The Protecting Americans from Tax Hikes (PATH) Act passed last year and provided taxpayers with goodies in time for the holidays. This post will focus on a new tax provision that helps taxpayers who make improvements to commercial buildings by making expenditures for these improvements eligible for bonus depreciation.
Under prior law, qualified leasehold improvement property qualified for bonus depreciation. Generally, long lived assets have to be depreciated over a number of years. Leasehold improvement property is generally deducted over 39 years. Qualified leasehold improvement property can be deducted over 15 years. Additionally, since it qualified for bonus depreciation, 50% of the cost of the qualified leasehold improvements could be deducted in the year the improvements were placed in service.
Example: ABC Corp spends $200,000 to remodel its leased space. Before the favorable qualified leasehold improvement property rules took effect, the $200,000 would have to be deducted over 39 years ($5,128 each year for 39 years).
Under the favorable qualified leasehold improvement property rules, 50% of the $200,000 can be deducted in the year of service and the remaining $100,000 cost can be deducted over 15 years (or $6,666 per year). The total first year depreciation expense is $106,666 (substantially more than the $5,128 that would apply without these rules)
Qualified leasehold improvement property included any improvement to the interior of a commercial building if:
• The improvement was made pursuant to a lease
• The interior building portion was to be occupied by the lessee or sublessee
• The improvement was placed in service more than 3 years after the building itself was first placed in service by any person
• The improvement was a structural component of the building
Qualified leasehold improvement property did not include expenses for:
• An enlargement of a building
• Any elevator or escalator
• Any structural component of a common area
• The internal structural framework of the building
Unfortunately, the qualified leasehold improvement property rules did not apply if the building owner was related to the tenant.
The New Law
Beginning in 2016, qualified improvement property is eligible for bonus deprecation. Now, bonus depreciation applies to qualified improvements to commercial buildings regardless of whether the building is leased or owned.
The definition of qualified improvement property has also been expanded.
Qualified improvement property is any improvement to an interior portion of a commercial building if the improvement is placed in service after the date the building is first placed in service. The improvement no longer needs to be placed in service more than 3 years after the building was first placed in service.
The definition of qualified improvement property now also applies to structural components of a building that benefit a common area.
Unfortunately, qualified improvement property still does not include any improvement for which the expense is attributable to: the enlargement of the building; any elevator or escalator; or the internal structural framework of the building.
To see how this applies to you, give us a call at 248-538-5331.
In September 2013, the IRS released 200 pages of guidance to business owners on when they should immediately deduct repair expenses or depreciate the repair expenses over several years. This guidance also addressed when business owners can immediately deduct asset purchases or when they should capitalize the asset purchase and deduct it over a number of years through depreciation.
Fortunately, the IRS has a de minimis safe harbor election that allows business owners to immediately deduct amounts paid for property if the business owner meets certain requirements.
This safe harbor was intended as an administrative convenience whereby a business owner can deduct small dollar expenditures for the purchase of new property or for the improvement of existing property. If the business owner spends an amount greater than the safe harbor amount, the safe harbor does not bar the business owner from immediately deducting the expense, but the business owner must establish that the expense qualifies as an item that can be expensed immediately.
How to Meet the Safe Harbor
To meet the safe harbor, the taxpayer:
• must have, at the beginning of the tax year, written accounting procedures treating as an expense for non-tax purposes amounts paid for property (1) costing less than $2,500 (per invoice or per item); or (2) with an economic useful life of 12 months or less
• treats the amount in its books and records as an expense
The original threshold limit was $500 per item or invoice. The IRS received a substantial number of comments noting that the cost of many commonly expensed items (for example, tablet-style computers, smart phones, and machinery and equipment parts) typically exceed the prior $500 per item or invoice threshold.
Example: ABC Corp has accounting procedures at the beginning of the year to expense amounts paid for property costing $2,500 or less and to expense amounts paid for property with an economic useful life of 12 months or less.
During the year, ABC buys 10 hand-held point-of-service devices at $600 each (total cost $6,000). Prior to the increase in the safe harbor threshold amount, ABC would have to capitalize the $6,000 purchase price and depreciate the expense over 5 years because each item cost more than the prior $500 safe harbor threshold.
Since the threshold has just been increased to $2,500 per item or invoice, ABC can now fully deduct the $6,000 purchase price of the items because the expense was less than $2,500 per item.
When Does the Safe Harbor Take Effect?
