Some Property Owners Could Face Surprising Tax Bills
By: Dan Thrailkill, Ellin & Tucker
A drafting error in the recent tax reform law has the potential to take a big bite out of the bottom line for developers who renovate properties for new tenants.
The ways we work, shop and live are changing at a rapid pace, and commercial real estate professionals have been forced to rapidly adjust how they are presenting, marketing and utilizing the spaces they own. E-commerce, coworking and urbanization are only accelerating these trends, and property owners can go from a consistent tenant relationship to a vacancy in short order.
E-commerce in particular has made a huge impact on the commercial real estate industry. Retailers small and large have closed their doors, and e-commerce giants are snapping up industrial space for last-mile deliveries and other uses.
For example, to cut costs and increase efficiencies, many big box tenants are reducing their square footage upon renewal of their lease. While it makes financial sense for the retailer, it often creates a problem for the owner of the property, who is suddenly left with vacant space that needs to be filled.
It is not uncommon for a store to change its footprint from 50,000 square feet to 30,000 square feet. The building owner must then find a use for 20,000 square feet of empty space. Additionally, that new occupant will most likely need major renovations to make the space work best for their business. An example would be a grocer moving into a former Toys “R” Us building who would need to install extensive refrigeration capacity.
The cost to attract, sign and retain a new tenant can be hefty. But because of a mistake by Congress in the new tax law, property owners now have an even bigger problem on their hands.
A Costly Mistake
Prior to the Tax Cuts & Jobs Act (TCJA), which was signed into law at the end of 2017, the majority of the build-out costs for a new tenant were deemed qualified improvement property (QIP), which was eligible for a 15-year depreciable life and 50 percent bonus depreciation. Essentially, this allowed the owner to deduct the majority of the renovation expenses in the first year, which is certainly the most ideal financial situation.
While the intent was to keep these costs eligible for 15-year depreciable life and a potential 100-percent first-year bonus depreciation, the final draft of the law missed the mark badly. As a result of a drafting error, property owners now must deduct the renovation costs over several years, not all at once. What was once a 15-year depreciable life is now 39 years under the current law — and the difference is jarring for property owners. In addition, many property owners are no longer allowed “immediate expensing” of many of their investments because of the technical error in the bill.
How Big of a Bite?
For example, if the owner of the building spends $1 million to retrofit the vacant space for a new tenant, the new tax treatment will put all $1 million on a 39-year depreciable life, only allowing for a deduction in the first year of about $25,600. Had the law met its intentions, these costs would have been eligible for bonus depreciation and a full $1 million deduction in the first year. That’s a stunning variance of $974,400 in tax deductions. It’s understandable for commercial property owners to be concerned.
Congress fully recognizes the mistake and acknowledges the error, and while this was clearly not the intent of the legislation, the IRS must still follow the letter of the law and cannot independently change anything in TCJA.
Qualified Improvement Property Bills Introduced in Congress
In the spring, lawmakers in the House and Senate took first steps toward mending the flawed QIP provision of the 2017 tax-reform bill.
U.S. Representatives Jimmy Panetta, D-Calif., and Jackie Walorski, R-Ind., introduced the Restoring Investment in Improvements Act. It mirrors an earlier bill introduced by Senators Pat Toomey, R-Pa., and Doug Jones, D-Ala., that would restore incentives for investments made by owners of commercial, restaurant, retail and other property types.
Congress had intended for the Tax Cuts and Jobs Act of 2017 (TCJA) to permanently shorten the cost recovery period for tenant leasehold improvements, now termed “Qualified Improvement Property” (QIP), instead of through annual tax extender legislation as had been done in the past. However, as a result of the drafting error in the tax reform bill, QIP investments must be written off over a far longer period than was intended. In some cases, property owners are being forced to spread these deductions out over 39 years.
Fixing QIP is a top legislative priority for NAIOP and its members. The association has been working with its allies in commercial real estate and other industry groups as part of a broad coalition advocating for technical corrections legislation to the tax reform bill. The introduction of these bills is an important milestone in that effort; however, it’s unclear when they will come up for a vote.
In December 2018, NAIOP and the coalition sent a letter to leaders in the House and Senate urging the corrective legislation “in order to increase investments in communities, grow jobs and sustain businesses that are suffering losses.” — NAIOP Government Affairs staff
Daniel J. Thrailkill, CPA, is a director in Ellin & Tucker’s tax department.