The Tax Cuts and Jobs Act (TCJA) expanded the definition of qualified property for immediate expensing under Section 179 to include certain improvements for nonresidential buildings. Internal Revenue Code section 179(f)(2) identifies costs for roofing, fire protection, alarm systems, security systems and HVAC property as being eligible for Section 179 expensing if the new improvement is placed in service after the date the nonresidential real property was placed in service. The TCJA also increased the maximum amount of Section 179 expense from $500,000 to $1 million and increased the phaseout from $2 million to $2.5 million. Not all taxpayers are eligible to take Section 179, and the benefit is still limited to the amount of the taxpayer’s business income (any unused amounts are carried forward to a future period). However, the new definition of property that qualifies for immediate expensing under Section 179 presents an interesting opportunity for tax planning for our clients.
First, we need to determine whether costs associated with these new components should be capitalized or expensed. Generally, a taxpayer must capitalize amounts paid to improve a unit of property. Treasury Regulation 1.263(a), Capitalization of Tangible Property, determines that property is improved if the cost of the expenditure results in a betterment, restoration or an adaptation of the unit of property. Whether a cost is considered an improvement or a repair is determined on a case-by-case basis, as the regulations do not identify a bright-line test to aid in the treatment of the cost.
If it is determined that an improvement should be capitalized, the partial disposition rule gives taxpayers some consolation. Reg. 1.168(i)-8(d) allows taxpayers to claim a loss upon the disposition of a component of a building. Prior to the passage of the Tangible Property Regulations in 2013, this “partial disposition” was not permitted. So, under the new rules, if a taxpayer installs a new roof and determines that it should be capitalized (and not expensed as a repair), they can take a deduction for the disposition of the old roof, even if the old roof is not separately stated on their fixed asset schedule. The 2013 regulations also prohibit a taxpayer from taking a repair deduction and a partial disposition deduction on the same item. So, the taxpayer described above cannot expense the new roof as a repair and dispose of the old roof. They can either expense the new roof as a repair (assuming it is not considered an improvement) or capitalize the new roof as an improvement and take a disposal deduction for the disposal of the old roof. They cannot get both benefits on the same item, which limits the available deduction.
Now that Section 179 is available for roofing, fire protection, alarm systems, security systems and HVAC systems, taxpayers may be able to get the best of both worlds. It may be more favorable for a taxpayer to capitalize costs associated with these components, take a deduction under Section 179 and take the additional deduction from the loss on the component that was disposed. This could result in the taxpayer taking a current-year deduction worth more than the amount spent on the improvement. The following examples illustrate the benefits of capitalizing costs for these components under the new tax law (these examples assume the taxpayers meet all requirements for 179 eligibility).
Example 1: Company A placed a $4.5 million nonresidential building in service on January 1, 2010. In July 2019, a significant portion of the roof had deteriorated, and the owner of Company A decided to replace the entire roof (including all decking, insulation, and flashing). The cost of the replacement is $900,000. Company A must capitalize these costs as an improvement; however, the new roof is eligible for 179 expensing and Company A can dispose of the old roof. Company A’s deduction may be calculated as follows:
Example 2: Company B updated their HVAC system to a more energy-efficient system on March 1, 2019. Assuming the new system must be capitalized, it would be eligible for 179 expensing and Company B could take a disposal deduction for the disposition of the old HVAC system. Relevant facts related to Company B’s building and their deduction are as follows:
As you can see, the new 179 expensing rules, in combination with the partial disposition rules, offer a rare opportunity for taxpayers to take a current-year deduction worth more than their cash outlay for that item. This technique can provide significant benefits to taxpayers facing taxable income. It also provides an opportunity for taxpayers to think strategically about the timing of their building improvements. Given the outlined benefits, it may be wise to plan for these types of improvements in a year where the taxpayer has taxable income. If you would like to discuss this strategy, please reach out to your CSH professional.