Congress Corrects Depreciation Mistake

Business owners got some good news earlier this year when Congress fixed an error included in 2017’s tax reform legislation.

The Problem

When improving nonresidential rental properties or other nonresidential buildings, a small business owner could depreciate qualified improvement property ("QIP") over 15 years and use bonus depreciation to expense more of the improvement in the first year. QIP is any improvement to a building's interior and was formally known as leasehold improvements. But in the haste of passing the Tax Cuts and Jobs Act in late 2017, the bill inadvertently eliminated the special depreciation rules for qualified improvements. The result was confusion, numerous errors in filing tax returns and the inadvertent elimination of a popular way to recapture more of the costs of improving a building over a shorter time period.

New Law

The CARES Act, passed on March 27, 2020, included a retroactive technical correction which confirms the 15-year recovery period and accessibility to 100% first-year bonus depreciation for Qualified Improvement Property. Businesses can now choose to amend their 2018 and 2019 tax returns to apply the 100% first-year depreciation deduction on qualified improvements placed in service during those years.

To Amend or Not to Amend

But is amending your past tax returns to capture bonus depreciation the right move for your business? Sure, expensing 100% of a QIP’s cost in a single year will drastically decrease your taxable income for that year, but here are several reasons why you may be better off spreading out the improvement's cost over 15 years.

• Depreciation may be worth more in the future. While income tax rates have historically fluctuated depending on the budget needs of the U.S. and the whims of the White House and Congress, chances are good that tax rates will increase in the not-so-distant future. You can either claim a 100% bonus deduction based on today’s top individual tax rate of 37%, or bet that the tax rates will increase, making a depreciation deduction more valuable in the future.
• Lower tax rate when you sell. If you claim 100% bonus depreciation and then sell your property, any taxable gain up to the amount of the bonus depreciation is treated as ordinary income, rather than capital gain, and could be subject to the top ordinary tax rate, currently at 37%. If you instead depreciate the property over 15 years using the straight-line depreciation method, the maximum individual federal rate would be 25% when depreciation is recaptured.
• Preserve current year qualified business income deduction (QBI). On your individual tax return, you can claim a federal income tax deduction for up to 20% of your business’s qualified business income. If you claim 100% bonus depreciation on a qualified improvement, your QBI and corresponding deduction will be lower.

Deciding to amend a tax return is never easy. Should you need a review of your situation, please call.