With the passage of the PATH Act of 2015, Congress extended or made permanent many tax benefits that were set to expire. This included extending “bonus depreciation” for qualifying property through 2019. Under the new rules, bonus depreciation is now available for the 2016 and 2017 tax years at a rate of 50%, for the 2018 tax year at 40%, and for the 2019 tax year at 30%.
Of particular interest to real estate companies, the PATH Act created a new category of property that is eligible for bonus depreciation. Effective January 1, 2016, “Qualified Improvement Property” is now eligible for bonus depreciation.
Qualified Improvement Property (“QIP”) is defined as any improvement to an interior portion of a non-residential building if such improvement is placed in service after the date the building was first placed in service. However, QIP does not include expenditures for the enlargement of a building (i.e., expansions/additions), elevators and escalators, or the internal structural framework of the building. Examples of qualifying items include flooring, ceilings, lighting, drywall, etc. While the PATH Act establishes QIP as being eligible for bonus depreciation, it does not require a specific recovery period for tax purposes (i.e., 15 year). Therefore, taxpayers can now take bonus depreciation on QIP even if the underlying asset is considered a 39-year asset.
The new QIP rules represent an additional category of “qualifying” property, beyond the traditional rules regarding qualified leasehold improvements (“QLI”), qualified restaurant property, and qualified retail improvement property. While those traditional rules remain intact under the PATH Act, the QIP standards are far broader and allow many more expenditures to qualify for bonus depreciation. For example, qualification for QIP does not require that a lease be in place or that the building be at least 3 years old; nor does it require the landlord/tenant to be unrelated parties. These are all requirements for QLI qualification. Prior to the PATH Act being passed, many taxpayers were required to depreciate improvements over 39 years and were not permitted to take bonus depreciation on those items, because they did not meet the qualifications for QLI (or other qualifying property).
For example, in 2014 Taxpayer A spends $500,000 to improve the interior of her facility and does not improve the elevators, escalators, or internal structural framework. Because Taxpayer A owns 100% of the building as well as 100% of the operating company using the building, she is not eligible to treat these costs as Qualified Leasehold Improvements. Therefore, the $500,000 would have to be treated as 39-year property and would not be bonus eligible (ignoring potential repair treatment and cost segregation of the $500,000). Taxpayer A would only be able to deduct 1/39th (roughly $12,820) of the cost each year over the next 39 years.
If Taxpayer A performed those same improvements in 2016, the new QIP rules would kick in and Taxpayer A would be able to deduct $250,000 in bonus depreciation in year one, plus 1/39th (roughly $6,410) of the remaining cost each year over the next 39 years. The impact on Taxpayer A’s 2016 taxable income and cash flow would be tremendous and allow her to take advantage of the time value of money.
Given this dramatic difference in tax treatment, many owners/developers are thinking strategically about new projects. Some are finding it is more advantageous to buy an existing facility and remodel it as opposed to constructing a new facility.
The example below illustrates this benefit:
Owner A builds a new facility at a cost of $5M. After performing a cost segregation study, Owner A determines the costs break down as follows:
- 39-year – $3,750,000
- 15-year – $500,000
- 5-year – $750,000
Under this scenario, only the 15-year and 5-year property would be eligible for bonus depreciation because this was a newly constructed building (and therefore not eligible for QIP), and the first year depreciation would be approximately $741,827.
Owner B purchases a $1M existing facility and immediately performs $4M of improvements. After performing a cost segregation study, Owner B determines the costs break down as follows:
- Building Purchase ($1M)
- 39-year – $750,000
- 15-year – $100,000
- 5-year – $150,000
- Building Remodel ($4M)
- 39-year – $1,500,000
- 39-year QIP – $1,500,000
- 5-year – $1,000,000
All of the 15-year and 5-year property would be eligible for bonus depreciation, in addition to the 39-year QIP, so the first year depreciation deduction for Owner B would be approximately $1,524,808, more than double the first year depreciation for Owner A.
This example illustrates the dramatic impact the new QIP rules can have on a building project. By purchasing an existing facility and renovating it instead of constructing a new building, Owner B was able to double their first-year depreciation deduction and dramatically accelerate the return-on-investment for their project.
Given that bonus depreciation is available through 2019, but expires after that year, construction and real estate firms should consider the new Qualified Improvement Property rules strategically as they plan for their upcoming projects. In addition to the traditional benefits of cost segregation, the new QIP rules reinforce the importance of having a qualified cost segregation study performed on new construction, building acquisition, and building remodel projects. As illustrated above, the benefits resulting from these studies can be substantial.