Alternative Tax Strategies for the Qualified Improvement Property “Glitch”|
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The road to tax reform was paved with good intentions. The Tax Cuts and Jobs Act (TCJA) produced the most sweeping tax law changes in more than 30 years, and yet it was passed just 51 days after it was introduced. However, rushed tax reform is bound to be messy. Such is the case with the so-called “retail glitch,” a tax reform typo that is proving costly to real estate, retail and restaurant investors looking for improvement property write-offs.
Under pre-Trump tax law, real estate owners could take accelerated depreciation deductions and bonus depreciation on certain interior building improvements, including qualified leasehold, restaurant and retail improvements. The Tax Cuts and Jobs Act aimed to simplify these rules by combining categories of building improvement — leasehold, restaurant and retail improvement property —into a single category of “qualified improvement property” (QIP).
Expanded access to “100 percent bonus depreciation” was a key provision of tax reform intended to encourage business investment by allowing businesses to immediately deduct the cost of short-lived investments. But in the rush to pass the new tax reform bill, Congress inadvertently excluded qualified improvement property investment from 100 percent bonus depreciation by failing to assign it an accelerated recovery period.
The Senate intended to assign a 10-year recovery period to qualified improvement property, but during negotiations with the House, it was changed to a 15-year recovery period. When the final bill was drafted, the 10-year language from the Senate amendment was removed, but the new 15-year language was accidentally left out. As the tax law is currently — and all agree, incorrectly — written, improvement property investments face an even higher tax burden than before tax reform.
“The result leaves the newly defined QIP category without an assigned recovery period, while the alternative recovery period definition references a 10-year period provision that does not exist in the final law,” writes Erica York, an Economist with the Center for Federal Tax Policy at Tax Foundation. “What this means for QIP is that without an assigned recovery period, QIP will in most cases be treated as nonresidential real property with a 39-year recovery period (and 40-year alternative recovery period) — making QIP ineligible for 100 percent bonus depreciation.”
Impact on Investment
Industry groups including National Retail Federation (NRF), the National Restaurant Association (NRA) and Building Owners and Managers Association (BOMA), immediately sounded the alarm and began lobbying lawmakers to “fix the glitch.” Industry experts warned that retailers, restaurants, real estate and construction companies would delay investments, triggering an economic ripple effect for manufacturers and service providers.
The mishandling of QIP directly affects cash flow for investors who are not able to fully recover the cost of their investments when they are placed in service. Instead, they must deduct their investment over 39 years — effectively reducing the overall rate of return on improvement property investments.
The industry organization Building Owners and Managers Association International (BOMA) lists a QIP fix among its top three 2019 Federal Legislative Priorities.
“As building owners negotiate leases with tenants, QIP is considered while determining tenant improvement dollars. Those dollars bring in building trades such as painters, carpenters, plumbers and electricians. With less money for tenant improvements, local jobs will suffer,” according to BOMA.
What Investors Can Do Today
Businesses that made improvement property investments after 2017 or are considering making investments in the near future have several options.
Option #1: Wait and See
Anyone who filed a 2018 tax extension has until the extended due date (Sept. 15, 2019 for partnerships and s-corporations and Oct. 15, 2019 for individuals and c-corporations) to hope Congress gets its act together and passes the Restoring Investment in Improvements Act, which would fix the “retail glitch.” Bipartisan companion bills introduced in House and Senate in March 2019 are still in committees (the earliest stage of the legislative process).
If one of the bills makes its way to President Trump’s desk before the tax filing deadline, the 15-year schedule for Qualified Improvement Property (QIP) would be restored and improvements would become eligible for immediate expensing, as was intended under the TCJA.
Option #2: Section 179
Also part of tax reform, TCJA increased the Section 179 maximum deduction from $500,000 to $1 million and expanded the definition of Section 179 property. It also increased the phase-out threshold from $2 million to $2.5 million. After 2018, these amounts will be adjusted for inflation.
The new law also expands the definition of Section 179 property to include:
- Qualified improvement property
- Roofs, HVAC, fire protection systems, alarm systems and security systems for nonresidential properties
These changes apply to property placed in service in taxable years beginning after Dec. 31, 2017.
Many improvement property investments will qualify under Section 179, but there are exceptions. First, in order to take the Section 179 deduction, the taxpayer must have taxable income and may not show a taxable loss. Second, not all taxpayers are eligible to take Section 179. Trusts, for example, cannot use this deduction. Third, not all states allow the federal Section 179 deduction, and other states have put limitations on the deduction. For example, Georgia generally allows for the Section 179 deduction, but not for all of the real property described above.
If a legislative fix does not get passed by the 2018 extended due date, some property owners may want to take Section 179, but be aware that it’s an irrevocable election. That means you can’t undo it if a bonus depreciation fix comes through.
Option #3: Cost Segregation
In cases where Section 179 doesn’t cover all QIP assets, a cost segregation study could reclassify some costs — effectively shifting depreciation of assets from longer-lived (39-years) to shorter-lived (3, 5, 7 or 15 years) categories for depreciation purposes. With the implementation of 100 percent bonus depreciation, the potential value of conducting a cost segregation study has increased greatly. While a technical correction of the law would be preferential, cost segregation studies are a good alternative.
It’s Decision Time
With the 2018 extended tax filing deadline coming fast and the real estate market as hot as ever, investors are facing some difficult decisions and no shortage of uncertainty. If you think you may be impacted by this tax legislation, talk to your tax advisor to discuss which tax strategy is right for you.