Most tax practitioners and real estate investors are aware of the depreciation-related changes to the Tax Code in recent years. However, because of the rapid changes to these rules, many people are less aware of the interactions between these provisions. In the last few years, bonus depreciation, qualified improvement property, 179 expensing and 1031 exchange rules have all been updated. In late 2019, Congress also retroactively extended 179D, the energy efficient building deduction. These interactions can be positive or negative, so careful scrutiny is important.
To illustrate, let’s first consider a positive interaction. A lot of discussion has centered over the new 1031 provisions and the requirement that only “real property” qualifies for 1031 treatment. The treatment of qualified improvement property (QIP) becomes critical in a 1031 transaction. While “personal property” may be limited, QIP is “any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property.” Based on this definition, QIP can, in most cases, be included in a 1031 transaction. This means a taxpayer can take bonus depreciation on QIP from a renovation and then sell the property and defer gains through a 1031 exchange. These savings can add up quickly for investors in office buildings or other properties that have large expenditures in tenant improvements that could be QIP eligible.
QIP can also have negative implications. Take a renovation to a historic property eligible for historic tax credits of 20 percent. Based on the definition of QIP, most historic tax credit projects also contain a significant amount of QIP-eligible property. However, the basis for this credit is calculated on the depreciable basis after considering bonus depreciation. A taxpayer cannot take both bonus depreciation and a historic tax credit on the same expenditure. This means historic tax credit projects will typically want to elect out of bonus on QIP assets. While they will not be able to take bonus depreciation, they can still take advantage of the 15-year life provided to QIP. This will be critical for tax professionals to understand as they are amending returns to take advantage of the QIP changes under the CARES Act.
The above interactions are based on the interplay of provisions in the CARES Act and the Tax Cuts and Jobs Act of 2017. Recent extenders have created other interactions as well. In late 2019, Congress retroactively extended 179D, the energy efficient building deduction. This provides taxpayers with a deduction of up to $1.80 per square foot for the installation of energy efficient improvements to buildings.
The most common improvements to trigger a 179D analysis are upgrades to HVAC and lighting. However, taxpayers need to keep in mind that HVAC upgrades to existing buildings are eligible for 179 treatment. Additionally, lighting upgrades are often eligible for QIP, which is eligible for bonus depreciation. Taxpayers need to make sure they are not eligible for one of these provisions before paying for a 179D analysis.
These are just a few of the interactions that now exist under these new provisions. They illustrate the importance of understanding the full picture of a real estate project when discussing tax-planning opportunities such as cost segregation, bonus depreciation and 179D. While these studies can often lead to large tax savings, maximizing their full value requires a complete understanding of the project. Taxpayers should confer with their CPA to ensure they realize all the potential savings.
