Posted by Evan Piccirillo, CPA
Patience is not a virtue in the world of tax and accounting. Taxpayers generally prefer to recover the cost of investments in capital property as rapidly as possible. Thanks to recent changes made by the Tax Cuts and Jobs Act (TCJA) in 2017, there is less waiting and more deducting.
For tax purposes, most taxpayers depreciate fixed assets under the Modified Accelerated Cost Recovery System (MACRS), which, as the name suggests, already offers accelerated tax deductions as compared to the de facto default method (straight-line). A certain method under MACRS front-loads the magnitude of the tax deduction to the beginning of the useful life of the asset. We also have even quicker options (if available) that provide even more up-front expensing: Section 179 and bonus depreciation. Both of these options have been enhanced by the TCJA.
Under this section of the code, 100% of the cost of an asset can be written off as a tax deduction. The amount of Section 179 (Sec. 179) benefit a taxpayer can receive in a given year is limited to taxable income; the excess carries over to future years. The TCJA has expanded the assets that are eligible to this type of expensing. In the past, Sec. 179 was not available for most real property, but under the new law, “Qualified Improvement Property” is now eligible (things like the roof of a building and components of A/C systems), as well as furnishings used predominantly in lodging activities. Be aware that qualified improvement properties are nonresidential only.
In addition, the limit on Sec. 179 expensing was increased from $500k to $1M per year, subject to a phase-out threshold increase from $2M to $2.5M (indexed for inflation). The phase-out threshold decreases your expense by costs of fixed asset additions in a given year that exceed the phase-out threshold, dollar-for-dollar. I always stress that the limit ($1M) is an absolute limit for any taxpayer. One must be very careful when using Sec. 179 on pass-through entities, because if an individual receives more than $1M in Sec. 179, the excess deduction is lost permanently.
These changes became effective January 1, 2018.
Bonus depreciation was introduced as a “special” option for taxpayers to incentivize investing in capital property back in 2002 for a limited time. For obvious reasons, bonus depreciation was very popular and was reintroduced several times since in subsequent legislation. The deduction has varied from 30% - 100% over that period and was eligible for qualifying property, which had to be “new” and have a useful life of 20 years or less. Bonus expense is figured after Section 179, if applicable. Under the TCJA, taxpayers can enjoy 100% bonus depreciation and the “new” property requisite has been lifted.
These changes became effective September 27, 2017, so be aware that certain property may be eligible for 100% bonus on your 2017 tax return.
There is a slight snag in the TCJA where “Qualified Improvement Property” isn’t granted the intended 15-year life, thus making it ineligible for bonus depreciation, but it is widely believed that this will be fixed in a technical correction bill. Your move, Congress.
Many states do not recognize bonus depreciation and have different limits for Sec. 179. Failing to recognize and plan for those differences might result in an unwanted (and unintended) surprise state tax bill.
The Alternative Depreciation System (ADS) must be used for certain assets or certain taxpayers and uses a straight-line method (slow). Additionally, ADS has a longer recovery period and may not use accelerated expensing methods described above (even slower). ADS has increased relevance in the world of the TCJA for reasons we will explore when we discuss the business interest deduction limitation in a future post. Under ADS, the useful life for residential real property was shortened from 40 years to 30 years, which puts it more in line with the MACRS life of 27.5 years.
Every change highlighted above is a boon to taxpayers seeking to accelerate tax deductions on the cost of capital investment property. These changes apply to more than just rental properties; all businesses with tangible property additions are impacted. In some cases, these changes can also be applied to residential properties, but that’s a longer and more in-depth conversation we can parse out at a later date.
Care must be taken when dealing with Sec. 179, and we can’t forget to consider the state differences. Taxpayers need to understand the nuance in the new law (and impending technical corrections) and how to maximize the benefit. Reach out to your advisor, or give me a call to discuss.