This may be the last year that a unique combination of tax breaks is available for three categories of real estate assets: qualified leasehold improvement property; qualified restaurant property; and qualified retail improvement property. Taxpayers who are contemplating such improvements, or who are in the process of making them, should, if possible, accelerate their plans and make sure the assets are placed in service before 2014. This way, they won’t lose out on qualified real property expensing, 50% bonus first-year depreciation, and a quick, 15-year depreciation period for that part of the cost that isn’t expensed or eligible for 50% first-year bonus depreciation.
Qualified Real Property Expensing—A Unique but Temporary Tax Break
Historically, Code Sec. 179 expensing has been available only for tangible personal property, but there’s a limited-time-only exception for certain types of real property. Specifically, for any tax year beginning in 2010, 2011, 2012, or 2013, a taxpayer may elect to treat up to $250,000 of qualified real property as Code Sec. 179 property. Otherwise eligible property placed in service in tax years beginning after 2013 won’t be eligible for this tax break, unless Congress acts to extend it.
What is qualified real property for expensing purposes?
Qualified real property is:
- qualified leasehold improvement property
- qualified restaurant property
- qualified retail improvement property
The qualified property must be depreciable, acquired for use in the active conduct of a trade or business, and can’t be certain ineligible property (i.e., used for lodging, used outside the U.S., used by governmental units, foreign persons or entities, and certain tax-exempt organizations, air conditioning or heating units).
A number of assets installed in commercial buildings are personal property depreciable over five or seven years under MACRS. As a result, these assets are subject to the general expensing rules for personal property, rather than the more-restrictive rules for qualified real property. Shorter-lived assets also are potentially eligible for the bonus first-year depreciation allowance if bought and placed in service this year.
What is qualified leasehold improvement property?
Qualified leasehold improvement property is an interior building improvement that qualifies for bonus first-year depreciation, except that if a lessor makes an improvement that is a qualified leasehold improvement, it can’t be qualified leasehold improvement property to any subsequent owner, subject to exceptions for nonrecognition and death transfers.
In general, qualified leasehold improvement property includes interior improvements to a building if:
- (1) The improvement is Code Sec. 1250 property
- The improvement is made “under or pursuant to a lease”, either by the lessee, sublessee or lessor of the building portion
- The portion of the building is to be occupied exclusively by the lessee (or any sublessee) of the portion
- The improvement is placed in service more than three years after the date the building was first placed in service
The Code doesn’t define what types of building improvements are eligible to be treated as qualified leasehold improvement property. Rather, it lists the types of property that can’t be so treated. Qualified leasehold improvement property does not include any improvement for which the expense is attributable to:
… the enlargement of the building,… any elevator or escalator,… any structural component benefiting a common area, and… the internal structural framework of the building.
What kinds of improvements are qualified leasehold improvements after eliminating those that are ineligible? The following types of improvements would appear to qualify, if they benefit the tenant’s space only rather than a common area:
- electrical or plumbing systems (including a sprinkler system);
- permanently installed lighting fixtures;
- ceilings and doors; and
- non-load-bearing walls.
All of these assets, to the extent they aren’t eligible for five or seven year depreciation, generally are treated as structural components of a building for depreciation purposes, but none of them is part of the internal structural framework of a building, a term defined by the investment tax credit regs to include all load-bearing internal walls and any other internal structural supports, including the columns, girders, beams, trusses, spandrels, and all other members that are essential to the stability of the building.
What is qualified restaurant property?
Property is qualified restaurant property if it is any Code Sec. 1250 property which is a building or an improvement to a building, if more than 50% of the building’s square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals.
What is qualified retail improvement property?
Qualified retail improvement property is any improvement to an interior portion of a building that is nonresidential real property if:
- that portion is open to the general public and is used in the retail trade or business of selling tangible personal property to the general public, and
- the improvement is placed in service more than three years after the date the building was first placed in service.
An improvement made by the owner of that improvement will be qualified retail improvement property, if at all, only so long as the improvement is held by that owner.
Qualified retail improvement property does not include any improvement for which the expenditure is attributable to the enlargement of the building, any elevator or escalator, any structural component benefitting a common area, or the internal structural framework of the building.
The Joint Committee on Taxation (JCT) has provided specific guidance on what will and won’t be treated as qualified retail improvement property. It says retail establishments that qualify for the 15-year recovery period include those primarily engaged in the sale of goods, such as grocery stores, clothing stores, hardware stores, and convenience stores. However, establishments primarily engaged in providing services, such as professional services, financial services, personal services, health services, and entertainment, aren’t qualified retail improvement property. The JCT adds that “it is generally intended” that businesses defined as a store retailer under the North American Industry Classification System (NAICS) will qualify while those in other industry classes won’t.
Two elections and two dollar limits.
