By Darden Bell, Senior Tax Manager | Real Estate & Construction Industry Team
The CARES Act Correction to Qualified Improvement Property: Considerations for Commercial Real Estate Holders
With the passage of the CARES Act, a major drafting error of the Tax Cuts and Jobs Act relating to Qualified Improvement Property (QIP) was corrected. Qualified Improvement Property consists of “any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service.” The error in the TCJA was failing to classify QIP as 15-year property under MACRS (20-year property under the Alternative Depreciation System (ADS)). That error prevented commercial property holders from taking 100 percent bonus depreciation on QIP assets, and it forced taxpayers to depreciate those assets over 39 years under MACRS (40 years under ADS). The CARES Act corrected that drafting error to now classify QIP as 15-year property under MACRS (20-year property under ADS) and makes that classification retroactive to January 1, 2018. That correction also allows taxpayers to take 100 percent bonus depreciation on QIP assets if they depreciate property under MACRS methods, also retroactive to January 1, 2018.
Real Property Trade or Business Election Considerations
While many taxpayers and tax professionals lauded this change as a major win for commercial real property holders, it may not be quite as beneficial as some may have initially thought. There is no denying this change is a taxpayer-favorable change, but many taxpayers may not be able to fully take advantage of the change. Taxpayers who are nonresidential property holders must still consider the impact of the business interest limitations of Code Section 163(j) and the positions taken on their 2018 and already filed 2019 tax returns. Many nonresidential property holders highly leverage their properties, which generates substantial interest expense each year, even in an interest-rate friendly environment. The TCJA implemented a new limitation on the deductibility of interest expense up to 30 percent of adjusted taxable income (ATI) for all businesses. The TCJA provided real estate businesses an opportunity to elect out of those interest limitations so they could deduct 100 percent of their interest expense, but it came at a cost of having to depreciate all real property assets under ADS instead of MACRS. Real property assets include QIP assets. Depreciating real property under ADS also meant they were ineligible for bonus depreciation. At the time, not being able to use bonus depreciation wasn’t very impactful since QIP had already been ineligible for bonus due to the original classification error. Therefore, on 2018 returns and 2019 returns filed before the CARES Act was passed, there was very little downside for commercial property holders to make the Real Property Trade or Business (RPTB) election since it meant adding only one more year to the life over which to depreciate their real property assets. For that reason, many commercial property taxpayers made the RPTB election so they could deduct 100 percent of their interest expense without losing much depreciation expense. The RPTB election is a one-time election, and originally, it was irrevocable.
For taxpayers who made the RPTB election on their 2018 returns or already filed 2019 returns, they originally prevented themselves from being able to take advantage of the new QIP correction that came with the CARES Act. Subsequent to the passage of the CARES Act, Treasury issued guidance allowing taxpayers to remove previously made RPTB election so they could take advantage of the QIP changes. In order to remove the previously made RPTB election, taxpayers must file amended returns for the year in which the election was made, and any subsequent years impacted by the changes – possibly 2018 and 2019. Taxpayers cannot remove the RPTB election by filing a change of accounting method on Form 3115. However, if no RPTB election is in place, taxpayers can take advantage of the QIP changes by filing a change of accounting method on Form 3115 to catch up all the depreciation they could have claimed since January 1, 2018.
If a RPTB election has been made, taxpayers and their tax advisors need to consider whether making a change is truly more beneficial. The limitations on interest expense still apply if a RPTB election is not in place or if it is removed. The CARES Act did increase the threshold for the deductibility of interest to 50 percent of ATI, but that change doesn’t go into effect for partnerships until 2020. Real estate is most commonly held in partnership form, so many real property owners are still facing the 30 percent ATI threshold for any 2018 and 2019 decisions. Because real property is often highly leveraged, being able to fully deduct interest still may be more beneficial than being able to claim bonus depreciation on QIP assets. For taxpayers who determine deducting interest is still more beneficial, the QIP changes still provide some benefit. The CARES Act shortened the life over which QIP assets are depreciated under ADS, which is mandatory when the RPTB election is in place, to 20 years instead of 40 years. So even though bonus depreciation cannot be claimed, QIP assets can now be depreciated twice as fact as they were under the Tax Cuts and Jobs Act of 2017. In order to take advantage of that shortened life, taxpayers can file a change of accounting method on Form 3115 rather than having to file amended returns.
It is unfortunate that Treasury did not allow taxpayers to modify RPTB elections by filing a change of accounting method. Change of accounting methods cannot be filed with amended returns either. So, any taxpayers who already filed 2019 returns, and wish to make changes, have to file amended returns for 2018 and 2019 or wait and file a change of accounting method with their 2020 tax returns. By forcing taxpayers to file amended returns for 2018 and 2019 to obtain those benefits, it places more administrative burden on taxpayers and investors who would then also have to file amended returns of their own for those years. For that reason, many taxpayers are foregoing filing amended returns and are choosing to delay the benefit of these changes to 2020 tax returns.
Change in Qualified Improvement Property Classification Summary
In conclusion, while some taxpayers may receive a large windfall from the change in QIP classification, there will be many who will only receive a small benefit from the change due to their preference to fully deduct interest expense. The potential administrative burden also poses a hurdle that taxpayers must consider in their decision-making process as well. Every taxpayer’s situation is different, and the factors of each situation will dictate the most beneficial path to take.
Additional Real Estate & Construction Resources
- Section 199A and the Rental Real Estate Safe Harbor
- Take Advantage of Virginia Real Property Investment Grants
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.