This increase is effective for costs incurred during tax years beginning 2016, but use of the new threshold won’t be challenged in tax years prior to 2016. And, if a taxpayer’s use of the de minimis safe harbor is an issue under consideration in examination, appeals, or before the U.S. Tax Court in a tax year beginning after Dec. 31, 2011 and ending before Jan. 1, 2016, and the issue relates to the qualification under the safe harbor of an amount that doesn’t exceed $2,500 per invoice (or item, as substantiated by invoice) and the taxpayer otherwise satisfies the applicable requirements, IRS won’t pursue the issue further.
To see how this applies to you, give us a call at 248-538-5331.
Business owners who buy assets that have useful lives longer than one year usually cannot immediately deduct the costs of these assets. The costs have to be deducted over a number of years through depreciation.
Luckily for restaurant owners, there is an exception that allows restaurant owners to immediately deduct the costs of smallwares in the year they are purchased and used.
What Are Smallwares?
Smallwares include the following items:
- Pots and pans
- Table top items
- Bar supplies
- Food preparation utensils and tools
- Storage supplies
- Service supplies
- Small appliances that cost $500 or less individually
This Provision Helps Other Food Services Businesses, Too…
This provision applies to corporations engaged in the business of preparing food and beverages to customer order for immediate on-premises or off-premises consumption. In addition to restaurants and cafeterias, this provision also applies to caterers, mobile food servers, bars and taverns, and food or beverage services located in grocery stores, hotels and motels, amusement parks, theaters, casinos, country clubs, and similar social or recreational facilities.
Watch Out for These Traps
There are two situations where an immediate deduction will not be available and the business owner will have to deduct the costs of smallwares over a number of years. The situations are:
- When the smallwares are purchased before the business begins operations. In this situation, the smallwares are treated as start-up expenses. Start-up expenses of up to $5,000 can be deducted the year business operations begin. Excess start-up expenses are deducted over 15 years.
- When the smallwares are purchased and stored, rather than put to immediate use. In this situation, the smallwares are treated as inventory and become deductible when they are put to use.
Example: Janson Family Restaurant will open to the public in July 2013. Prior to its opening, it buys $10,000 of smallwares. Later during 2013, it buys $5,000 of additional smallwares. During 2014, it buys an additional $4,000 of smallwares. Finally, during the last week of 2015, it buys $10,000 of smallwares, but keeps them in storage until 2016.
Janson Family Restaurant can deduct the costs of smallwares as follows:
- The $10,000 of smallwares purchased before opening are treated as start-up expenses. It can immediately deduct $5,000 and deduct the remaining $5,000 over 15 years.
- The $5,000 of additional smallware purchased in 2013 after the restaurant opened are fully deductible in the year of purchase
- The $4,000 of smallwares purchased during 2014 are fully deductible in the year of purchase
- The $10,000 of smallwares purchased during 2015 must be recorded as inventory in 2015 since the smallwares aren’t being used. The $10,000 will be fully deductible in 2016 once they are used.
Find This Post Informative?
When purchasing real property such as office buildings, apartment buildings, factories, shopping centers, and restaurants, taxpayers often fail to allocate the purchase price in a way that maximizes depreciation deductions. The purchase price can be allocated to land, land improvements, buildings, and personal property.
There are different depreciation rules for each of these classifications: often fail to allocate the purchase price in a way that maximizes depreciation deductions. The purchase price can be allocated to land, land improvements, buildings, and personal property.
There are different depreciation rules for each of these classifications:
- Land is not depreciable
- Land improvements are depreciated over 15 years using 150% declining balance (accelerated depreciation)
- Nonresidential buildings are depreciated over 39 years using straight-line depreciation
- Residential rental buildings are depreciated over 27.5 years using straight-line depreciation
- Equipment tends to be depreciated between 3 to 7 years using 200% declining balance (really accelerated depreciation)
A three step process can help taxpayers allocate as much of the purchase price to classifications that are depreciated most quickly:
- Make an initial land to building cost allocation
- Separate land improvements from overall land costs
- Use a cost segregation analysis to separate personal property costs from building costs
Make an Initial Land to Building Cost Allocation
The allocation should be based on relative market values of the land and the building. This allocation may be agreed upon by the buyer and seller and included in the sales contract. The allocation may also be based on a qualified appraisal. As much as possible, costs should be allocated to the building since land is not depreciable. However, it is preferable if costs can be allocated to land improvements rather than to the building because land improvements are depreciated more quickly than building costs.
