Renewal of Bonus Depreciation & Enhanced Expensing Offers Tax-saving Opportunities

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1 Renewal of Bonus Depreciation & Enhanced Expensing Offers Tax-saving Opportunities The recently enacted "Protecting Americans from Tax Hikes (PATH) Act of 2015" (P.L , 12/18/2015) made a number of significant taxpayer-friendly changes in the tax law, but few have a wider impact on ordinary businesses than the retroactive permanent extension of the enhanced Code Sec. 179 expensing rules and the 5-year extension of 50% bonus first-year depreciation (with a rate that gradually decreases). Enhanced Sec. 179 expensing. Under Code Sec. 179, a taxpayer, other than an estate, a trust, or certain noncorporate lessors, may elect to deduct as an expense, rather than to depreciate, up to a specified amount of the cost of new or used tangible personal property or certain real property placed in service during the tax year in the taxpayer's trade or business. The maximum annual expensing amount generally is reduced dollar-for-dollar by the amount of Code Sec. 179 property placed in service during the tax year in excess of a specified investment ceiling. Amounts ineligible for expensing due to excess investments in expensing-eligible property can't be carried forward and expensed in a subsequent year. Rather, they can only be recovered through depreciation. The amount eligible to be expensed for a tax year can't exceed the taxable income derived from the taxpayer's active conduct of a trade or business. Any amount that is not allowed as a deduction 1

2 because of the taxable income limitation may be carried forward to succeeding tax years. For tax years beginning in 2014: (1) the dollar limitation on the expensing deduction was $500,000; and (2) the investment-based reduction in the dollar limitation began to take effect when property placed in service in the tax year exceeds $2 million (the investment ceiling). Under the 2014 limits, the Code Sec. 179 deduction didn't phase out completely until the cost of expensing-eligible property exceeded $2.5 million ($2 million (investment ceiling) + $500,000 (dollar limit)). Under pre-path Act law, for tax years beginning after Dec. 31, 2014, the maximum expensing limit dropped to $25,000, and the investment ceiling dropped to $200,000. Thus, the Code Sec. 179 deduction phased out completely when the cost of expensing-eligible property exceeded $225,000 ($200,000 (investment ceiling) + $25,000 (dollar limit)). In general, under pre-path Act law, property was eligible for Code Sec. 179 expensing if it was:... tangible property that's Code Sec property (generally, machinery and equipment), depreciated under the MACRS rules of Code Sec. 168, regardless of its depreciation recovery period;... for any tax year beginning in 2010 through 2014, up to $250,000 of qualified real property-qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property that's depreciable, 2

3 acquired for use in the active conduct of a trade or business, and not otherwise excluded under Code Sec (Under a carryover limitation for qualifying real property no portion of the disallowed expensing could be carried to a tax year beginning after 2014); or... depreciable computer software that is readily available for purchase by the general public, is subject to a non-exclusive license, and has not been substantially modified (i.e., off-the-shelf computer software), but only if placed in service in a tax year beginning before Jan. 1, Under pre-path Act law, for tax years beginning before Jan. 1, 2015, an expensing election or specification of property to be expensed could be revoked without IRS's consent, but, if revoked, couldn't be reelected. However, for tax years beginning after Dec. 31, 2014, the expensing election, and any specification made in it, could be revoked only with IRS's consent. New law. The PATH Act made the following changes to the Code Sec. 179 expensing election: The $500,000 expensing limitation and $2 million phase-out amounts are retroactively extended and made permanent. ( Code Sec. 179(b) ) For any tax year beginning after Dec. 31, 2015, both the $500,000 and $2 million limits are indexed for inflation. ( Code Sec. 179(b)(6) ) 3

