The IRS has issued guidance (Rev. Proc. 2019-08
) addressing how taxpayers change to use the alternative depreciation system (ADS) on both newly acquired and existing property after electing out of the interest limitation under Section 163(j).
This long-awaited guidance reflects changes made by the Tax Cuts and Jobs Act (TCJA) (P.L. 115-97), and also addresses the implications and procedures for the change in use to ADS, the change to the ADS recovery period for residential rental property and certain definitions in Section 179. The guidance affects taxpayers with qualified real property placed in service after Dec. 31, 2017, and taxpayers engaged in certain trades or businesses that elect out of the interest limitation under Section 163(j).
The changes, definitions and modifications to other procedures provided in Rev. Proc. 2019-08 are effective immediately and will impact 2018 tax returns and provisions. Therefore, taxpayers should be aware of the rules and remaining uncertainties. The following contains more information on these issues and related areas identified as in need of technical corrections by the general explanation of TCJA released by Joint Committee on Taxation (commonly referred to as the “Bluebook”).
Electing trades or businesses
Section 163(j)(7) allows certain real property and farming businesses to elect out of the new general limit on interest deductions enacted by the TCJA under Section 163(j). However, the TCJA also amended Section 168(g) to require the businesses making this election to depreciate certain property using ADS. Electing real property businesses must use ADS to depreciate nonresidential real property and residential rental property and qualified improvement property (QIP), and electing farming businesses must use ADS to depreciate property with a recovery period of 10 years or greater. Property depreciated under ADS must use a straight-line method and generally has longer recovery periods than property using the general depreciation system (GDS) under Section 168(a).
These amendments apply to taxable years beginning after Dec. 31, 2017, regardless of when such affected properties were originally placed in service. The IRS previously addressed the elections for these businesses in the proposed regulations under Section 163(j). See Tax Flash 2018-22 for more details.
Rev. Proc. 2019-08 addresses the transition for affected property from GDS to ADS for electing trades or businesses. ADS is required for use by properties placed in service during the election year and all subsequent years (“newly-acquired property”) and in addition ADS is required for properties that were placed in service in taxable years prior to the year in which an election is made (“existing property”).
For existing property, a change in use occurs as a result of an election made under Section 163(j)(7). Therefore, depreciation on such property is determined in accordance with the rules under Treas. Reg. Sec. 1.168(i)-4(d). Existing property that was originally qualified for bonus depreciation under Section 168(k) is not required to redetermine the bonus allowance because of the change in use. Also, such a change is not considered a change in method of accounting under Section 446(e), and a Form 3115 is neither permitted nor required. The change-in-use rules do not allow a Section 481(a) adjustment because the change is essentially made on a cut-off basis for each asset.
Depreciation deductions for newly-acquired property should be determined using ADS for the year when it is placed in service and all subsequent years. Because the property is required to use ADS, it will not qualify for bonus depreciation in the year it is placed in service.
If a taxpayer fails to properly apply these rules to existing property and newly acquired property in the election year and the subsequent taxable year, then the taxpayer will have adopted an impermissible method of accounting under Section 446(e). To change to a permissible method of accounting for the item(s), a Form 3115 is required to be filed either under the automatic or non-automatic procedures of Rev. Proc. 2015-13, as applicable.
Grant Thornton Insight: This procedure is consistent with the change in use rules provided in the regulations prior to the TCJA. Generally, this is welcome guidance for taxpayers contemplating the elections under Section 163(j)(7) in planning for potential interest expense limitations. Taxpayers engaged in interest limitation planning may be especially relieved to know that prior years’ bonus depreciation is not required to be redetermined.
However, while this guidance addresses how to make the required changes, it does not fully define what property is required to be changed. The revenue procedure did not address whether QIP includes qualified leasehold improvement property (QLIP), qualified restaurant property (QRP) and qualified retail improvement property (QRIP) that was placed in service prior to the QIP definition in the PATH Act or that does not also meet the definition of QIP.
A Bluebook footnote highlights that Congress intended for an electing trade or business to also use ADS to depreciate QLIP, QRP and QRIP (as defined under prior law) placed in service prior to 2018. However, the Joint Committee on Taxation
noted a technical correction may be necessary to clarify Section 168(g)(8), because, as enacted, it only states QIP.
Grant Thornton Insight: Businesses considering the election under Section 163(j)(7) that have QLIP, QRP or QRIP that did not also meet the definition for QIP when originally placed in service may wish to consider the possible effects of using ADS to depreciate these types of property if a technical correction is passed.
