Congress is in the middle of a two-week spring recess, after having spent the first three and a half months discussing different tax reform ideas and speculating about how the Trump White House and Senate Republicans will approach several controversial proposals contained in the House GOP’s Blueprint for Tax Reform. Of course, the commercial real estate industry is focused keenly on this tax reform debate. However, as we look ahead to the rest of the year, it’s important not to forget the legislative victories that have already been achieved by NAIOP on the tax front, and the opportunities that these provide to members of the commercial real estate industry.
One of these wins for NAIOP and the industry was passage of the “Protecting Americans Against Tax Hikes Act” (the PATH Act) at the end of 2015. The PATH Act extended the ability of businesses, including real estate, to use bonus depreciation for five years. Under current law, commercial building structures on real property can generally be depreciated for tax purposes over a period of 39 years, with certain improvements on leasehold property (qualified leasehold improvements, or “QLI”) depreciable over 15 years. Bonus depreciation, however, allows a business to take an immediate first-year deduction of 50 percent of the cost of the eligible property, such as leasehold improvements.
The PATH Act’s extension of bonus depreciation was indeed a considerable achievement and big news in the world of commercial real estate. But what the PATH Act also did was introduce a new category of building improvements known as “qualified improvement property” (QIP) which has not received as much attention. Although QIP is characterized as property that is supposed to be depreciated over 39 years, people are beginning to realize that QIP is the gateway to bonus depreciation, allowing much more favorable depreciation than otherwise available.
QIP is defined as any improvement to an interior portion of a building which is nonresidential real property, as long as the improvement was placed in service after the date the building was first placed in service. Improvements to the internal structural framework are excluded, as are building enlargements and elevators/escalators. Other than that, the definition of QIP is quite broad and encompassing of many improvements. As of January 1, QIP replaced the other acronyms in the tax code: QLI (qualified leasehold improvements), QRP (qualified restaurant property) and QRIP (qualified retail improvement property) as the only category of improvements now eligible for bonus depreciation.
Unlike the requirements under the definition of qualified leasehold improvements, the new qualified improvement property does not require the property to be subject to a lease. In even bigger news, QIP eliminates QLI’s “three-year rule” which requires that the building in question be at least three years old. Now under the new law, as long as the building predates the improvement, QIP is an option – thereby opening the door for more opportunities for bonus depreciation.
How would QIP work in a real-world example? Assume a business owner builds a new 40,000-square-foot property, and his business occupies 30 percent of the space. The building was placed in service on June 1, 2016, and the total spent was $6 million. Six months go by, and the owner adds a tenant who will occupy 10,000 square feet of the building. The tenant requires an extensive fit-out of his new space, costing $500,000.
Since the building was less than three years old at the time of the $500,000 worth of leasehold improvements, these would not qualify as QLI for 15-year depreciation. This improvement to the tenant space would be classified as QIP, since the improvement was made after the building was placed in service, and doesn’t involve any non-eligible improvements (such as an enlargement of the building, for example). Now, QIP is 39-year property, whereas QLI is 15-year property. But remember that QIP is eligible for bonus depreciation. By classifying this improvement as QIP, that $500,000 is now 50 percent bonus eligible.
Clearly, for the commercial real estate industry, the availability of QIP further expands the utility of techniques such as cost segregation, and broadens the scope of properties eligible for bonus depreciation. In short, the ability to choose QIP and its eligibility for bonus depreciation may have major advantages for a commercial real estate project’s bottom line.
Thank you to Bruce A. Johnson, MBA, CEM, for sharing his perspective and expertise on this issue. Learn more about Bruce at https://capstantax.com/people/bruce-johnson/.
Bruce A. Johnson, MBA, CEM is a co-founder and partner at Capstan Tax Strategies, and a member of NAIOP’s Tax and Finance Government Affairs Subcommittee.