4 The rule that allows expensing for computer software is retroactively extended and made permanent. ( Code Sec. 179(d)(1)(A)(ii) ) For tax years beginning after Dec. 31, 2015, air conditioning and heating units are eligible for expensing. ( Code Sec. 179(d)(1) ) For tax years beginning after Dec. 31, 2014, an expensing election or specification of property to be expensed may be revoked without IRS's consent. ( Code Sec. 179(c)(2) ) Thus, the ability to revoke a Code Sec. 179 election without IRS consent is made permanent. Qualified real property is eligible to be expensed for tax years beginning before 2016 ( Code Sec. 179(f)(1) ), but no portion of disallowed expensing may be carried to a tax year beginning after Dec. 31, ( Code Sec. 179(f)(4) ) For tax years beginning after Dec. 31, 2015, expensing of qualified real property is made permanent without a carryover limitation ( Code Sec. 179(f)(1), Code Sec. 179(f)(4) ), and the $250,000 expensing limitation with respect to qualifying real property is eliminated. ( Code Sec. 179(f) ) The expensing break is enhanced by the de minimis safe harbor in the capitalization regs that allows businesses to elect to expense their outlays for "lower-cost" business assets. Under this safe harbor, which applies to an amount paid during the tax year to acquire or produce a unit of property, or acquire a material or supply, and which generally 4

5 applies to amounts paid in tax years beginning on or after Jan. 1, 2014, qualifying businesses with an applicable financial statement (AFS) can expense eligible property if the amount paid doesn't exceed $5,000 per invoice (or per item as substantiated by the invoice). If the taxpayer does not have an AFS, the same rule applies except that the amount paid for eligible property can't exceed $2,500 per invoice (or per item as substantiated by the invoice). Before 2016, the $2,500 amount was $500, but IRS won't challenge an earlier use of the higher amount. The $5,000 and $2,500/$500 amounts can be changed by published IRS guidance. Assets expensed under the de minimis safe harbor election may be deducted in the year of purchase, assuming that the costs that otherwise qualify as ordinary expenses, and assuming the costs don't have to be capitalized under the uniform capitalization (UNICAP) rules of Code Sec. 263A. The PATH Act also provided that:... the expensing rules for qualified film and television productions are retroactively restored and extended to productions beginning before Jan. 1, ( Code Sec. 181(g) ) In addition, for production that begin in calendar year 2016, they apply to qualified live theatrical productions ( Code Sec. 181(a) ; Code Sec. 181(g) );... the election to expense the cost of qualified advanced mine safety equipment property is retroactively restored and extended to property placed in service through 2016; ( Code Sec. 179E(g) ) 5

6 and... the special Code Sec. 179 expensing election for enterprise zone businesses (increasing the maximum amount that can be expensed by $35,000 and computing the phaseout of the maximum amount allowed to be expensed using 50% of the cost of the qualified zone property) is retroactively restored and extended through Dec. 31, (Code Sec. 1397A(a)(12), Code Sec. 1391(d)(1)(A) ) Bonus first-year depreciation. Under pre-path Act law, Code Sec. 168(k) generally allowed an additional first-year depreciation deduction (also called bonus first-year depreciation) equal to 50% of the adjusted basis of qualified property acquired and placed in service after Dec. 31, 2011, and before Jan. 1, 2015 (before Jan. 1, 2016 for certain longer-lived and transportation property). The additional firstyear depreciation deduction was allowed for both regular tax and alternative minimum tax (AMT) purposes, but was not allowed for purposes of computing earnings and profits. The basis of the property and the depreciation allowances in the year of purchase and later years were appropriately adjusted to reflect the additional first-year depreciation deduction. A taxpayer could elect out of additional firstyear depreciation for any class of property for any tax year. In general, an asset qualified for the bonus depreciation allowance if:... It fell into one of the following categories: property to which the modified accelerated cost recovery system (MACRS) rules 6

7 apply with a recovery period of 20 years or less; computer software other than computer software covered by Code Sec. 197 ; qualified leasehold improvement property; or certain water utility property.... It was placed in service before Jan. 1, (Certain longproduction-period property and certain transportation property could be placed in service before Jan. 1, 2016.)... Its original use commenced with the taxpayer. Original use was the first use to which the property is put, whether or not that use corresponded to the taxpayer's use of the property. The PATH Act extended bonus depreciation for qualified property acquired and placed in service during 2015 through 2019 (subject to a phase down), through 2020 for certain longer-lived and transportation property. Eligible taxpayers will be able to claim: (1) a 50% bonus depreciation allowance for qualified property placed in service in 2015 through 2017; (2) a 40% bonus depreciation allowance for qualified property placed in service in 2018; and (3) a 30% bonus depreciation allowance for qualified property placed in service in ( Code Sec. 168(k) ) The percentages apply to certain longer-lived and transportation property placed in service one year later than shown in the list above. The PATH Act also provided that: 7

