by: Lisa White, CPA

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act, H.R. 748) was signed into law. Since inception, much of the focus has been on the establishment of additional funding sources, such as the Paycheck Protection Program (PPP), or on the creation of new tax credits, such as the Employee Retention Credit. However, the Act also made some significant revisions to existing tax law to provide additional relief to affected businesses. This article takes a closer look at two of these provisions and delves into how the related benefits associated with the changes might be derived.

Technical Correction for Qualified Improvement Property

The Protecting Americans from Tax Hikes (PATH) Act of 2015 created a new category of asset called “Qualified Improvement Property” or “QIP”. This term referred to any improvement to an interior portion of nonresidential real property, but excluded expenditures for elevators or escalators, enlargements, or interior structural components. Although this category of asset technically had a 39-year cost recovery period, it was specifically identified as being eligible for bonus depreciation. When the Tax Cuts and Jobs Act (TCJA) was signed into law at the end of 2017, the intention was to assign a shorter, 15-year recovery life to qualified improvement property, thus ensuring it’s eligibility for the enhanced 100% bonus depreciation provision also included in the TCJA. Unfortunately, the necessary wording was not included in the final bill, resulting in qualified improvement property retaining its 39-year cost recovery period, but excluding it from being eligible for bonus depreciation.

Not only did the CARES Act include the technical correction necessary for QIP to have its originally intended 15-year cost recovery period, but the correction was directed to apply retroactively to all eligible assets placed in service after December 31, 2017. Then, in mid-April, the IRS provided guidance on how to capture this additional benefit from the change in the depreciable life and the possible eligibility for bonus depreciation. Primarily, the two methods are to either file amended returns for the impacted year(s) or to file a Change in Accounting Method (Form 3115), which allows a “catch-up” for the differences in the recovery periods and applicable depreciation methods.

Example:
There is a business that holds commercial rental property and operates on a December 31st year-end. On July 15, 2018, the business incurred expenses of $150,000 in costs that meet the QIP definition. Assume Section 179 expense was not taken. Due to the technical error in the law, only $1,763 of depreciation expense was allowed in 2018 and $3,846 of depreciation expense would be allowed in 2019. With the technical correction, bonus depreciation can now be taken on the entire amount of the qualified improvement property even though it was placed in service in 2018:

  1. If the 2019 tax return has already been filed, an amended return should be filed for both the 2018 and 2019 tax years. Taxable income in 2018 will be reduced by the additional $148,237 [$150,000 – $1,763] of accelerated depreciation expense, and taxable income in 2019 will be increased by the removal of the $3,846 of depreciation expense originally recognized.
  2. If the 2019 tax return has not yet been filed, filing a Form 3115 might provide the easier option. Instead of filing two years of returns, only the 2019 tax return is filed, and the $148,237 of additional accelerated depreciation expense not captured in 2018 is included in the 2019 tax return as a section 481(a) adjustment.

Its important to note that there are certain circumstances where either an amended return or an administrative adjustment request (AAR) must be filed. It is important to consult with your tax advisor to determine the best course of action.

Changes to the Business Interest Limitation

Although most of the provisions enacted as part of the TCJA were intended to be taxpayer favorable, there were some new components that had the opposite effect. One of these was the revision and expansion of the business interest limitation rules. If subject to the new rules, the regulation essentially limited the amount of business interest expense to 30% of taxable income adjusted for, among other things, depreciation. The interest expense in excess of this 30% threshold would not be deductible in the current year but would instead be carried forward to the following tax years.

The TCJA also included an option for certain businesses to elect out of having this regulation apply. Instead, these businesses that met the definition of a “real property trade or business”, could make an irrevocable election to realize a longer recovery period for the cost of real property and to forego any bonus depreciation that would otherwise be allowed on that real property. Prior to the retroactive change under the CARES Act, the differences in the recovery periods were not substantial, and none of the real property was eligible for bonus depreciation. However, with the CARES Act’s retroactive fix to qualified improvement property, that property is now eligible for bonus depreciation. The loss of being able to take that accelerated depreciation in addition to another CARES Act provision increasing the limitation threshold from 30% to 50% (for all businesses except partnerships) for 2019 and 2020, might now result in the impact of the irrevocable election having an undue, unfavorable result.

To provide relief to those businesses that made the irrevocable election and that could now benefit from the shorter recovery period, and the applicable depreciation methods, the IRS has issued guidance that provides for the irrevocable election to be rescinded for tax years 2018 or 2019. This is accomplished by filing an amended return for the year the election was made. If 2018 was the election year, and 2019 has already been filed, 2019 must be amended as well to reflect any changes to taxable income resulting from withdrawing the election.

So, What Now?

The CARES Act provides several relief provisions, including a number that can be realized through proper tax planning. Owners of nonresidential (i.e. commercial) real property should review any expenditures that were capitalized in 2018 and 2019 to see if any of these costs can be realized now under the new qualified improvement property measures. Also, it would be prudent to review any elections made during those tax years that might need to be revisited to make sure those elections still result in the most favorable tax position. As with most things related to the tax code, the final answer is usually complex and nuanced and somewhere in the grey. But with proper planning and timely tax advisor consultation, realizing additional relief during these unprecedented times can be achieved.

This material is generic in nature. Before relying on the material in any important matter, users should note date of publication and carefully evaluate its accuracy, currency, completeness, and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances.