New Rules Allow Significant Opportunities to Expense Capital Expenditures
New legislation included in the Protecting Americans from Tax Hikes of 2015 Act (PATH Act) along with recently issued final tangible property regulations provide taxpayers with significant opportunities to expense or accelerate tax deductions for the cost of fixed assets.
However, taxpayers may need to put new processes in place to fully take advantage of these new rules.
Taxpayers should first consider whether expenditures can be immediately expensed under the de minimis safe harbor. A taxpayer can expense any item that does not exceed $2,500 ($5,000 for taxpayers with an audited financial statement), as long as it is also expensed for book purposes. This expensing rule covers routinely purchased items such as office furniture and equipment, laptops, appliances and smartphones. For example, if a taxpayer pays a $100,000 invoice for the purchase of 50 computers that cost $2,000 each, each computer falls under the $2,500 de minimis amount and the entire $100,000 invoice can be expensed for tax purposes so long as the taxpayer also expenses the computers in its books and records. To elect the de minimis safe harbor, a taxpayer must have a policy in place to expense items for book purposes as of the beginning of the year (the policy must be in writing for taxpayers with audited financial statements). Therefore, taxpayers should ensure a policy is in place by the end of 2016 in order to make the de minimis safe harbor election for 2017.
When incurring expenditures related to existing buildings, land improvements or other tangible property, a taxpayer should consider whether the expenditure must be capitalized for tax purposes or whether it could be currently deducted as repair and maintenance expense. Generally, such expenditure must be capitalized for tax purposes if it results in an improvement (a betterment, a restoration or an adaptation) to a building, building system or other unit of property. Expenditures that taxpayers routinely capitalize and depreciate for book purposes can be expensed for tax purposes under these rules. For example, a cosmetic refresh or remodel of a portion of a building where there is no impact to the building’s structure or systems is generally not required to be capitalized. Costs that are deducted under the de minimis rule or as a repair and maintenance expense are not subject to depreciation recapture rules upon a future transaction.
When there is a capitalizable improvement made to a building or other property, taxpayers can write-off the remaining tax basis of the replaced property by making a partial disposition election. Often times, taxpayers do not separately track the tax basis of a component of a building, such as a roof or elevator system. The regulations provide a simple technique for estimating the tax basis of the disposed property when a restoration is made. To use this technique, the taxpayer applies a formula based on the producer price index and tax depreciation tables to estimate the remaining tax basis of the disposed property [See prior article on partial dispositions].
Assume a taxpayer spends $750,000 in 2016 to replace all elevators in the building. The replacement of the elevators is required to be capitalized as a restoration to the building. The taxpayer purchased the entire building, including the elevators, for $10,000,000 in 2012. The building was depreciated using the straight-line method over a 39-year recovery period.
A partial disposition election is made by disposing of the $601,650 remaining tax basis of the retired elevators on the originally filed tax return for the year of disposition (2016).
The PATH Act also extended the availability of bonus depreciation through 2019 (2020 for certain longer-lived and transportation property) and made enhanced small business expensing levels under Sec. 179 permanent. The $500,000 dollar limitation for expensing Sec. 179 eligible property and the dollar-for-dollar reduction in the maximum for property placed in service over $2,000,000 are indexed to inflation. Beginning in 2016, there is no separate real property dollar limitation for expensing qualified real property under Sec. 179. As a result, taxpayers may elect to use their entire Sec. 179 dollar limitation to expense qualified real property expenditures, including qualified leasehold improvement, restaurant and retail property.
Beginning in 2016, The PATH Act also expanded the definition of building improvements that are bonus eligible. A new category called qualified improvement property includes any improvement to the interior portion of a nonresidential building that is not attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. The improvement must be placed in service after the date the building was originally placed in service, it must be original-use property and it must be placed in service during a year when bonus depreciation is in effect (currently through 2019).
No special recovery period was specified for qualified improvement property. Thus, a 39-year recovery period for a commercial building will continue to apply, unless the property fits the definition of qualified leasehold improvement, restaurant, or retail property, which has a 15-year recovery period. This new category is distinctly different from qualified leasehold improvement property, which was eligible for bonus depreciation prior to 2016. Qualified leasehold improvement property is made under or pursuant to a lease by the lessor or the lessee (restrictions apply to related party leases) to a building that is at least three years old. Under the expanded definition, bonus depreciation is available for owner-occupied, 39-year building improvements or improvements to common areas of leased buildings that otherwise fit the criteria for qualified improvement property. Taxpayers should either put a process in place to identify qualified improvement property and take the allowable bonus depreciation, or should affirmatively elect out of bonus depreciation for the 39-year property.
Putting it all together
Assume a taxpayer makes expenditures in 2016 related to the interior portion of an existing commercial building that it owns and uses in its business and the expenditure is not for qualified real property under Sec. 179. The taxpayer should identify separate property such as appliances and furniture and determine whether those items could be expensed under the de minimis safe harbor. If the items are above the dollar threshold, consider whether to expense under Sec. 179 (if applicable) or whether bonus depreciation should be taken instead. Next, the taxpayer should determine whether the remaining expenditure results in an improvement to the building or is deductible as a repair based on the standards described above. If the expenditure results in an improvement that fits the definition of qualified improvement property, 50 percent bonus depreciation will apply even though the recovery period is 39 years. If the improvement replaced an existing portion of the building, a partial disposition election could also be made to write-off the remaining tax basis in the replaced property.
Taxpayers have abundant opportunities to accelerate deductions related to fixed assets given the changes provided by the PATH Act as well as under the final tangible property regulations. Determining how these rules apply to your business and optimizing the available deductions and implementing the strategies will require careful planning and coordination of the different rules and elections that may apply.