8 For property placed in service after Dec. 31, 2014 and before Jan. 1, 2020, the Code Sec. 280F limitation for passenger autos and for light trucks or vans (i.e., passenger autos built on a truck chassis, including minivans and sport-utility vehicles (SUVs) built on a truck chassis, rated at 6,000 pounds gross (loaded) vehicle weight or less) is increased (subject to a phase down) for qualified property subject to bonus depreciation. For an auto or light truck or van placed in service in 2015 through 2017, the limitation is increased by $8,000; for an auto or light truck or van placed in service in 2018, the limitation is increased by $6,400; and for an auto or light truck or van placed in service in 2019, the Code Sec. 280F limitation is increased by $4,800. ( Code Sec. 168(k)(2) ) For property placed in service after Dec. 31, 2014, the 15-year recovery period for qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property is retroactively restored and made permanent. ( Code Sec. 168(e)(3)(E) ) For property placed in service after Dec. 31, 2015, qualified leasehold improvement property is no longer qualified property, but instead a new category, "qualified improvement property" (which includes qualified leasehold improvement property and qualified retail improvement property) is qualified property (eligible for bonus depreciation); qualified restaurant property may or may not meet the requirements for qualified improvement property. First-year 8

9 bonus depreciation is allowed for qualified improvement property without regard to whether the improvements are property subject to a lease, and there is no requirement that the improvement must be placed in service more than three years after the date the building was first placed in service. ( Code Sec. 168(k)(3) ) For plants planted or grafted after Dec. 31, 2015 and before Jan. 1, 2020, bonus depreciation (subject to a phase down) is allowed for certain trees, vines, and plants bearing fruit or nuts when planted or grafted, rather than when placed in service; 50% for a plant that is planted or grafted in 2016 or 2017; 40% for a plant that is planted or grafted in 2018; and 30% for a plant that is planted or grafted in ( Code Sec. 168(k)(5) ) For tax years beginning after Dec. 31, 2014 and before Jan. 1, 2020, the elective exchange by corporations trading bonus and accelerated depreciation for the refund of otherwise deferred AMT credits is retroactively restored and extended (subject to a phaseout). ( Code Sec. 168(k)(4) ) The special rule for the allocation of bonus depreciation to a longterm contract is extended for five years to property placed in service before Jan. 1, 2020 (Jan. 1, 2021, in the case of certain longer-lived and transportation property). ( Code Sec. 460(c)(6)(B) ) For property placed in service after Dec. 31, 2014 and before Jan. 1, 2017, first-year 50% bonus depreciation allowance for second 9

10 generation biofuel plant property is retroactively restored and extended. (Code Sec. 168(l)(2)(D))) Planning considerations. Under Code Sec. 179 expensing, the most accelerated form of depreciation available, an eligible taxpayer can elect to deduct all or part of the cost of qualifying property ( Code Sec. 179 property) in the tax year the qualifying property is placed in service, even if the property is placed in service on the last day of the year. However, as noted above, besides not being available to certain taxpayers (e.g., estates and trusts, and many non-corporate lessors), a number of other limitations apply. And, the expensing deduction is limited by an annual maximum dollar amount and an investment ceiling that gradually reduces the deduction if more than a specified amount of qualifying property is placed in service by the taxpayer during the tax year. The expensing deduction is further limited to taxable income from the taxpayer's active trades or businesses, with any amount which can't be deducted because of this limitation carried over indefinitely to later years. The property subject to expensing must be purchased for use in the active conduct of a trade or business, not merely for the production of income. On the other hand, bonus depreciation, while not providing as quick or as large a deduction as Code Sec. 179 expensing, is not subject to an active business income requirement, maximum amount limitation, or a deduction phaseout for amounts in excess of a specified investment ceiling. Bonus depreciation is available only for property whose 10

