The newly passed Tax Cuts and Jobs Act (TCJA) is pro-business for a number of reasons. One such reason is the increase and expansion of bonus depreciation. However, not every provision in the new law is quite so positive, including the limitation on business interest expense. In fact, the way these provisions interact with and impact each other can create some difficult decisions that many real estate entities, along with other businesses, will need to make starting with their 2018 tax returns.
Bonus Depreciation Expansion
Bonus depreciation has existed in many forms for the last decade; however, the TCJA both expands the definition of property that qualifies and increases the amount of bonus depreciation available.
For assets placed in service prior to the TCJA, bonus depreciation was allowed on new qualified property, and taxpayers were eligible to take a one-time deduction of 50% for the cost of the qualified property. The TCJA allows a taxpayer to take a one-time deduction of 100% of the cost of new or used qualified property placed in service after September 27, 2017.
Furthermore, and we will caution that for now this analysis is based on an assumption, we also expect that qualified improvement property will be eligible for bonus depreciation. This aspect of the new law would allow real estate taxpayers a 100% deduction on any improvement made to the interior portion of a building that is nonresidential real property, as long as the improvement is made after the building was first placed in service.
It’s important to note that we expect qualified improvement property to be eligible because we assume it will be assigned a 15-year recovery period to make it eligible. Currently, the recovery period included in the TCJA does not allow for bonus depreciation. However, we understand that it was Congress’ intention to allow this property to qualify for bonus depreciation, so we expect remediation in the form of a technical correction of this oversight in the coming months.
Interest Expense Limitation
Prior to the TCJA, there was no limitation to the amount of trade- or business-related interest expense a taxpayer could deduct in the current year. Beginning in 2018, the new business interest expense limitation limits the amount of interest expense a trade or business may deduct to 30% of its adjusted taxable income for the year. The term "adjusted taxable income" reflects taxable income; however, some non-cash expenditures are added back, including depreciation, amortization and net operating losses carry-forwards. Interest expense in excess of this limitation is carried forward to future years to offset future adjusted taxable income for the trade or business.
The TCJA provides taxpayers with a few exceptions that would allow unlimited trade or business interest expenses. Two such exceptions relate to electing real estate trade or businesses and small businesses that do not exceed a certain revenue threshold.
Exception for Electing Real Estate Trade or Business
A taxpayer's trade or business that focuses on any of the various real estate functions (development, construction, rental, management, leasing and others) may choose to make a permanent election to not apply the interest limitation. However, in addition to eliminating any limitation on interest expense, making this election requires the use of a different depreciation system. Specifically, taxpayers would be forced to use the Alternative Depreciation System (ADS), which results in higher depreciable lives for real property, and prevents the use of 100% bonus depreciation on qualified improvement property explained above. The difference in depreciable lives are:
Standard Life ADS Life
Non-Residential Real Property 39 Years 40 Years
Residential Rental Property 27.5 Years 30 Years
Qualified Improvement Property 15 Years 20 Years
Exception for Small Businesses
If a taxpayer has less than $25 million of average gross receipts over the prior three years, they are eligible to be considered a small business under the TCJA. Landing in this category would give real estate trades and businesses the benefit of avoiding the interest expense limitation, while still maintaining preferable depreciable lives as well as bonus depreciation. One important caveat is that if a small group of owners is considered to have control (over 50% ownership) of multiple entities, all of the entities in the "controlled group" are combined when determining the gross receipts.
With different options available, it is important to evaluate which alternatives optimize your tax situation under these new rules. A taxpayer with a significant amount of leveraged property may come to a different conclusion than one with significant renovations planned in the coming years. The potential of making an irrevocable election only increases the need for careful consideration. And while a taxpayer may appear to be excluded from interest limitation due to revenue thresholds, the controlled group rules are complex and cumbersome to apply. Although the interest deduction limitation is not in effect for most taxpayers for another year, it is a provision that deserves attention and planning well in advance of next year's tax return preparation.
As with every other provision outlined in the TCJA, work closely with your tax advisory team to determine what makes the most sense for your organization.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.