February 26, 2018 What asset managers need to know to comply with the new full expensing and cost recovery provisions in the Tax Cuts and Jobs Act The "Tax Cuts and Jobs Act" (P.L. 115-97) (the Act), enacted December 22, 2017, changed certain elective expensing and cost recovery provisions of the Internal Revenue Code. This Alert highlights the changes of interest to management companies in the private equity and alternative asset management industry. Expansion of Section 179 expensing Prior law Before enactment of the Act, businesses could elect to immediately expense up to $510,000 of the cost of any Section1 179 property placed in service each tax year. This immediate expensing was subject to an investment limitation ($2,030,000 for 2017) after which it was reduced dollar for dollar to the extent that the expense exceeded the limit. Section 179 property included tangible personal property or certain computer software purchased for use in the active conduct of a trade or business, as well as certain "qualified real property," defined as qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property that is depreciable and purchased for use in the active conduct of a trade or business. Current law For property placed in service in tax years beginning after December 31, 2017, the Act increases the expensing limitation under Section 179 from $510,000 to $1 million, with the investment limitation increased from $2,030,000 to $2.5 million, both of which are indexed for inflation. The Act also indexes the $25,000 sport utility vehicle limitation for inflation for tax years beginning after 2018. The Act modifies the definition of qualified real property to: (1) eliminate references to qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, replacing such references with a reference to qualified improvement property; and (2) include the following improvements to nonresidential real property placed in service after the date the property was first placed in service: roofs, heating, ventilation and air-conditioning property, fire protection, and alarm systems and security systems. Implications The increased expense and investment limitation, coupled with the revised and expanded definition of "qualified real property," will provide additional immediate expensing opportunities to taxpayers that invest in personal and certain "qualified real property" as described in Section 179. Bonus depreciation for qualified property Prior law Before the Act, taxpayers could claim additional depreciation (i.e., bonus depreciation) under Section 168(k) in the year in which qualified property (as described later) was placed in service through 2019 (with an additional year to place the property in service for qualified property with a longer production period, as well as certain aircraft). Bonus depreciation generally equaled 50% of the cost of the property placed in service in 2017 and phased down to 40% in 2018 and 30% in 2019. To be eligible for bonus depreciation, the original use of the property had to begin with the taxpayer (i.e., used property did not qualify). Qualified property was defined as: 1. Modified accelerated cost recovery system (MACRS) property with a recovery period of 20 years or less Prior to the Act, taxpayers could annually elect to not claim bonus depreciation with respect to qualified property under Section 168(k)(7). Alternatively, taxpayers could elect under Section 168(k)(4) to accelerate alternative minimum tax (AMT) credits (as refundable credits) in lieu of claiming bonus depreciation with respect to qualified property. Such election came with the added requirement to depreciate qualified property using a straight-line recovery method. Current law The Act extends the additional first year depreciation deduction for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2027 (January 1, 2028, for certain qualified property with a longer production period, as well as certain aircraft). The bonus depreciation percentage and phase-down schedule for most qualified property is as follows: — 100% for property acquired and placed in service after September 27, 2017, and before January 1, 2023 For certain property with longer production periods, as well as certain aircraft, the end dates in the prior list are increased by one year. For example, bonus depreciation is 80% for long-production-period property or certain aircraft placed in service after December 31, 2023 and before January 1, 2025. Under the Act, qualified property is defined as: 1. MACRS property with a recovery period of 20 years or less, The Act applies to property acquired and placed in service after September 27, 2017, as well as specified plants planted or grafted after that date. Property acquired before September 27, 2017, is subject to the bonus depreciation rules in place before the Act became law. Further, a transition rule allows a taxpayer to elect to utilize 50% bonus depreciation, instead of 100%, for qualified property placed in service during the first tax year ending after September 27, 2017. Effective for otherwise bonus-eligible property acquired and placed in service after September 27, 2017, property previously used by an unrelated person may qualify for bonus depreciation if it meets certain additional acquisition requirements. The acquisition requirements are met if: — The taxpayer did not use the property at any time before acquiring it Furthermore, the Act repeals the election to accelerate AMT credits in lieu of bonus depreciation. Implications Immediate expensing or 100% bonus depreciation for property meeting the definition of "qualified property" under Section 168(k)(2) provides taxpayers acquiring such property with an immediate cash-tax benefit. Further, as the Act allows taxpayers to elect out of Section 168(k), consistent with prior law, taxpayers that are in a loss position and will not otherwise benefit from immediate expensing have the flexibility to elect not to apply Section 168(k) and, instead, utilize the depreciation provisions in Section 168 generally. Such election, along with other Section 168 elections to "slow down" depreciation (e.g., annual election to use the alternative depreciation system), will become more relevant in tax years beginning on or after January 1, 2022, when depreciation deductions will reduce "adjusted taxable income" for purposes of the 30% interest deduction limitation under Section 163(j). Thus, beginning with the 2022 tax year, companies will want to carefully model out the impact that depreciation elections will have on interest deductibility. Asset managers should also consider the possible interaction between depreciation elections, which could generate losses, and the new limit on the deductibility of excess business losses. Although the new loss limitation rules apply at the individual level, asset managers should model whether particular depreciation elections could result in losses. Further, Section 168(k)(4), which allowed taxpayers to elect to utilize straight-line depreciation associated with bonus-eligible property and monetize a portion of pre-2016 AMT credit carryforwards, was repealed by the Act. This repeal is largely due to the fact that the AMT repeal transition rules provide a mechanism for taxpayers to fully refund any unused AMT credits from 2018 through 2021. As previously described, certain used property is now considered qualified property eligible for bonus depreciation. The ability to apply bonus depreciation to certain used property is a substantial benefit to taxpayers. Qualified property acquired and/or placed in service on or before September 27, 2017 is, however, not subject to the immediate expensing bonus provisions detailed earlier but is eligible for the pre-Act bonus depreciation percentages. Cost recovery of real property Prior law Before the Act, Section 168(e) contained separate definitions for qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property, providing a 15-year recovery period for each type of property. Further, Section 168(k)(3) provided an additional definition for qualified improvement property (QIP). Specifically, QIP referred to certain improvements to the interior of a building that was nonresidential real property if the improvement was placed in service after the date the building was first placed in service. Further, QIP could be recovered under the general depreciation system over either 15 or 39 years, depending on whether such property also met the definition of qualified leasehold improvement property or nonresidential real property. Current law The Act makes the following changes related to MACRS recovery periods for real property, effective for property placed in service after December 31, 2017: — The 15-year recovery period for qualified leasehold improvement property, qualified retail improvement property and qualified restaurant improvement property is eliminated. Important to note: The Act establishes a single definition for QIP under Section 168(e)(6), but does not specifically include QIP in Section 168(e)(3)(E) as having a 15-year recovery period. Although it appears that Congress intended to provide a 15-year recovery period to QIP under the MACRS general depreciation system, the Act's provisions do not currently provide a 15-year recovery period for QIP. As a result, QIP has a depreciable recovery period of 39 years, not 15 years, and does NOT qualify for 100% bonus expensing for property placed in service on or after January 1, 2018. See Tax Alert 2018-0012 for details. Since the definition of QIP does not take effect until January 1, 2018, qualified leasehold improvement property and qualified retail improvement property still have a 15-year recovery period and are eligible for 100% bonus depreciation if acquired and placed in service from September 28, 2017, to December 31, 2017. Implications To the extent that a technical correction of this provision is not adopted, managers with large current or anticipated spends in improvements (renovations) to nonresidential real property should consider further analysis, such as a cost segregation study that can determine shorter recovery periods for specified assets. Practical examples 1. ABC Management LP incurs qualified leasehold improvement expenditures for renovations incurred and completed from September 28, 2017 through December 31, 2017. Outcome: Taxpayer could fully expense the costs as a bonus depreciation allowance under Section 168 on its 2017 tax returns. 2. ABC Management LP incurs expenditures related to an office renovation; expenditures are incurred after January 1, 2018. Outcome: The expenditures do not qualify for bonus depreciation, but may be deductible under Section 179 (depending upon whether those costs meet the definition of qualified real property under Section 179). The amount of the deduction is still subject to the limitations for 2018 set forth in Section 1789. If the Section 179 limitations are exceeded, then the remaining costs are recovered straight line over 39 years. 3. ABC Management LP leases office space in a recently constructed building and anticipates incurring expenditures related to office build-out in 2019 for an expected move in 2020. Outcome: The expenditures are not currently eligible for bonus depreciation and must be depreciated over 39 years. Taxpayers may want to consider a cost segregation study in an effort to have certain expenditures reclassified to asset classes with a shorter recovery period (and potential bonus depreciation eligibility). State tax considerations Asset managers will want to monitor state conformity with the federal laws when it comes to fixed assets and depreciation changes under the Act. States with a rolling conformity date will automatically adopt these changes unless they specifically decouple, while states with a fixed date of conformity will have to update their date of conformity to the IRC in order to conform to these changes. In the past, many states have decoupled from the bonus depreciation provisions under Section 168(k), but coupled to the increased expensing provisions under Section 179. Whether or not states will conform to these new federal provisions will depend upon legislative determinations in each state and consequently, have to be determined on a state-by-state basis. Lack of state conformity not only would affect state taxable income but could also potentially affect state apportionment. ———————————————
——————————————— 1 References to "Section" are to the relevant section or sections of the Internal Revenue Code of 1986, as amended (the "IRC" or "Code") | |||||||||||
| |||||||||||