11 original use begins with the taxpayer, but the property can not only be used in a trade or business, it can also be used for the production of income. However, while the 50% bonus depreciation portion isn't subject to the depreciation conventions (half-year and mid-quarter conventions which reduce the depreciation deduction based on when in the tax year the property is treated as placed in service), the conventions do apply to the other first-year depreciation deductions allowed with respect to qualified property. In many cases, a taxpayer may be able to use both methods. PATH Act improves realty tax breaks but introduces new complications As a general rule, the cost of commercial real estate improvements is recovered over a painfully long period of 39 years via straight line depreciation only. ( Code Sec. 168(b)(3) and Code Sec. 168(c) ) However, for specially defined categories of realty improvements, taxpayers may be entitled to the hat-trick of tax breaks: expensing under Code Sec. 179 of part of the cost of the improvements; bonus first-year depreciation deductions of the portion of the cost that isn't (or can't be) expensed; and a relatively short 15-year recovery period of the cost that isn't (or can't be) expensed or recovered via bonus firstyear depreciation. Larger businesses may not qualify for expensing, but they still may be able to score bonus depreciation and a short 15-11

12 year recovery period. The PATH Act substantially liberalized the expensing break for qualifying real estate improvements. It also made it easier for improvements to qualify for bonus first-year depreciation, but in the process may have caused some complications. For example, not all bonus-depreciation-eligible improvements will qualify for a 15-year writeoff of the remainder of the costs. And some expenses eligible for bonus first-year depreciation under the liberalized rules may not be eligible for expensing under Code Sec This article, the first installment of a 2-part Practice Alert, takes a closer look at the expensing of realty improvements under Code Sec Part II will examine the bonus first-year depreciation allowance and the fast 15-year writeoff for qualifying building improvements. Taxpayers, except trusts, estates and certain noncorporate lessors, can elect on to expense (deduct in lieu of depreciation) the cost (subject to dollar limits) of "section 179 property" ( Code Sec. 179(a), Code Sec. 179(b)(1) ) Under pre-path Act law, for tax years beginning in calendar years before 2015, the maximum expensing amount was $500,000, reduced dollar-for-dollar by the amount of section 179 property placed in service during the tax year in excess of $2,000,000 (the investment ceiling). ( Code Sec. 179(b)(2) ). The deduction amount was further limited to the amount of taxable 12

13 income from any of taxpayer's active trades or businesses, computed without regard to the cost of qualified expense property, the deduction for one-half of self-employment tax, NOL carrybacks or carryforwards, and deductions suspended under other Code sections ( Code Sec. 179(b)(3) ; Reg (c)(1) ), e.g., the passive activity rules. Generally, section 179 property is tangible depreciable property, other than buildings or their structural components, and "off the shelf" computer software that is acquired by purchase and used in an active trade or business. However, under pre-2015 PATH Act law, for tax years beginning before calendar year 2015, a taxpayer could elect to treat "qualified real property" as section 179 property. But the aggregate amount of the cost of qualified real property that a taxpayer could elect to treat as an expense was subject to both an annual limit of $250,000 and the $500,000 annual per taxpayer overall limit on Code Sec. 179 expensing (which, as described above, was itself subject to reduction if the investment ceiling was exceeded). The PATH Act retroactively extended and made permanent the $500,000 expensing limitation and $2 million phase-out amount (these dollar limits had been scheduled to drop, respectively, to $25,000 and $200,000 respectively). Additionally, both dollar limits are inflation adjusted after 2015 (for 2016, the expensing limitation remains unchanged but the phaseout amount rises to $2,010,000). ( Code Sec. 179(b) ; Rev Proc , IRB ) 13

14 The PATH Act also:... Permanently extended the elective treatment of qualified real property as section 179 property, effective for tax years beginning after Dec. 31, ( Code Sec. 179(f)(1) ).... Removed the annual $250,000 limitation under former Code Sec. 179(f)(3) on the amount of qualified real property that can be treated as section 179 property, effective for tax years beginning after Dec. 31, (PATH Act 124(c)(2)) Thus, effective for property placed in service in tax years beginning after Dec. 31, 2015, the PATH Act can double the maximum amount of qualifying realty improvements that can be expensed-from $250,000 to $500,000. This change will be a boon to smaller businesses that need to make improvements to their properties. Illustration 1 A calendar-year entrepreneur spends $1 million to redesign his restaurant. The improvements are qualified real property and are placed in service in The entrepreneur has no other qualifying Code Sec. 179 expenses, and his taxable income for the year is $600,000. Under the PATH Act, the entrepreneur can elect to expense $500,000 of the cost of his improvements. 14