Identifying Land Improvements
Land improvements include such assets as sidewalks, roads, drainage facilities, bridges, fences, landscaping and shrubbery. Only landscaping that is adjacent to the building is depreciable. Landscaping around the perimeter of the land tract is treated as a pure land cost and is not eligible for depreciation.
Use a Cost Segregation Study to Allocate Costs from the Building to Equipment
Equipment is depreciated much more rapidly than building costs. A closer examination of building costs often shows that part of the building cost actually relates to equipment, which is eligible for faster depreciation deductions over a shorter period of time. A cost segregation study is the process of reviewing the costs incurred to identify the specific types of assets being placed into service. For example, electrical and plumbing systems are typically depreciated over the building’s depreciable life. However, a cost segregation study may reveal that specialized plumbing and electrical systems are related to equipment and should be depreciated over the equipment’s shorter life. An example would be a hospital whose equipment requires specialized electrical wiring.
Example: ABC Corp buys a commercial building for $1 million. It does a rough cost allocation and allocates $200,000 to land and $800,000 to the building. The $200,000 land cost is not depreciable. The $800,000 building cost is depreciated straight line over 39 years at $20,512.
Total first year depreciation: $20,512
Example 2: Same facts as above except that ABC Corp does a more thorough allocation. It determines that $60,000 of the $200,000 land costs are actually land improvements. After a cost segregation study is done, it finds that specialized electrical and plumbing work costing $50,000 should be depreciated as equipment.
The depreciation for each classification is as follows:
- Land of $140,000 is not depreciable
- Land improvements of $60,000 are depreciated over 15 years using 150% declining balance method
- Specialized wiring and electrical costs of $50,000 are depreciated over 7 years using 200% declining balance method
- Building costs of $750,000 are depreciated straight line over 39 years
Total first year depreciation:
- Land Improvements $8,000
- Equipment $14,250
- Building $19,230
- Total $41,480
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Normally, when you buy long lived property, you can’t deduct the full cost of the property in the year you purchase it. The purchase price is deducted over the expected life of the property. In late 2010 through 2011, business owners were allowed to immediately deduct 100% of the cost of certain assets. This was known as 100% bonus depreciation. 100% bonus depreciation ended on December 31, 2011. Bonus depreciation is alive and well in 2012; however, it has been reduced to 50% from 100%. 50% bonus depreciation lasts through December 31, 2012. It is extended to December 31, 2013 for property having a longer production period (discussed later).
What is Eligible Property?
To be eligible for bonus depreciation, the property must meet three criteria:
1. The asset must be qualified property
- The asset must have a recovery period of 20 years or less. This includes most tangible personal property. It excludes almost all real estate.
- General purpose buildings used in agriculture, such as machine sheds and shops, are 20 year property and are eligible for bonus depreciation
- Off the shelf software qualifies
- Qualified leasehold improvement property qualifies
2. The ORIGINAL use must commence after December 31, 2007
- The asset must generally be NEW. Used property doesn’t qualify.
- New property initially used by a taxpayer for personal use and subsequently converted to business use meets the original use requirement
- Expenditures to recondition or rebuild assets satisfies the original use requirement, but purchases of reconditioned or rebuilt assets do not qualify. However, an asset that contains used parts will not be considered used if the cost of the used parts is 20% or less of the total cost.
3. The asset must be acquired and placed in service on or before December 31, 2012
- The placed in service requirement is extended to December 31, 2013 for property that has a longer production period and has an expected life of at least 10 years OR is commercial transportation property or certain aircraft.
- A longer production period is defined as exceeding two years OR an estimated production period exceeding one year and a cost exceeding $1 million.
- Only costs attributable to production before January 1, 2013 will qualify for this exception.
Qualified leasehold improvement property also qualifies for 50% bonus depreciation. Qualified leasehold improvement property meets the following tests:
- The improvement is to an interior of a building
- The building is nonresidential
- The improvement is made pursuant to a lease by either the lessee, sublessee, or by the lessor to property to be occupied by the lessee or sublessee
- The improvement is placed in service more than three years after the date the building was first placed in service by any person
- Leases between related parties do not qualify
Call us if you would like to discuss how this applies in your business.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
When a business owner buys fixed assets such as machinery and equipment, the business owner cannot deduct the full cost of the asset immediately. Instead, the business owner deducts the cost of the asset over a number of years through depreciation. Most equipment purchased by small business owners is depreciated over 3 to 7 years. A special deduction known as a Section 179 deduction exists that allows business owners to deduct in the year of purchase the cost of certain fixed assets.
