Cost recovery changes in the TCJA

Some of the changes brought about by the law known as the Tax Cuts and Jobs Act (TCJA)¹ were straightforward, including increasing standard deductions and eliminating personal exemptions. Others, however, were more complex, such as various changes that the TCJA made to cost recovery. This article discusses some of the cost recovery changes in the TCJA, focusing in particular on the ones addressed in Rev. Proc. 2019-8, which include deducting expenses under Sec. 179(a) and deducting depreciation under Sec. 168(g).

Expensing qualified real property

Under Sec. 179, taxpayers can deduct the cost of certain property as an expense when the property is placed in service. The Sec. 179 deduction applies to tangible personal property, such as equipment or machinery purchased for use in a trade or business. If the taxpayer elects, the deduction can also be used for “qualified real property.”

The TCJA expanded the types of real property that are eligible for immediate expensing. Prior to the 2017 law, qualified real property included only three categories of property — qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. For an improvement to be qualified leasehold improvement property or qualified retail improvement property, the improvement had to be placed in service more than three years after the building the improvement was made to was placed in service.

The TCJA greatly expanded the scope of qualified real property that can be expensed under Sec. 179. It replaced the three categories of property included in qualified real property described above with a single category of property called “qualified improvement property,” or QIP, which is defined as any improvement to an interior portion of a building that is nonresidential real property (other than an improvement that is attributable to an enlargement of a building, any elevator, escalator, or the internal structural framework of the building).² In addition, the TCJA added to qualified real property the following improvements to nonresidential real property:

• Roofs;
• Heating, ventilation, and air-conditioning property (HVAC);
• Fire protection and alarm systems; and
• Security systems.

The changes made by the TCJA apply to property placed in service in tax years beginning after 2017 that is placed in service after the date the building was first placed in service by any person.

Rev. Proc. 2019-8 explains how to make an election to treat qualified real property as Sec. 179 property.³ Under the procedure, a taxpayer may elect (without the IRS’s consent) to expense the cost, or a portion of the cost, of qualified real property placed into service for any tax years beginning after 2017 by filing an original or amended tax return for that tax year in accordance with procedures similar to those in Regs. Sec. 1.179-5(c)(2) and Section 3.02 of Rev. Proc. 2017-33. The election must specify the items of Sec. 179 property and the portion of the cost of each such item to be taken into account under Sec. 179(a).⁴ Essentially, this can be accomplished by completing Part I of Form 4562, Depreciation and Amortization, and filing the form with the original or amended return.

Alternative depreciation system (ADS)

The TCJA also expanded the situations in which taxpayers must use the ADS, which generally requires a longer recovery period than the general depreciation system. Essentially, prior to the TCJA, Sec. 168(g) listed five types of property that were required to be depreciated under the ADS:

• Any tangible property used predominantly outside the United States during the tax year (with certain exceptions);
• Any tax-exempt use property (such as property a taxpayer is leasing to a government or other tax-exempt entity);
• Any tax-exempt bond financed property;
• Certain imported property covered by an executive order (see Sec. 168(g)(6)); and
• Any property to which an election to use the ADS applies (see Sec. 168(g)(7)).

To this list the TCJA added two new categories. These pertain to certain businesses that have made the choice to retain their full interest expense deduction by electing out of Sec. 163(j)’s limit; specifically, “electing real property trades or businesses” or “electing farming businesses.” These businesses must now use the ADS for certain types of property. In particular, the two new categories of property subject to the ADS are:

• Nonresidential real property, residential rental property (discussed later), and qualified improvement property held by an electing real property trade or business (as defined in Sec. 163(j)(7)(B)); and
• Any property with a recovery period of 10 years or more that is held by an electing farming business (as defined in Sec. 163(j)(7)(C)).

The TCJA amendment expanding the ADS to this property applies to tax years beginning after 2017 without regard to when the property was or is placed in service. The two new categories of ADS property will be described from here forward, collectively, as “covered property” of “electing real property or farming trades or businesses” or simply “electing businesses.”

Note: Under the TCJA, due to a drafting error, QIP was treated as nonresidential real property with a recovery period of 39 years for modified accelerated cost recovery system (MACRS) depreciation rather than as 15-year recovery property. Treated as such, it was not eligible for bonus depreciation, whether or not a taxpayer was an electing business. Congress fixed the drafting error in the recently enacted Coronavirus Aid, Relief, and Economic Security (CARES) Act,⁵ by designating QIP placed in service after 2017 as 15-year recovery period property for MACRS depreciation, which is eligible for 100% bonus depreciation.

Thus, although electing businesses receive an increased interest deduction by making the election, it comes at the cost of losing bonus depreciation deductions for QIP, potentially making the election much less attractive. However, electing businesses that might not have made their election if QIP had always been treated as 15-year property eligible for bonus depreciation could not change their status because the election is irrevocable. The IRS recently provided relief to these electing businesses in Rev. Proc. 2020-22, which allows them to withdraw their election for 2018, 2019, or 2020, and “be treated as if the election was never made.”