15 The accepted wisdom for taxpayers is to elect to expense those assets that otherwise would be recovered via depreciation over the longest recovery period. Thus, those taxpayers that have expensing-eligible personal property and qualified real property should elect to expense the qualified real property, which would otherwise be recovered over 15 years (as explained later in this article), ahead of the other section 179-eligible property (which typically will have a 5- or 7-year depreciation recovery period). What is qualified real property? Qualified real property is property that is classified as: (1) qualified leasehold improvement property as defined in Code Sec. 168(e)(6) ; (2) qualified retail improvement property as defined in Code Sec. 168(e)(7) ; and (3) qualified restaurant property as defined in Code Sec. 168(e)(8). For expensing purposes, these three classes of property are defined the same way as they were under prior law, although the placement of some of the definitions within the Code has been changed. 15

16 The qualified property must be depreciable, acquired by purchase 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). ( Code Sec. 179(f)(1) ) Under prior law, air conditioning and heating units were also on the list of property ineligible for treatment as qualified real property, and therefore ineligible for Code Sec. 179 expensing. Fortunately, effective for tax years beginning after Dec. 31, 2015, the PATH Act removed the language in the Code that excluded air conditioning units and heating units from being Code Sec. 179 property. ( Code Sec. 179(d)(1), as amended by PATH Act 124(e)) To be eligible for Code Sec. 179 expensing, an air conditioning or heating unit that's a structural component must otherwise meet the definition of qualified real property. For example, as explained below, if the unit is to be treated as qualified leasehold improvement property, it must be an improvement to the interior of a nonresidential building. An HVAC unit installed outside of or on a building isn't qualified leasehold improvement property (see Chief Counsel Advice ). 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 16

17 personal property, rather than the more-restrictive rules for qualified real property. What is qualified leasehold improvement property? In general, qualified leasehold improvement property is any improvement to an interior portion of a building which is nonresidential realty if: (1) The improvement is Code Sec property. (2) The improvement is made "under or pursuant to a lease" (as defined in Code Sec. 168(h)(7), namely any grant of a right to use property), either by the lessee, sublessee or lessor of the building portion. Leases between certain related persons aren't treated as leases. (3) The portion of the building is to be occupied exclusively by the lessee (or any sublessee) of the portion. (4) The improvement is placed in service more than three years after the date the building was first placed in service. ( Code Sec. 168(e)(6)(A), Reg (k)-1(c)(1) ) 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. ( Code Sec. 168(e)(6)(D) ) The Code doesn't define what types of building improvements are 17

18 eligible to be treated as qualified leasehold improvement property. Rather, it lists the types of property that can't be so treated. Under Code Sec. 168(e)(6)(B), 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 and not a common area: (1) electrical or plumbing systems (including a sprinkler system); (2) permanently installed lighting fixtures; (3) ceilings and doors; and (4) non-load-bearing walls. All of these assets, to the extent they aren't eligible for 5- or 7-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, one of the disqualified categories for qualified leasehold improvement purposes. The 18

19 internal structural framework of a building is defined by the investment tax credit regs ( Reg (b)(3)(iii) ) 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 retail improvement property? Qualified retail improvement property is any improvement to a building which 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. ( Code Sec. 168(e)(8) ) 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. Exceptions similar to the exceptions under Code Sec. 168(e)(6)(B) (e.g., for death, or like-kind exchange transactions) apply for purposes of this provision. ( Code Sec. 168(e)(8)(B) ) 19

20 As is the case with qualified leasehold improvement property, 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. ( Code Sec. 168(e)(8)(C) ) The Joint Committee on Taxation (JCT) says retail establishments that are qualified retail improvement property include those primarily engaged in the sale of goods, such as grocery stores, clothing stores, hardware stores, and convenience stores. 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 a business that is defined as a store retailer under the North American Industry Classification System (NAICS) will qualify, while those in other industry classes won't. (JCX-55-10, with respect to the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010; and JCX-55-10, General Explanation of Tax Legislation Enacted in the 111th Congress) Note that the current NAICS lists categories as "Retail Trade." What is qualified restaurant property? Property is qualified restaurant property if it is any Code Sec 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 20

21 consumption of, prepared meals. ( Code Sec. 168(e)(7) ) The definition of qualified restaurant property is unique in that it allows a building (rather than an improvement to one) to qualify for expensing. Additionally, an otherwise qualifying improvement need not have been placed in service more than three years after the date the building was first placed in service, as is the case with qualified leasehold improvement and qualified retail improvement property. 21