Residential rental property
The TCJA also modified Section 168(g) to reduce the recovery period under ADS from 40 years to 30 years for residential rental property placed in service after Dec. 31, 2017. Taxpayers requested an optional depreciation table to compute the annual depreciation allowance for such property, because one had not yet been provided. Section 4 of Rev. Proc. 2019-08 amplifies Rev. Proc. 87-57 by adding a new optional depreciation table for property depreciated straight-line under ADS with a recovery period of 30 years and a mid-month convention.
Grant Thornton Insight: The 30-year ADS recovery period for residential rental property only applies to assets placed in service after Dec. 31, 2017. For assets placed in service prior to such date, the 40-year ADS recovery period previously in effect still applies. If an asset is subject to a change in use, for example in a real property trade or business election, the date on which it was originally placed in service by the taxpayer determines whether a 40- or 30-year ADS recovery period is required.
Modifications to Section 179 expensing
Section 179 provides an immediate expensing election for certain property placed in service by a taxpayer. The amount that may be expensed in a given year is subject to a dollar limitation and aggregate investment limitation. The TCJA provided that for taxable years beginning in 2018, the dollar limitation is a $1,000,000 expense and the investment limitation is $2,500,000, with adjustments for inflation. Pursuant to Rev. Proc. 2018-57, the limitations for taxable years beginning in 2019 will be increased to $1,020,000 and $2,550,000, respectively.
Section 179(d) defines the property purchased for use in the conduct of a trade or business that is eligible for the expensing election. Prior to the TCJA, that generally included tangible personal property depreciated under Section 168 and computer software depreciated under Section 167. Section 179(f) provided a separate election to include qualified real property, defined as QLIP, QRP and QRIP, as property eligible for the expensing election.
The TCJA amended Sections 179(d) and (f) to modify the definition of qualified real property to mean QIP and certain other improvements to nonresidential real property placed in service after the building was first placed in service, including: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems. It also added language to allow property used predominantly to furnish lodging to be eligible for expensing. These amendments apply to property placed in service in taxable years beginning after Dec. 31, 2017.
Rev. Proc. 2019-08 now clarifies that an election to expense all or a portion of the cost of qualified real property on either an original or an amended tax return is made in accordance with procedures similar to those in Treas. Reg. Sec. 1.179-5(c)(2) and Section 3.02 of Rev. Proc. 2017-33.
Grant Thornton Insight: Because the amendments to Section 179 are effective for tax years beginning after Dec. 31, 2017, taxpayers with fiscal years beginning in 2017 and ending in 2018 are subject to the more limited rules in effect prior to the TCJA. While QIP replaced QLIP, QRP and QRIP for purposes of Section 179, the additional language on specific building systems further expands what can be considered qualified real property. This expanded definition may include property not eligible for bonus depreciation, which could make the election more attractive to taxpayers than in previous years.
The changes, definitions and modifications to other procedures provided in Rev. Proc. 2019-08 are effective Dec. 21, 2018, and apply to property placed in service, generally for taxable years beginning after Dec. 31, 2017. Therefore, taxpayers should be aware of the rules for making elections under Section 163(j) and Section 179 for the next quarterly or year-end tax provisions on financial statements, because they may significantly affect depreciation expense or other cost-recovery deductions.
Taxpayers finally have confirmation of the procedures for converting GDS depreciation to ADS depreciation after making an election under Section 163(j)(7). The procedure indicates that it applies broadly to all defined property that was existing prior to the election and property acquired after the election. However, this procedure does not answer some lingering questions about the property required to convert, specifically the treatment of QLIP, QRP and QRIP.
The footnote in the Bluebook states that Congress intended for all QLIP, QRP and QRIP to use ADS as a result of making the real property trade or business election. When making estimates or performing modeling exercises, taxpayers should consider the impact of that footnote, and what difference it might make if the Section 163(j) election is made. Further, if guidance is not issued prior to tax returns being filed, taxpayers will have to take a position to either convert QIP only, or the broader list in the Bluebook. Choosing to not follow the broader definition may result in amended returns being required if a retroactive technical correction is subsequently passed. Alternatively, if guidance is later issued that is narrower than the footnote, taxpayers that followed the broad definition may need to amend returns to follow the narrowed definition.
For more information contact:
Partner, Accounting Methods
Washington National Tax Office
Grant Thornton LLP
+1 202 861 4140
Manager, Accounting Methods
Washington National Tax Office
Grant Thornton LLP
+1 202 521 1555
Manager, Accounting Methods
Washington National Tax Office
Grant Thornton LLP
+1 202 521 1501
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