Switching to the ADS

Rev. Proc. 2019-8 provides guidance to electing businesses about how to change the depreciation of their covered property to the ADS, which is the tradeoff for making the election.⁶ Under the procedure, an electing business must use the ADS in the first tax year it makes the election. For existing covered property (covered property placed in service before the year of election) the rule is that a change in use occurs under Sec. 168(i)(5) and Regs. Sec. 1.168(i)-4(d) as a result of the election. Rev. Proc. 2019-8 also provides that the change in use is not a change in method as described in Sec. 446(e), such that it would require the IRS’s consent.⁷

Therefore, a taxpayer that holds covered property and later elects to be treated as an electing business determines the depreciation allowances beginning with the year of change as though the covered property had been originally placed in service by the taxpayer with the longer recovery period and/or the slower depreciation method.⁸ Thus, the taxpayer depreciates the tax basis left in the property at the beginning of the year of change over the remaining life of the property as if the taxpayer had originally depreciated the property over its ADS life.

The rule for newly acquired covered property is that it is required to be depreciated under the ADS and does not qualify for additional first-year depreciation.⁹ Under Sec. 168(k)(2)(D), property that qualifies for additional first-year depreciation shall not include any property subject to the ADS.

Rev. Proc. 2019-8 also provides guidance on the consequences of failure to change to the ADS. For existing property, an electing business that fails to change to the ADS is then using an impermissible method and is subject to a change in accounting method to which Sec. 446(e) applies requiring the IRS’s consent. The taxpayer should make the request to change to the appropriate ADS method by filing Form 3115, Application for Change in Accounting Method. If the taxpayer is eligible to make the change under the automatic change procedures, the method change is described in Rev. Proc. 2018-31 (or any successor), which requires the taxpayer to make a Sec. 481(a) adjustment.¹⁰ Essentially, Sec. 481(a) allows an adjustment for the difference between the depreciation actually taken on property and the depreciation that should have been taken had the property been depreciated under the new depreciation method from the beginning.

For newly acquired covered property, Rev. Proc. 2019-8 provides that if the ADS is not adopted, then the electing business is using an impermissible method of depreciation.¹¹ As a result, a subsequent change to the appropriate method of depreciation under the ADS is considered a change in accounting method under Sec. 446(e). Again, the taxpayer must file Form 3115. A Sec. 481(a) adjustment will also apply.

Finally, it should be noted that Rev. Proc. 2019-8 amends Rev. Proc. 2018-31 to now include a new Sec. 481(a) adjustment paragraph.¹² This new paragraph, found in Section 6.05, stipulates that the taxpayer is required to calculate the Sec. 481(a) adjustment as of the first day of the year of change as if the proposed method of accounting (ADS) had always been used by the taxpayer beginning with the year of the change.

Residential rental property under the ADS

Prior to the TCJA, the recovery period for residential rental property under the ADS was 40 years. The TCJA reduced the recovery period to 30 years. This change applies to residential rental property placed in service after 2017.

For such residential rental property, Rev. Proc. 2019-8 offers an optional alternative depreciation table, using a straight-line method, a midmonth convention, and a 30-year recovery period.¹³ This optional table modifies Rev. Proc. 87-57, which addresses the manner of computing depreciation deductions in Sections 2-7, and in Section 8 provides optional depreciation tables that may be used in lieu of the methods described in Sections 2-7. The optional table in Rev. Proc. 2019-8, which the IRS created in response to taxpayers’ requests, provides an additional table to those found in Rev. Proc. 87-57.

Expanded applications, new accounting requirement

The TCJA modified various cost recovery rules. For one thing, it expanded the definition of qualified real property eligible under Sec. 179 for immediate expensing. Prior to the TCJA, eligible property included only property under lease, restaurant real property, and retail real property. Now, any nonresidential real property qualifies if the improvements are to the interior of the building, with certain exceptions. In addition, items such as roofing, HVAC, and so forth, once treated as components and not improvements, are now eligible.

Further, the TCJA made additional property subject to the ADS of Sec. 168(g). This change affects certain businesses that elect out of Sec. 163(j)’s limit on interest expense deductions, that is, “electing real property trades or businesses” or “electing farming businesses.” They must now use the ADS for specific types of property.

A third change that the TCJA made was to reduce the recovery period for residential rental property under the ADS from 40 years to 30 years.

Rev. Proc. 2019-8 provides guidance on these changes to cost recovery rules, including: (1) how to make an election to treat qualified real property as Sec. 179 property; (2) how a business making a Sec. 163(j) election can correct its previous failure to shift to the ADS; and (3) what ADS depreciation tables are available for residential rental property placed in service after 2017.

Footnotes

¹P.L. 115-97.

²Secs. 179(e) and 168(e)(6); Rev. Proc. 2017-33, §4.02.

³Rev. Proc. 2019-8, §3.02.

⁴Regs. Sec. 1.179-5(c)(2).

⁵Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136.

⁶Rev. Proc. 2019-8, §4.02.

⁷Id.

⁸Regs. Sec. 1.168(i)-4(d)(4)(i).

⁹Rev. Proc. 2019-8, §4.02.

¹⁰Rev. Proc. 2018-31, §4.03(a).

¹¹Rev. Proc. 2019-8, §4.02(3)(b).

¹²Rev. Proc. 2019-8, §5.

¹³Rev. Proc. 2019-8, §4.01.