Posted on MarketWatch.com | February 19, 2019
The Tax Cuts and Jobs Act (TCJA) made several favorable changes to the federal income tax depreciation rules for real estate. Here’s what real estate investors need to know about the TCJA changes, including the potential downsides.
More Generous Section 179 Deduction Rules for Real Estate
For qualifying assets placed in service in tax years beginning in 2018 and beyond, the TCJA greatly increased the maximum Section 179 deduction to $1 million (up from only $510,000 for 2017), with annual inflation adjustments. The inflation-adjusted number for 2019 is $1.02 million. You can write off your allowable Section 179 deduction in Year One, subject to limitations explained below.
The TCJA also increased the threshold for the Section 179 deduction phase-out rule to $2.5 million (up from $2.03 million for 2017), with annual inflation adjustments. The inflation-adjusted number for 2019 is $2.55 million. The phase-out rule kicks in if you add more than the threshold amount of qualified real property during the year. If the phase-out rule applies, it can wipe out some or all of your Section 179 deduction. Consult your tax adviser for full details.
As under prior law, you can claim Section 179 deductions for qualifying real property expenditures, up to the maximum annual Section 179 deduction allowance ($1 million for tax years beginning in 2018; $1.02 million for tax years beginning in 2019). There’s no separate limit for real property expenditures, so claiming Section 179 deductions for real property reduces the maximum annual allowance dollar for dollar.
Qualifying real property expenditures mean those for any improvement to an interior portion of a nonresidential building that is placed in service after the date the building is placed in service — except for any expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.
The TCJA also expanded the definition of qualifying real property for Section 179 deduction purposes to include expenditures for roofs, HVAC equipment, fire protection and alarm systems, and security systems for nonresidential real property. To qualify, these items must be placed in service in tax years beginning after 2017 and after the nonresidential building has been placed in service.
Personal Property Used in Connection with Lodging
For property placed in service in tax years beginning after 2017, the TCJA removed the prior-law restriction that disallowed Section 179 deductions for personal property used predominately to furnish lodging. Examples of such property include furniture, kitchen appliances, other equipment used in the living quarters of a lodging facility, lawn mowers, and other personal property used in connection with a lodging facility. A lodging facility can be a hotel, motel, apartment house, dormitory, rental condo, rental single-family home, or any other facility (or part of a facility) where sleeping accommodations are provided and rented out.
Favorable Section 179 Changes are Permanent
The aforementioned favorable changes to the Section 179 rules are permanent for qualifying property placed in service in tax years beginning in 2018 and beyond.
Beware of Section 179 Business Taxable Income Limitation
Your Section 179 deductions cannot create or increase an overall tax loss from your business activities, including rental real estate. So you might need plenty of positive business taxable income to take full advantage of the new-and-improved Section 179 deduction privilege. If you operate using a partnership, LLC treated as a partnership for tax purposes, or S corporation, the business taxable income limitation gets tricky because it applies at both the entity level and at your personal level. Talk to your tax pro if you have questions about this rule.
Uncertainty Regarding First-Year Bonus Depreciation for Real Estate
Congress intended for the TCJA to allow 100% first-year bonus depreciation for qualified real estate improvement property placed in service between 1/1/18 and 12/31/22. Qualified real estate improvement property is defined as an improvement to an interior portion of a nonresidential building that is placed in service after the date the building is first placed in service — except for any expenditures attributable to the enlargement of the building, any elevator or escalator, or the building’s internal structural framework.
However thanks to a drafting error, the intended first-year bonus depreciation break for qualified real estate improvement property never made it into the actual statutory language. Oops.
While real estate investors can hope that this error will be fixed by future technical corrections legislation, the current political environment does not encourage one to think that will happen anytime soon. Until the fix is made (if it ever is), real estate qualified improvement property placed in service in 2018 and beyond is generally assigned the 39-year depreciation period that applies to nonresidential building improvements.
First-year bonus depreciation allowed for qualified real estate improvement property acquired and placed in service between 9/28/17 and 12/31/17
Weirdly enough, IRS proposed regulations state that 100% first-year bonus depreciation is allowed for real estate qualified improvement property that was both acquired and placed in service between 9/28/17 and 12/31/17. Whatever. We will take what we can get.
Beware of Downside of Claiming First-Year Depreciation for Real Estate
There is a potentially significant downside to Section 179 deductions and/or first-year bonus depreciation for real property. If you later sell the property for a taxable gain, gain up to amount of the Section 179 and/or bonus depreciation deductions will be treated as depreciation recapture that is taxed at higher ordinary income rates (up to 37% for 2018-2025 plus another 3.8% if the dreaded net investment income tax also applies).
In contrast, if you depreciate commercial real property over the normal 39-year period or residential real property over the normal 27.5-year period, the maximum federal income tax rate on gain attributable to depreciation is “only” 25% (plus the 3.8% net investment income tax if it applies).
Key point: The advantage of claiming Section 179 and/or bonus depreciation deductions is big tax-saving write-offs in Year One. The potential disadvantage is higher tax rates on gains attributable to those write-offs when you eventually sell the property. But if you don’t anticipate selling for many years, that disadvantage is of less concern.
Beware of Potential Negative Side Effect on QBI Deductions
The new deduction for up to 20% of qualified business income (QBI) from pass-through entities (including sole proprietorships) cannot exceed 20% of your taxable income calculated before any QBI deduction and before any net capital gain (net long-term capital gains in excess of net short-term capital losses plus qualified dividends). So moves that reduce your taxable income and/or your QBI, such as claiming Section 179 and/or bonus depreciation deductions, can potentially have the adverse side effect of reducing your allowable QBI deduction.
The Bottom Line
The TCJA expanded the federal income tax depreciation breaks available to real estate owners.
However, the intended bonus depreciation break for real estate qualified improvement property remains up in the air.
Also, there are significant potential downsides to claiming Section 179 and/or bonus depreciation deductions for real estate.
Huddle with your tax adviser to determine the best overall tax strategy for your real estate assets.