Business owners are allowed to deduct up to $139,000 of the cost of eligible property acquired and placed in service during 2012. Eligible property is tangible personal property (e.g., equipment, machinery, computers, furniture) that is used more than 50% in a business. However, if the business owner purchases more than $560,000 of such property, the Section 179 deduction is reduced dollar for dollar by the amount of assets purchased in excess of $560,000.
Example: Joan buys $40,000 of furniture and $50,000 of equipment in her business. Since the $90,000 total cost of these assets is less than $560,000, Joan is eligible to fully deduct the $90,000 purchase price.
Example 2: John buys $400,000 of furniture and $200,000 of equipment in his business. Since John’s total purchases of $600,000 exceed $560,000, his Section 179 deduction is reduced by the $40,000 excess of assets purchased over the maximum limit. John may claim a Section 179 deduction of $99,000 ($139,000 maximum amount reduced by $40,000 of asset purchases over maximum limit).
Another important limitation on the Section 179 deduction is the taxable income limitation. The Section 179 deduction cannot exceed the total amount of taxable income derived from the active conduct of ANY trade or business of the business owner or his/her spouse during the year.
Active business income includes:
- Proprietorship income or loss
- Partnership income or loss
- S corporation income or loss
- Certain gains from sales of business assets
- Interest on working capital loans related to a business
Any Section 179 deduction limited because of inadequate taxable income can be carried forward indefinitely.
Example: Joan buys $40,000 of equipment in her proprietorship. She has $15,000 income in her business before any Section 179 deduction. Joan’s Section 179 deduction is limited to her taxable income of $15,000. Her business will have no profit for the year since her taxable income was sheltered by her Section 179 deduction. The disallowed Section 179 deduction of $25,000 will be carried forward to offset Joan’s future taxable income.
Example 2: Same as above except Joan’s husband has $40,000 of wages from his job. Active business income includes wages earned by a spouse. The couple’s active business income is therefore $55,000 ($15,000 from Joan’s business and $40,000 from the spouse’s wages). Joan can now deduct the full $40,000 of equipment purchases.
If the business owner operates through a LLC or S corporation, the taxable income limitation also applies at the entity level.
Example: John operates his business through an S corporation, ABC Corp. ABC Corp has $15,000 of taxable income. ABC Corp buys $20,000 of qualifying property. ABC Corp’s Section 179 deduction is limited to its taxable income of $15,000. ABC Corp carries forward the excess $5,000 Section 179 deduction indefinitely.
For S corporations and LLCs, the active business income is increased by shareholder wages and guaranteed payments, respectively.
Example: Same as above example except that ABC Corp paid John $10,000 in wages during the year. The $10,000 of shareholder wages is added back to ABC Corp’s taxable income of $15,000. ABC Corp’s active business income is now $25,000 and it can take the full Section 179 deduction of $20,000.
Of course John must have enough active business income on his personal return to utilize the Section 179 deduction.
Example: On John’s personal return, the $25,000 of active business income from his S corporation flows through. If John has a $10,000 loss from a separate business, his active business income is now $15,000 ($25,000 income from the S corporation less $10,000 loss from his separate business). John’s Section 179 deduction is limited to his $15,000 active business income. The remaining $10,000 of Section 179 will be carried forward by John.
What Type of Assets Don’t Qualify for Section 179?
Certain types of property are not eligible for Section 179 deduction. These include:
- Air conditioning and heating units
- Property used to furnish lodging (with the exception of hotels and motels)
- This prevents most taxpayers with residential rental property from claiming Section 179 deductions
- Property used outside the U.S.
- Property used by a tax exempt organization
- Property used by governmental units
- Property used by an estate or trust
What’s Changed Since 2011?
Before January 1, 2012, the maximum Section 179 deduction was $500,000 and this deduction was reduced dollar for dollar when property exceeding $2,000,000 was purchased during a year. A special Section 179 deduction of $250,000 was allowed for certain purchases of real property. The Section 179 deduction was therefore reduced from $500,000 to $139,000 in 2012. The Section 179 deduction for certain real property purchases was eliminated at the end of 2011. It is possible that Congress will retroactively reinstate the higher Section 179 deduction of $500,000. But it remains to be seen. Finally, unless Congress acts, the Section 179 deduction for 2013 will be $25,000. A very substantial reduction.
For more information on how these rules apply in your situation, please give us a call.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.