Tax Cuts and Jobs Act: Treatment of Qualified Improvement Property

Meghan Gardner, Manager

Depreciation is not always a word that creates a positive response.

Remember the age old saying that a vehicle starts to depreciate the minute it’s driven off the lot? Also, no one wants to find out that the house they sunk their savings into has in fact depreciated. However, when it comes to business and property acquisitions, depreciation can create some benefit.

With the Tax Cuts and Jobs Act (TCJA) came new depreciation rules that seemed simple at first glance, but the amount of benefit derived from these rules was not as straightforward as it seemed.

Whole textbooks could be written on depreciation rules and how to apply them, but one aspect has caused some frustration and confusion amid the overall positive changes made.

Prior to the TCJA, Section 168(k) accelerated depreciation (more commonly known as bonus depreciation) allowed for a 50% deduction with no dollar limitation on certain property in the year it was placed into service.

Bonus depreciation included accelerated cost recovery for qualified improvement property defined as improvements to an interior portion of nonresidential real property that were placed into service after the building itself was placed into service.

The TCJA increased the cost recovery percentage to 100% (with a percent phase out over the subsequent nine years) on new and used property.

Overall this was a positive change that created more benefit. However, the rule inadvertently left out the allowance to apply 100% cost recovery to qualified improvement property. Although many have asked for a technical correction bill, Congress has yet to pass one, and for the time being, qualified improvement property (under the current definition) must be depreciated using a straight-line method over 39 years.

Section 179 expensing, on the other hand, generally allows for 100% deduction on property in the year placed in service subject to dollar amount limitations. The TCJA expanded the definition of qualified real property under Section 179. While it previously included qualified leasehold improvement property, it now includes improvements to nonresidential real property such as roofs, HVACs, fire alarms and security systems as well.

Given these facts, a better choice may be to expense qualified improvement property under Section 179 where applicable.

The complication arises, specifically for S-corporation banks, when we look at where the income and expenses land — with the shareholders. Estates and certain trusts are not allowed to deduct Section 179 expenses. Passive shareholders must have other sources of business income in order to deduct Section 179 expenses.

Lastly, there is a limitation applied at the shareholder level that creates a possible disallowance of Section 179 expenses in a given year.

If neither bonus depreciation or Section 179 expenses are options for certain assets, is there a solution? Although there is not a single solution that allows for 100% deduction of all assets in the year they are placed in service, there may be ways to mitigate this issue.  

Cost segregation opportunities may exist to reclassify certain assets and take advantage of accelerated depreciation where those assets might otherwise be lumped into a 39-year cost recovery class. It is also an ideal time to review written capitalization policies that may not have been updated for a few years. Banks may deduct up to $5,000 (per invoice line item) under the safe harbor rule and as specified in a written capitalization policy.

The best answer can vary on a case-by-case basis, and your Wipfli tax advisor can help provide further guidance on this issue.