The Tax Cuts and Jobs Act (TCJA) of 2017 changed the depreciation rules for qualified real property. Contractors need to be aware of these changes, as well as how certain assets need to be depreciated or expensed under TCJA.

TCJA consolidated three categories of qualified real property (qualified leasehold improvements, qualified restaurant property and qualified retail improvement property) into one qualified improvement property (QIP). Property placed in service after December 31, 2017, must be classified as QIP.

Real Property Trade or Business Rules

A real property trade or business (RPTB) can elect out of the business interest limitation rules and deduct all its business interest expenses. RPTB includes any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. An RPTB could take 100% bonus depreciation on its QIP plus land improvements or other personal property building components. Property on the modified accelerated cost recovery system (MACRS) must have a recovery period of 20 years or less.

An RPTB can elect out of the business interest limitation rules and deduct all its business interest expenses. In this case, the RPTB is generally required to depreciate any residential rental property, nonresidential rental property and QIP using the alternative depreciation system (ADS), with lives of 30 years, 40 years and 20 years, respectively. The ADS method of depreciation prohibits the use of bonus depreciation.

Business interest deductions after Dec. 31, 2017, are limited to the sum of business interest income plus 30% of adjusted taxable income (computed before allowable deductions for interest, depreciation, amortization, depletion, net operating losses and the pass-through entity deduction).

QIP Class Lives

The class lives of QIP should have been defined under TCJA to determine bonus depreciation eligibility. Although it is likely that Congress intended to make QIP eligible for a 15-year MACRS class life and 20-year ADS class life, it was omitted in TCJA.

The uncertainty of the class life of QIP directly affects anyone with average gross receipts of $25 million over the prior three years. This is due to the interplay between 100% bonus depreciation and the new rules limiting business interest.

Because of this congressional oversight, QIP is not available for 100% bonus depreciation and must be depreciated over 39 years. Bonus depreciation allows for the faster deprecation of assets with class lives of 20 years or less. The deduction for bonus depreciation increased under TCJA from 50% to 100%. A 100% first-year deduction is allowed for qualified property placed in service after Sept. 27, 2017, and before Jan. 1, 2024. The deduction will start phasing out in 2024, going down to 80%, with a decrease of 20% for each year after that, until it phases out completely in 2026.

The House did pass a bill last December allowing for the 100% depreciation allowance for these expenses. However, the bill was sent to the Senate along with the spending bill that shut down the government, so it was never passed.

IRS Code Sections 179 and 168(k)

IRS code Sections 179 and 168(k) (bonus depreciation) allow for the immediate deduction of part or all the cost of qualified property. TCJA changed the limits for the deductions allowed under both code sections.

The maximum annual Section 179 deduction increased from $500,000 to $1 million for qualified property placed in service after Dec. 31, 2017. TCJA increased the annual phase-out threshold from $2 million to $2.5 million. The Section 179 deduction begins to phase out dollar-for-dollar after $2.5 million is spent on qualified property.

TCJA expanded the definition of qualified real property eligible for code Section 179. Improvements to nonresidential real property (roofs, HVAC systems, fire protection and alarm systems, and other security systems) may qualify to be included after the date such property was first placed in service.

Clarification from the IRS

The IRS issued Rev Proc 2019-08: Expansion of Depreciation on Dec. 21, 2018, in hopes of clarifying TCJA rules for expensing under Section 179 and depreciation under Section 168(g). These changes are effective as of Dec. 21, 2018.

Rev Proc 2019-08 allows for accelerated deprecation under Section 179 for QIP such as leasehold improvements, qualified restaurant equipment and qualified retail improvement property.

However, losses not taken in the current tax year must be carryforward and company profits cannot go below zero. Taxpayers may elect to expense some or all of the cost of qualified real property placed in service after 2017 by filing or amending a tax return.

The Rev Proc does not allow the 100% depreciation deduction for these properties. Even so, Rev Proc 2019-08 says that a company whose main activities are RPTB can elect Section 163(j) limitation rules. Contractors that make this election must use the ADS system for non-residential real property, residential real property and QIP. For tax years beginning after 2017, the ADS recovery period under Section 168(g) decreased from 40 years to 30 years

Further clarification on the deprecation rules are expected from the IRS when the House and the Senate clearly define the class lives of QIP.