Taxpayers who own real property used in their business or rent real property to tenants, whether residential or commercial, often incur costs that can be immediately written off or capitalized and depreciated over the useful life of the capitalized asset. With the 2013 issuance of final tangible property regulations (repair regs) and other IRS guidance, determining what to immediately write off and what to capitalize for tax purposes can be challenging.
Additional IRS guidance issued in previous years supplements the repair regs in several ways. Read Part I of this series for additional information on those changes.
The repair regs provide tax opportunities to write off costs previously required to be capitalized, require certain costs to be capitalized and depreciated over the useful life of an asset and clarify the definition of a unit of property (UOP). Part I covered some questions to ask yourself when applying the repair regs and additional IRS guidance for a business that owns or rents real property. Here are some additional items to consider.
1. What qualified leasehold improvements did I make during the year?
The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) retroactively extended and made permanent the favorable 15-year recovery period for qualified leasehold improvements (QLI). The IRS defines a QLI as any improvement to an interior part of a building that is nonresidential real property, if all of the following requirements are met:
- The improvement is made under or according to a lease by the lessee/sublessee or lessor of that part of the building (a lease between related persons, defined later, isn’t treated as a lease)
- That part of the building is to be exclusively occupied by the lessee/sublessee of that part
- The improvement is placed in service more than three years after the date the building was first placed in service
- The improvement is Section 1250 property
However, a QLI doesn’t include any improvement for which the expenditure is attributable to any of the following:
- The enlargement of the building
- Any elevator or escalator
- Any structural component benefiting a common area
- The internal structural framework of the building
2. What land improvements did I make during the year?
While a parcel of land usually isn’t a depreciable asset, improvements to that parcel generally are. Examples of land improvements include parking lots, walkways, drainage and irrigation systems, fencing, landscaping, swimming pools, wharves, docks or bridges.
The costs to modify a parcel of land for its intended use are capitalized to the land parcel and are nondepreciable assets. Examples of such costs include demolition of an old building and clearing and leveling of the parcel.
3. Should any lease costs be capitalized due to new tenant leases in the current year?
Costs associated with a tenant lease should be capitalized in the year the costs are incurred; the costs then are amortized over the life of the lease. Examples of such costs include lease commissions, legal fees and any other fees associated with the lease.
4. Should any QLIs or lease costs capitalized in previous years be written off due to tenants moving out in the current year?
When a tenant lease expires or is cancelled and the tenant moves out during the year, the capitalized QLIs and lease costs associated with the lease can generally be disposed of in that same year. The taxpayer will report a loss equal to the adjusted tax basis of each asset disposed of in this manner. One exception is if a QLI still is being used in the taxpayer’s business; in this case, the QLI won’t be written off upon the expiration or cancellation of the lease and will continue to be depreciated through its useful life.
5. Should expenditures to remodel or refresh a restaurant/retail building be immediately deducted or capitalized and depreciated?
IRS regulations require taxpayers operating a restaurant or retail establishment to apply additional analysis to their remodel-refresh projects to determine which costs must be capitalized as direct and indirect costs of producing property used in their trade or business.
The IRS recently implemented a safe harbor method for determining the portion of remodel-refresh costs that must be either deducted or capitalized. This safe harbor method is intended to simplify the additional analysis necessary and eliminate the need to apply the additional analysis to each UOP. This means the safe harbor method is applied to the entire building rather than each building component.
Although the safe harbor method now is available to taxpayers, a CPA can be helpful, since the new method requires understanding of IRS regulations and latest tax law changes.
6. Are any current-year fixed asset additions eligible for the Section 179 deduction?
Per the IRS, property must be tangible personal property, off-the-shelf computer software or qualified real property to qualify for the Internal Revenue Code Section 179 deduction. To qualify, the property must have been acquired by a taxpayer other than an estate or trust for use in a trade or business. Property acquired only for the production of income, e.g., investment property, rental property (if renting property isn’t your trade or business) and property that produces royalties, doesn’t qualify. In addition, the property must have been acquired by purchase. For example, property acquired by gift or inheritance doesn’t qualify.
In general, the total amount a taxpayer can elect as Section 179 expenses for property placed in service during a single tax year cannot exceed $500,000. For tax year 2015, up to $250,000 of the $500,000 expensing limit may consist of qualified real property, generally defined as qualified leasehold improvement property (see Question 8). For tax years beginning after December 31, 2015, the PATH Act makes expensing of qualified real property permanent; in addition, the entire Section 179 expense can consist of qualifying real property.
If the cost of all qualifying Section 179 property placed in service during a tax year is greater than $2 million, the taxpayer generally must reduce the dollar limit (but not below zero) by the amount of cost above $2 million. If the cost of the Section 179 property placed in service is $2.5 million or more, a Section 179 deduction cannot be taken.
7. Are any current-year fixed asset additions eligible for bonus depreciation?
Per the IRS, a taxpayer could take a special depreciation allowance (bonus depreciation) to recover part of the cost of qualified property placed in service during 2014. The allowance applied only for the first year the property was placed in service. For qualified property placed in service in 2014, a taxpayer could depreciate an additional 50 percent, taken as an additional deduction after any Section 179 deduction and before calculating regular depreciation under the Modified Accelerated Cost Recovery System for the first year. The 50 percent bonus depreciation has been extended through 2017; for 2018 and 2019, it’s reduced to 40 percent and 30 percent, respectively.
For purposes of claiming bonus depreciation on real property improvements, the PATH Act eliminates the “qualified leasehold improvement property” classification for tax years beginning after December 31, 2015. The classification is replaced by a new classification called “qualified improvement property” (QIP).
QIP is any improvement to an interior portion of a building that is nonresidential real property if the improvement is placed in service after the date the building was first placed in service. However, QIP doesn’t include any improvement for which the expenditure is attributable to any of the following:
- The enlargement of the building
- Any elevator or escalator
- The building’s internal structural framework
The new classification treats building improvements as qualified property without regard to whether the improvements are property subject to a lease; it also removes the requirement that the improvement be placed in service more than three years after the date the building was first placed in service. In addition, there’s no longer an exclusion of structural building components that benefit a common area.
If you need more information about how to answer these questions, or if you need to know more about the repair regulations, please contact your BKD advisor.