Ever since the passage of the 2017 tax reform amendments to the tax code (the 2017 Tax Act), various real estate, restaurant, retail and related industry groups have urged Congress to fix a mistake made in the 2017 Tax Act which had inadvertently denied taxpayers the ability to claim bonus depreciation deductions relating to “qualified improvement property.” Although such efforts have thus far been in vain, the increased urgency created by economic fallout of coronavirus appears to have finally caused Congress to include this fix as part of the CARES Act. The tax impact of this legislative fix, when enacted into law, will benefit not just owners of restaurants and retail businesses, but also many commercial property landlords as well.
Pre-2017 Tax Incentives
Most costs associated with the purchase of non-residential real estate, such as office buildings, restaurants, retail facilities, etc., as well as additional amounts incurred for improvements to such properties, are, as a general rule, not permitted to be claimed as a current tax deduction. Instead, such amounts would typically be capitalized and deducted over a period of time, sometimes up to 40 years.
Prior to the enactment of the 2017 Tax Act, the tax law sought to incentivize and subsidize businesses with respect certain of these types of capital investments. One way the pre-2018 tax law did so was through the so-called “bonus depreciation” provisions of the tax code. Generally speaking, these provisions permitted businesses to claim a current deduction for up to 50% of the costs of certain new business equipment placed in service during the year, with the remaining 50% of such costs generally being deductible over normal depreciation periods applicable to such equipment.
Prior to the enactment of the 2017 Tax Act, these bonus depreciation provisions applied to more than just investments in business equipment. These provisions were also applicable to various types of real estate improvements, primarily consisting of certain types of interior building improvements made by real estate owners, as well as restaurant and retail businesses. While such types of interior building improvements would otherwise be required to be deducted by the owner over the 39-year recovery periods typically applicable to real estate improvements, the application of the bonus depreciation rules allowed the owner a current year deduction for up to 50% of such building improvement costs. Moreover, in many cases, the owner would be permitted to deduct the remaining 50% of such costs over a 15-year period, as opposed to what might otherwise be a much longer recovery period (i.e., up to 39 years).
The types of interior building improvements which typically qualified for these pre-2017 Tax Act incentives were those which fell into one of three separate categories which were tightly defined by the tax code, and which are very generally summarized as follows:
- Qualified leasehold improvement property (generally defined as improvements to an interior portion of building which is a non-residential property, if made pursuant to a lease and more than three years after the building first placed in service, excluding certain types of costs, such as elevators, etc.).
- Qualified restaurant property (generally defined as any improvement to a building if more than 50% of the building’s square footage is devoted to on-premises consumption of meals).
- Qualified retail improvement property (generally defined as any improvement to an interior portion of a building which is nonresidential property if such portion is open to the public and used in the business of selling tangible personal property to the public and such improvement is placed in service more than three years after the date the building was placed in service).
A fourth category of tax-favored building improvements was added in 2015 which allowed certain additional improvements to owner-occupied, nonresidential properties to also qualify for the 50% immediate tax write-off under the bonus depreciation rules (although the balance of the 50% of costs of these improvements did not automatically qualify for the shorter 15 year recovery periods applicable to the other categories described above).
Not surprising, these 50% bonus depreciation provisions proved to be very popular for many real estate owners and restaurant and retail businesses which were able to take advantage of this provisions, at least for improvements placed in service prior to January 1, 2018.
The 2017 Tax Act
The 2017 Tax Act was signed into law in December 2017. One of the centerpieces of the 2017 Tax Act was providing significant tax cuts and incentives for businesses. This included an expansion of the bonus depreciation rules described above to allow not just a 50% current year tax deduction for certain capital outlays by businesses, but 100%. Congress also intended to expand the types of properties and improvements which would qualify for this new 100% tax deduction.
As relates to interior building improvements of the types described above, Congress consolidated the four categories of qualified improvements described above into a single category of property known as “qualified improvement property.” The new defined term “qualified improvement property” simplifies, and in many respects expands upon, the types of real property improvements which are intended to qualify for the 100% tax deduction (so long as the taxpayer did not make certain elections and met certain requirements). These changes were intended to apply to property placed in service after December 31, 2017.
Unfortunately, through a drafting error, Congress neglected to include this new category of “qualified improvement property” as part of the list of properties which are eligible for the 100% deduction. As a result, the 2017 Tax Act failed in its attempt to provide additional tax incentives to real estate owners, and restaurant and retail businesses, with respect to their investments in qualified improvement property. Thus, the costs of such qualified improvement properties placed in service after December 31, 2017, are only tax deductible by such taxpayers over a period of 39 years. In other words, far from improving the tax treatment of qualified improvement property, the tax treatment of these costs were made far worse for taxpayers than what applied prior to the 2017 Tax Act.
The CARES Act “Fix”
The CARES Act, if enacted into law in its current form, would retroactively fix the aforementioned mistake. It would do so by simply adding “qualified improvement property” to list of items that qualify for the 100% bonus depreciation. Thus, real estate owners, as well as restaurant and retail businesses, who previously would have qualified for the 50% bonus depreciation provisions applicable prior to the 2017 Tax Act, would now potentially qualify for the 100% bonus depreciation for qualified improvement property placed in service after December 31, 2017. Also, as noted above, the new term “qualified improvement property” actually expands the definition and allows certain types of improvements which previously did not qualify for the benefits to now qualify.
Furthermore, as noted above, the CARE Act amendments to these provisions of the 2017 Tax Act would be made retroactively. Thus, taxpayers who, for example, may have made expenditures during calendar year 2018 and who have already filed U.S. federal tax returns for 2018, may be entitled to tax refunds based on the retroactive application of this amendment.
However, for entities that are classified for tax purposes as “partnerships” (as is the case with many owners of real estate), there is perhaps one additional unintended glitch. The U.S. federal tax rules relating to tax audits and refunds of partnership tax returns were substantially revised in 2015. Partnerships meeting certain narrowly defined requirements can elect out of these new rules, but for those partnerships who cannot, or do not elect out, the new rules apply beginning in 2018. One of the many impacts of these new rules is that refund claims relating to partnership returns are obtained not through amended partnership tax returns, but instead through the partnership’s filing of a what is known as an administrative adjustment request (AAR). If, for example, the results of an AAR filed by a partnership in 2020 is a reduction in the 2018 tax liabilities of the partners, the reductions are taken into account not as tax refunds to the partners, but instead as an adjustment the partners’ 2020 income tax returns. The problem, though, is that these 2020 tax returns will not be filed by the partners until next year. Thus, if part of the motivation of this provision of the CARES Act was to provide immediate tax relief to taxpayers, Congress may have once again inadvertently failed to deliver on this intention, at least in the case of entities classified as partnerships that are unable to elect out of the 2015 revised audit and refund rules.