Last year, Congress achieved what few thought it could by passing a significant overhaul of our nation’s tax code. For the most part, commercial real estate professionals fared well. Crucial provisions and incentives were preserved, while tax rates were reduced. But as with any major piece of legislation, a “technical corrections” bill usually follows to address unintended results arising from errors in drafting or ambiguities in statutory language. For NAIOP members and others in the commercial real estate industry, a drafting error in the original tax reform bill could have vast consequences.
The issue centers around the way businesses depreciate certain improvements made to nonresidential real property. Depreciation is an allowance for the wear and tear or obsolescence of property (including certain repairs and improvements). It’s given to taxpayers in the form of an annual deduction, but is spread out across the asset’s usable lifespan, a number of years predetermined by the IRS. In theory, the system is supposed to allow businesses to recover the cost of their investment. In practice, however, mandated depreciation schedules often do not reflect the real-world useable lifespans of these assets.
Certain improvements to real property, such as a build-out of a tenant space, or “leasehold improvements,” are a good example. Back in the 2000s, these had to be depreciated over the full 39-year life of the underlying property. As NAIOP members will attest, office space that’s nearly four decades old is all but guaranteed to be well past the point of obsolescence.
Recognizing this challenge to property owners, Congress over the years allowed for speedier cost recovery. First, a new category called “Qualified Leasehold Improvements” (QLI) was created. Assigned a 15-year lifespan, it allowed businesses to recover the costs of their investment more than twice as quickly. The only catch was that a QLI had to be made pursuant to a lease between unrelated parties, and made more than three years after the building was first placed into service. Thus, while the new depreciation period was certainly attractive, the restrictions made it unavailable to a large swath of building owners. The 15-year lifespan for QLI was not a permanent part of the tax code, and had to be periodically renewed as part of tax extender legislation.
In 2015 Congress passed the PATH Act, creating a new category called “Qualified Improvement Property” (QIP). The criteria for qualifying as QIP was less strict than for QLI (QIP does not need to be made pursuant to a lease, nor to a building at least three years old), but QIP was subjected to a 39-year depreciation schedule. Importantly however, the bill made QIP and QLI eligible for bonus depreciation: a 50 percent write-off of the total cost of the expenditure in the first year. Thus, instead of having to depreciate $100,000 in QIP over 39 years, a property owner could write off $50,000 in the first year, depreciating the remaining $50,000 over 39 years. This was an important incentive for investment in CRE.
The Tax Cuts and Jobs Act (TCJA) upended this system by introducing a new set of rules. One was a new limitation on the deductibility of interest payments for businesses with average gross receipts of over $25 million annually. Real estate businesses, however, were given an option to opt-out and continue deducting their interest payments. The trade-off, however, was that those making this election would have to depreciate their assets using the Alternative Depreciation System (ADS), which uses longer asset lives. More consequentially for real estate, property depreciated under ADS is not eligible for bonus depreciation, which the TCJA increased from 50 percent to 100 percent.
This is where an inadvertent drafting error in the legislation has a big impact on commercial real estate. In the TCJA, Congress eliminated the separate definition for Qualified Leasehold Improvements that had been given 15-year depreciation schedules under earlier tax bills, bringing these under the broader definition of Qualified Improvement Property. Congress also intended that real estate businesses electing out of the new interest-deductibility imitation would have to depreciate assets under ADS. This was supposed to be a term of 20 years for leasehold improvements. For others not using ADS, they would depreciate leasehold improvements over 15 years and be eligible for bonus depreciation as well. Instead, the drafters inadvertently left leasehold improvements out of the list of properties afforded the 20-year depreciation schedule and customary 15-year lifespan. The text of the statute, as written, instead requires depreciation of 40 and 39 years, respectively.
As a consequence, despite the TCJA having implemented rate reductions and a new deduction for certain pass-through income, some firms with large tenant improvement investments could see their tax liability increase.
NAIOP and its allies are urging Congress to pass a technical corrections bill to remedy this situation. But advancing legislation in an election year is always challenging. Democrats, who were shut out of the tax reform writing process last year, are reluctant to help Republicans fix a bill they had no part in crafting. That said, the goal of reducing depreciation lives of improvement property is shared by lawmakers from both sides of the aisle. It’s been the subject of numerous bipartisan, bicameral bills over the years. Therefore, while a legislative fix may not materialize prior to November, this could be the first order of business for a “lame duck” Congress.