Preface: Appropriately planning contactor costs when renovating business property can result in tax benefits; read this blog to see how certain qualifying improvements have tax advantages.
Depreciation of Real Property Improvements
Credits: Jake Dietz, CPA
Is it time to renovate your business property? Have you considered how quickly you can deduct the expenditure? The IRS allows some capital expenditures to be deducted in the first year, either in whole or in part, using Section 179 expense or bonus depreciation. On the other hand, some capital expenditures must be deducted over decades. This timing difference can affect your tax liability and therefore your cash flow. This article examines certain categories of property and rules that apply to deducting them.
Qualified retail improvement property is an improvement made to the interior portion of a building that is accessible by the public and is part of retailing tangible personal property to the public. An example would be a hardware store. Qualified retail improvement property excludes:
- “the enlargement of the building,”
- “any elevator or escalator,”
- “any structural component benefitting a common area, or”
- “the internal structural framework of the building.”
The qualified retail improvement must be made more than 3 years after the building was first placed in service by any taxpayer. It therefore will not apply to constructing a new building, but it can apply to remodeling an existing building even if it was originally placed in service by a separate taxpayer. For example, ABC Building was constructed in 2011 for use as a store. In 2017, it is sold, and the new store owner makes qualifying improvements immediately. The 3 year rule is met because the building had originally been placed in service more than 3 years before, even though it was by a different taxpayer.
Another category is qualified leasehold improvement property, which are improvements to leased property. The improvements may be made by the lessee or lessor. This property must be placed in service more than three years after the original building was first put in service. Certain improvements are not included. The exclusions are the same four improvements that are excluded from the definition of qualified retail improvement property listed above.
Related party leases do not qualify for the leasehold improvement rules. For example, suppose John and Samuel own an LLC that operates a construction company, and they also own a separate LLC that rents a shop to the construction company. Improvements to the shop would not qualify as leasehold improvement because of the related party rules.
Qualified restaurant property is a third category we will examine. This category is a building, or building improvements, “if more than 50 percent of the building’s square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals.” There is no 3 year in service requirement.
Qualified improvement property is an improvement to the interior of the building. The improvement must be placed in service after the original date of the building, but there is not a three year waiting period. QIP excludes 3 types of improvements:
- “the enlargement of the building,”
- “any elevator or escalator,”
- “the internal structural framework of the building.”
Now that we have defined these categories, how can they be written off?
Qualified restaurant property, qualified leasehold improvement property, and qualified restaurant property qualify for section 179 expensing. This allows them to be written off immediately, subject to the Section 179 limits. Qualified improvement property is only subject to section 179 if it also qualifies as one of the other three categories.
Bonus depreciation allows a certain percentage of qualifying property to be depreciated in the first year. That percentage is 50% for 2017. Qualified retail improvement property, qualified leasehold improvement property, and qualified improvement property qualify for bonus depreciation. Qualified restaurant property, however, is excluded from bonus unless it also qualifies as qualified improvement property.
Qualified retail improvement property, qualified leasehold improvement property, and qualified restaurant property are each 15 year property that is depreciated straight line. Qualified improvement property, on the other hand, is 39 year straight line property unless it falls into one of the other three categories. The 15 year life can make a nice difference for annual depreciation because depreciation is deducted more quickly than the normal 39 year life for nonresidential real property.
While each of the categories discussed has its benefits, they also each have qualifications that must be met. If you are renovating, part of the job may fall into one of these categories, and another part may not. Talk with your accountant beforehand to see what might qualify, and then ask your contractor to give you invoices that have the appropriate breakdown of expenses.