One of the few potential tax increases in the Tax Cuts and Jobs Act is the limitation on interest expense deductions. Under TCJA business net interest deduction is limited to 30% of taxable income. Real property and farming businesses, as well as some infrastructure businesses, can elect out of the limitation in return for longer lives and slower depreciation write-offs. Those who opt out of the 30% limitation must utilize a slower depreciation method, the alternative depreciation system (ADS).
The interplay between the interest limitation, expensing elections and switching to a slower depreciation method is the subject of a new IRS revenue procedure.
Favorable Interpretation of New Law
The revenue procedure explains how businesses change to ADS for property placed in service before 2018. Importantly, it adopts the view that the election is not a change in accounting method, but only a change in use of the asset. This distinction is important. It means that taxpayers will not have to recapture depreciation previously taken under a more accelerated method. Instead, real estate companies will depreciate the remaining basis of the asset over the longer ADS recovery period.
For property placed in service after 2017, electing real property businesses must use the longer ADS write-off periods of 40 years for nonresidential real property, 30 years for residential rental property, and 20 years for qualified improvement property. Note that qualified improvement property technically now has a 39-year life because an error in drafting but will have the 20-year life if and when Congress enacts a technical correction.
Expensing Qualified Improvement Property
The IRS also explains how taxpayers can elect to treat “qualified improvement property” as eligible for the Sec. 179 expensing election. The TCJA allows a 15-year recovery period for qualified improvement property, which includes roofs, ventilation, heating and air conditioning systems, fire protection, alarm systems, and security systems. As a result, these improvements are eligible for immediately expensing and bonus depreciation. The election to expense is made by filing an original or amended return. As stated above, if a taxpayer elects out of the interest limitation, the taxpayer’s qualified improvement property must be written off over 20 years under the ADS system.
Infrastructure Businesses Qualify for Election
The IRS also has created a safe harbor which allows taxpayers to treat some infrastructure businesses as real property businesses eligible to elect out of the interest limitation. Rev Prov. 2018-59 explains that businesses that design, build, manage, operate, or maintain core infrastructure projects will be considered real property businesses. Eligible projects must meet the parameters for public infrastructure projects that qualify for private activity bond financing described in the White House’s “Legislative Outline for Rebuilding Infrastructure in America.”
The takeaway here is that real estate and farming businesses have the opportunity to elect out of the 30% net interest limitation in return for longer lives and slower depreciation write-offs. This can be a significant benefit for real estate companies and farmers who carry a lot of debt on their assets.
When determining whether to make the election, taxpayers engaged in a real property business will have to weigh the benefit of unlimited interest deductions versus the cost of slower depreciation schedules. Your Frazier & Deeter tax advisor can help you evaluate your options.