To use the expensing break for qualified real property, the taxpayer must make what is effectively an election within an election. He must first elect under Code Sec. 179 to treat the cost of the property as not chargeable to capital account. Second, he must elect under Code Sec. 179(f) to treat qualified real property as Code Sec. 179 property. There also are two dollar limitations at play: the overall $500,000 per-tax-year limitation (for 2010, 2011, 2012 and 2013) on the expense deduction, and the $250,000 per-tax-year limitation on the aggregate cost of qualified real property that may be treated as Code Sec. 179 property for 2010, 2011, 2012, and 2013.
Additionally, the reduction in the overall $500,000 limitation on expensing starts to take effect when property placed in service in a tax year exceeds $2,000,000 (beginning-of-phaseout amount).
Before making the election to treat qualified real property as Code Sec. 179 property, taxpayers should consider: (1) whether the election will either (A) cause the total cost of their Code Sec. 179 property placed in service in the tax year to exceed $2,000,000 or (B) increase the extent to which the total cost of such property placed in service in the tax year exceeds $2,000,000; and (2) the extent, if any, that the increases will affect the availability of expensing deductions for Code Sec. 179 property other than qualified real property. This is so because, for tax years beginning in 2010, 2011, 2012, and 2013, $2,000,000 is the amount above which placing Code Sec. 179 property into service causes the annual $500,000 limitation amount on the expensing deduction, in effect for tax years beginning in 2010 through 2013, to be reduced on a dollar-for-dollar basis,
Example: Earlier this year, Eatery, a calendar-year restaurant chain, placed $500,000 of five-year MACRS property in service, and before the end of the year it places in service $2,000,000 of qualified real property consisting of qualified restaurant property. If it makes the Code Sec. 179(f) election to expense qualified real property, it will effectively wipe out its entire Code Sec. 179 deduction ($500,000 expensing limit – ($2,500,000 total Code Sec. 179 property − $2,000,000 beginning-of-phaseout amount) = zero). If it does not make the Code Sec. 179(f) election, Eatery can expense the full $500,000 of five-year MACRS property placed in service earlier this year (if it has enough taxable income) since the total amount of Code Sec. 179 property won’t exceed the $2,000,000 beginning-of-phaseout amount.
Taxpayers can change their minds (e.g., because an election turns out to be disadvantageous). Taxpayers may revoke a Code Sec. 179 election made before 2014 without IRS consent.
Special carryover rules.
Not withstanding the general carryover rule for expensing deductions, no amount attributable to qualified real property can be carried over to a tax year beginning after 2013.
Thus, there is no carryover for an unused expensing deduction for qualified real property placed in service in 2013.
To the extent that any amount is not allowed to be carried over to a tax year beginning after 2013 due to the qualified real property carryover limit, the Code is applied as if no Code Sec. 179 expensing election had been made for that amount.
First-Year Bonus Depreciation Allowance for Qualified Leasehold Improvement Property
A 50% bonus first-year depreciation allowance applies to qualified property acquired and placed in service after Dec. 31, 2011, and before Jan. 1, 2014 (before Jan. 1, 2015 for certain specialized property). To be qualified property, an asset must, among other conditions, fall into one of several categories, one of which is MACRS property with a recovery period of 20 years or less, and another is qualified leasehold improvement property, as defined earlier in this article.
At first glance, qualified restaurant property and qualified retail improvement property would seem to qualify for 50% bonus first year depreciation, if timely acquired and placed in service, since these assets have a 15-year recovery (see discussion below). But hopes for claiming a first-year bonus write off for such properties are seemingly dashed, which specifically provide that qualified restaurant property and qualified retail improvement property are not treated as qualified property for purposes of the bonus depreciation rules in Code Sec. 168(k) and thus aren’t eligible for the 50% bonus first-year depreciation allowance.
Treating “dual character” property as qualified leasehold improvement property. Despite what appears to be a hard and fast bar, 50% bonus first-year writeoffs are permitted for “dual character property,” namely, property that falls within the statutory definition of qualified restaurant property or qualified retail improvement property, and the statutory definition of qualified leasehold improvement property.
Example: In 2013, a calendar-year owner of a 40-year-old building that’s leased to a restaurant makes an improvement that meets the definition of both qualified restaurant property and qualified leasehold improvement property. The owner can claim a 50% bonus first-year depreciation allowance for the improvement, assuming all other statutory requirements are met.
Quicker Recovery Period for Three Types of Real Estate Assets
As a general rule, the Code prescribes a super-long, 39-year recovery via straight line depreciation for nonresidential real property. However, the recovery period temporarily is cut to a relatively short 15 years for:
- any qualified leasehold improvement property placed in service before Jan. 1, 2014 ;
- any qualified restaurant property placed in service before Jan. 1, 2014; and
- any qualified retail improvement property placed in service after Dec. 31, 2008, and before Jan. 1, 2014.
Taxpayers in the process of making such improvements should, if at all possible, make sure they are placed in service before 2014, to avoid the longer recovery period that will apply next year unless Congress acts to extend the “temporary” 15-year writeoff.
If you have any questions regarding the depreciation options of real property and how they apply to your overall tax strategy, please do not hesitate to contact us.