall tax liability. These are just two small examples to consider, so be sure to work closely with your Sikich advisor to avoid lost deductions and opportunities.

Qualified Improvement Property

Under prior law, many improvements that were made to real estate property were often considered building components, and as a result, were depreciated on a straight-line basis over a 39-year life. These expenditures couldn’t qualify for additional first year depreciation (Section 179 and bonus) unless they fell under the umbrella of “qualified improvement property.” Qualified improvement property, while depreciated over 39 years, was eligible for bonus depreciation. Qualified improvement property that fit into one of three categories—qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property—was depreciated using the 15-year straight-line method after taking allowable Section 179 or bonus depreciation.

Under the new law, the three separate categories were eliminated, and one definition was established: qualified improvement property (QIP). The Act expands the type of property that can qualify as QIP by including previously unqualified property such as roofs, heating, ventilation and air-conditioning property (HVAC property), fire-protection and alarm systems, and security systems. QIP also includes property without regard to the business it was used in or whether the improved space was leased or owned. The law applies to property that is placed in service in tax years beginning after December 31, 2017.

As the law is currently written, QIP property is subject to a 39-year life; and while eligible for Section 179 deduction, it is not eligible for bonus depreciation. However, a technical correction is expected that will allow a 15-year useful life as well as bonus depreciation, since this was Congress’ original intent. We are currently anticipating that the oversight will be fixed by year end, but time will tell. Between Section 179, bonus, and a reduced useful life, this provision could be a great planning tool for taxpayers. If you are making improvements to the buildings you own or lease in 2018, it is important to consider whether a cost segregation study is needed to classify property as the lowest life possible (5, 7, or 15-years) as well as the impact of this new law on your depreciation deductions.

Annual Caps on Depreciation of Passenger Automobiles

The Construction and Real Estate industry often requires a significant amount of capital investment in cars and trucks. If the vehicle being placed in service is under 6,000 pounds gross vehicle weight, the IRS caps on the amount of depreciation that can be taken on that vehicle for any given year. Under the pre-Act law, the base amounts for calculating the caps were $2,560 for the year the vehicle was placed in service, $4,100 for the second year, $2,450 for the third, and $1,475 for the remaining recovery period of the asset. Due to inflation adjustments over time, the first year limit in 2017 was $3,160. The Act currently provides that the base amounts of depreciation caps for passenger automobiles are as follows:

• $10,000 for the year that a vehicle is placed in service
• $16,000 for the second year in the recovery period
• $9,600 for the third year in the recovery period
• $5,760 for the remaining recovery period of the asset

This change allows an additional $6,840 of depreciation to be deducted in year one per vehicle. If your business has an aging fleet of vehicles, this is a law that can have a positive impact on your decision making process.

Changes in Rules for Like-Kind Exchanges

There are many changes in the Act that are taxpayer-friendly; however, as is to be expected there are provisions that people need to be mindful of when conducting day-to-day operations. As equipment ages, it is common practice to simply trade in the old piece, put some money down, and get a new, upgraded piece of equipment for the business. Any gain that was realized from the trade-in was deferred and not included in that year’s taxable income. Effective January 1, 2018, when a trade-in occurs with property other than real property, the trade-in value received from the dealer is considered proceeds on the sale of that asset. This creates a taxable event on the trade-in of fully depreciated equipment that you wouldn’t normally expect. If it makes financial sense, you may want to consider leasing the equipment or selling the old equipment outright. The good news is that the cost of the new equipment will be eligible for immediate deduction under Section 179 or the 100 percent bonus depreciation rules.

It is important to recognize, as previously stated, that real property is still eligible for like-kind exchange treatment. Using like-kind exchanges for real property transactions can save significant tax dollars, so please contact your Sikich tax expert if you are looking to sell real property and reinvest the proceeds.

Conclusion

These are only a few parts of the new tax law currently in effect, so if you haven’t looked into this yet, now is the time to take that important step. Many of these new rules are complex, so contact your Sikich tax expert to tailor your best path moving forward to make sure you are ahead of the game. Be on the lookout for upcoming alerts in our Tax Considerations for Real Estate Investors series, as our experts continue to monitor IRS guidance and relevant news.