The Tax Cuts and Jobs Act (TCJA) included several favorable changes to the federal income tax depreciation rules for real estate. However, one intended change didn't make it into the statutory language, and there are some potential pitfalls to avoid. Here's what real estate investors need to know.
Bonus Depreciation for Qualified Improvement Property
The TCJA allows 100% first-year bonus depreciation for eligible property placed in service between September 28, 2017, and December 31, 2022. That means you can write off the entire cost of eligible property in the first year it's placed in service. Eligible property includes property with a normal depreciation period of 20 years or less.
For real estate qualified improvement property that was acquired and placed in service between September 28, 2017, and December 31, 2017, 100% first-year bonus depreciation was allowed.
For property placed in service after 2017, due to an oversight in drafting the TCJA, real estate qualified improvement property was not included in the list of 15-year property — even though Congress intended for such property to have a 15-year depreciation period.
Real estate qualified improvement property is defined as any improvement to an interior portion of a nonresidential building that's placed in service after the date the building is first placed in service — except for any expenditure attributable to the enlargement of the building, any elevator or escalator, or the building's internal structural framework.
The intended 15-year depreciation period for such qualified improvement property is reflected in the Conference Committee explanation of the TCJA. Therefore, it's possible that Congress could fix this legislative glitch in technical corrections legislation.
A fix, if enacted, would make qualified improvement property placed in service after 2017 eligible for bonus depreciation, because it would then have a 15-year depreciation period.
Until the fix is passed into law, however, qualified improvement property placed in service after 2017 is generally assigned the 39-year depreciation period that applies to nonresidential building improvements. To summarize, as the law currently reads, real estate qualified improvement property is noteligible for bonus depreciation.
Important: With the Democrats taking control of the House in January, any technical corrections bill will require bipartisan support to be enacted.
Section 179 Deduction Rules
The TCJA permanently increases the maximum Section 179 deduction to $1 million (up from $510,000 for tax years beginning in 2017) for qualifying property placed in service in tax years beginning after 2017. The Sec. 179 deduction phaseout threshold has also been increased to $2.5 million (up from $2.03 million for tax years beginning in 2017). For post-2018 years, these amounts will be adjusted for inflation. The inflation-adjusted amounts for tax years beginning in 2019 are $1.02 million and $2.55 million, respectively.
As under prior law, you can claim Sec. 179 deductions for qualifying real property expenditures, up to the maximum annual Sec. 179 deduction allowance ($1 million for tax years beginning in 2018). There's no separate limit for real property expenditures, so claiming Sec. 179 deductions for real property reduces the maximum annual allowance dollar for dollar.
Qualifying real property expenditures include any improvement to an interior portion of a nonresidential building that's placed in service after the date the building is placed in service — except for any expenditure attributable to the enlargement of the building, any elevator or escalator, or the building's internal structural framework.
There's an important change under the TCJA: The definition of qualifying real property for Sec. 179 deduction purposes has been expanded to include expenditures for:
To qualify, these items must be placed in service in a nonresidential building for tax years beginning after 2017 and after the building has been placed in service.
Personal Property Used in Lodging
For property placed in service in tax years beginning after 2017, the TCJA allows taxpayers to claim Sec. 179 deductions for personal property used predominantly to furnish lodging or in connection with the furnishing of lodging. These items didn't qualify for Sec. 179 deductions under prior law. Examples of such property include:
This list isn't exhaustive. Other equipment used in the living quarters of a lodging facility and other personal property used in a lodging facility also may qualify. Lodging facilities may include hotels, motels, apartment houses, dormitories, rental condos, rental single-family homes, and any other facility (or part of a facility) where sleeping accommodations are provided and rented out.
When considering the expanded first-year real estate depreciation breaks provided by the TCJA, there are three possible downsides to watch out for.
1. The business taxable income limitation. Sec. 179 deductions can't create or increase an overall tax loss from your business activities, including rental real estate. So you may need to generate more business taxable income to take full advantage of the Sec. 179 deduction privilege. This issue is trickier if your business is structured as an S corporation, a partnership or a limited liability company that's treated as a partnership for tax purposes. That's because the business taxable income limitation applies at both the entity level and your personal level.
2. Depreciation recapture on gains from sales. There's a potentially significant downside to claiming bonus depreciation and/or Sec. 179 deductions for real property that you later sell for a taxable gain. Any gain up to the amount of the bonus depreciation and/or Sec. 179 deductions will be treated as "depreciation recapture" that's taxed at higher ordinary-income rates. Federal ordinary-income tax rates are as high as 37% for 2018 through 2025. In addition, the 3.8% net investment income tax may apply to higher-income taxpayers.
In contrast, if you depreciate commercial real property over the normal 39-year period or residential real property over the normal 27-1/2-year period, the maximum federal income tax rate on gain attributable to depreciation (the so-called "unrecaptured Section 1250 gain") is 25% (plus the 3.8% net investment income tax if applicable). If you don't expect to sell a property for many years, depreciation recapture is less problematic, however.
3. A negative side effect on QBI deductions. The new deduction for up to 20% of qualified business income (QBI) from pass-through entities (including sole proprietorships) can't exceed 20% of your taxable income calculated before any QBI deduction and before any net capital gain (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
Because bonus depreciation and Sec. 179 deductions reduce your taxable income and QBI, these tax breaks can potentially reduce your allowable QBI deduction. Depreciation breaks are just a matter of timing; the total deductions stay the same over the life of the asset. But the QBI deduction is a use-it-or-lose-it tax break that will expire at the end of 2025 unless Congress extends it, so you should take every opportunity to maximize it.
For More Information
The TCJA expands the federal income tax first-year depreciation breaks available to real estate owners. But there's still uncertainty about the availability of bonus depreciation for real estate qualified improvement property, along with a handful of potential pitfalls to consider. Work with your Ross Hughes & Associates, CPAs, PLLC or your tax advisor to identify the optimal overall tax planning strategy for your specific situation.
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Depreciation is a reduction in the value of an asset over time resulting from wear and tear, deterioration or obsolescence. The tax law acknowledges depreciation by allowing taxpayers to take deductions over a period of years. The number of years over which the property can be depreciated depends on the category into which it falls under the Modified Accelerated Cost Recovery System (MACRS),...