Editor's note: This article was originally published in April 2021 and is preserved here for reference. Several provisions it describes — including 100% bonus depreciation and the temporary CARES Act NOL carrybacks — have since phased down or expired. Always confirm current rules with a qualified tax professional before acting.
This piece was shared in my CCIM group by Bob Bauer and Jill Starrs of UHY Advisors. It was too good not to pass along — and it deserves better than my paraphrasing — so here it is in their words.
Wading through the tax implications of the 2017 tax reform and the 2020 CARES Act can be overwhelming for many real estate companies. But there's no doubt the industry should pay attention. Passed in the weeks after COVID-19 shut down much of the U.S. economy in 2020, the legislation created several significant tax opportunities that can accelerate savings and provide liquidity for commercial real estate investors.
1. First-year depreciation deduction
The 2017 tax reform bill — officially the Tax Cuts and Jobs Act of 2017 — increased the first-year depreciation deduction from 50% to 100% for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.
This matters because real estate companies can deduct the full cost of qualified property in the year of purchase, reducing the after-tax cost of an investment. The deduction phases down after 2022, so timing is critical. A cost segregation study should be performed to identify the portion of the purchase price that can be written off in the first year.
Example: A partnership that purchased a multifamily property in 2019 can write off more than 25% of the property cost in the year of acquisition, whereas under the old law they would have recovered only 10%. The partnership can pass large taxable losses to its investors, who can use them to offset other real estate income and gains from property sales.
Result: The 10% investor's allocable share of the first-year depreciation deduction is $1 million, rather than $400,000 under the old law. Assuming the investor has other rental income reduced by this deduction, that income would be eligible for the 20% qualified business income (QBI) deduction, producing an effective federal tax rate of 29.6%. Using the $1 million deduction yields first-year tax savings of $296,000. If a $40 million multifamily property is 65% leveraged, that savings — relative to the 10% investor's $1.4 million equity investment — represents a first-year return of 21% from the tax savings alone.
2. Faster write-offs for interior building improvements
The 2020 CARES Act made a technical correction to the 2017 law, making qualified improvement property (QIP) eligible for 100% bonus depreciation and assigning it a 15-year recovery period.
QIP is defined as any improvement to the interior portion of a nonresidential building, placed in service after the building was first placed in service. Expenditures for enlarging the building, for elevators or escalators, or for the internal structural framework are excluded.
This correction is effective for property placed in service after Dec. 31, 2017. Taxpayers and their advisers should review 2018, 2019, and 2020 fixed-asset additions to determine whether they qualify as QIP. The taxpayer can then either file an amended return to correct the depreciation in the year acquired, or file a change in accounting method, recompute the missed deductions, and bring them forward to the current year.
Example: A commercial real estate partnership acquired an office and retail property in early 2019 and then invested $2 million to update and retrofit the interior.
Result: In addition to the first-year depreciation on the purchase price, the partnership can deduct the full $2 million improvement. A 10% investor would receive a $200,000 deduction to offset other rental income. Assuming that income is QBI (effective federal rate of 29.6%), the investor sees an additional $59,200 in tax savings from the QIP correction.
3. Use net operating losses to create liquidity
The added deductions above can be substantial — large enough to create a net operating loss (NOL), or to substantially increase one. That NOL can then be used to obtain immediate tax refunds.
Before the CARES Act, the law limited business losses to $500,000, didn't allow NOL carrybacks, and capped NOL carryforwards at 80% of future-year income. Under the CARES Act, businesses could instead recalculate the depreciation that should have been allowed in prior years and either amend those years or catch everything up on an extended 2019 or 2020 return.
If those deductions were large enough to create NOLs, taxpayers — including owners of and investors in commercial real estate — could carry those losses back and obtain immediate refunds for tax paid at any point in the prior five years. Modeling the carryback and refund opportunities is essential to determine the highest and best use of the losses: carried forward, they might only offset income taxed at 29.6%; carried back, they might reduce income taxed at 39.6% and produce a refund.
Example: If the losses created by the added deductions are non-passive, a taxpayer can use them to offset other income and create an NOL.
Result: Using the two previous examples, a 10% non-passive investor could apply the $1 million multifamily bonus depreciation and the $200,000 QIP bonus depreciation to reduce current-year income by $1.2 million. With $500,000 of other income, that produces a $700,000 NOL. If the investments were made in 2019, that $700,000 NOL could be carried back (assuming $500,000 of income in 2014 and 2015) to recover tax paid in those years. A married couple filing jointly who reported $500,000 of income in those prior years and incurred a $700,000 NOL in 2019 could receive a federal refund of $215,000 — on top of $145,000 in savings on the 2019 deductions.
These provisions created a real opportunity for commercial real estate companies to review past fixed-asset additions, plan current and future additions, and take advantage of accelerated write-offs to generate liquidity. As always, the right move depends on your specific situation — so talk with your tax advisor before acting.