What’s the Impact of Claiming Section 179 Deductions for Real Property?

Posted by Kim Chen on August 5th, 2014

Under the Internal Revenue Code, some tax breaks seem to be a good deal — but later, you find there are strings attached. The ability to claim Section 179 deductions for qualified real property is a good example. New IRS guidance explains that there could be future negative tax consequences when businesses opt to claim current deductions under Section 179 — rather than depreciate real property assets over time.

Section 179 Deduction Basics

Annual Deduction Limitation. For qualifying property placed in service in tax years beginning in 2012 and 2013, the ATRA restored the maximum Section 179 deduction to $500,000 (same as for 2010 and 2011). The $500,000 limitation applies separately to each year. Without the ATRA, the maximum deduction for tax years beginning in 2012 would have been only $139,000, and the maximum deduction for tax years beginning in 2013 would have been only $25,000.

Deduction Phase-Out Rule. When a business is large enough to add lots of assets that would otherwise qualify for Section 179 deductions, a phase-out rule can come into play. Under the rule, additions in excess of the applicable annual threshold reduce the taxpayer’s maximum Section 179 deduction dollar for dollar. For tax years beginning in 2012 and 2013, the ATRA restored the phase-out threshold to a relatively generous $2 million (same as for 2010 and 2011). Without the law, the phase-out threshold for tax years beginning in 2012 would have been only $560,000, and the threshold for tax years beginning in 2013 would have been only $200,000.

Ineligible Property. Property eligible for the Section 179 deduction doesn’t include:
•Air conditioning and heating units.
•Property used for lodging, property outside the U.S., property used by certain tax-exempt organizations, and property used by governmental units or foreign persons or entities.
•Property owned by estates and trusts (including indirect ownership via partnerships and S corporations).

Background information: The American Taxpayer Relief Act of 2012 (ATRA) made beneficial changes to the Section 179 depreciation deduction rules for tax years beginning in 2012 and 2013. Under these rules, businesses can potentially claim first-year depreciation write-offs for up to $500,000 of eligible asset costs. (See right-hand box for more about the election.)

While Section 179 deductions are allowed for most personal property assets (including the majority of vehicles, equipment and most software costs), these deductions have traditionally not been allowed for real property. However, a temporary provision allowed Section 179 deductions for up to $250,000 of qualified real property placed in service in tax years beginning in 2010 and 2011. The ATRA extended this break to cover qualified real property placed in service in tax years beginning in 2012 and 2013.

There’s a significant potential downside to this seemingly irresistible tax goodie, so taking advantage of it is definitely not a no-brainer. Here’s what you need to know.

Ordinary Income Recapture Threat When Property Is Sold

Recently issued IRS Notice 2013-59 clarifies that claiming Section 179 deductions for qualified real property can result in so-called ordinary income recapture when the property is later sold.

In contrast, claiming “regular” straight-line depreciation deductions for real property expenditures doesn’t result in any ordinary income recapture when the property is sold. Instead, any gain on sale is treated as a tax-favored Section 1231 gain, assuming the property is held for more than one year. Net Section 1231 gains are treated the same as long-term capital gains for federal income tax purposes.

On the other hand, ordinary income recapture from a real property sale can be taxed at a federal rate of up to 39.6 percent when it’s recognized by individual business owners, such as partners, LLC members, S corporation shareholders, and sole proprietors. In addition, ordinary income recapture recognized by individual business owners may get hit with the new 3.8 percent Medicare surtax on net investment income. If so, the maximum federal rate on the recapture income can soar to a whopping 43.4 percent (39.6 percent plus 3.8 percent)!

The potential for ordinary income recapture is important to understand at tax return preparation time when business owners are deciding if they should claim or forego Section 179 deductions for qualified real property expenditures.

Key Point: The ordinary income recapture issue is much less important for businesses that are operated as C corporations, because C corporations pay the same federal income tax rates on ordinary income, Section 1231 gains and capital gains. In addition, C corporations don’t have to worry about the 3.8 percent Medicare surtax on net investment income.

Section 179 Basics for Qualified Real Property

The ATRA resurrected the Section 179 deduction privilege for up to $250,000 of qualified real property costs placed in service in tax years beginning in 2012 and 2013. The $250,000 limit applies separately to each year. The $250,000 annual limit is part of the overall $500,000 annual limit for all eligible assets rather than in addition to the $500,000 limit. Qualified real property includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.

Qualified Leasehold Improvement Property

This category covers non-residential building interior costs that are incurred pursuant to leases between unrelated parties (as defined). Certain interior costs are excluded, such as elevators and interior structural frameworks of buildings. The improvements must be placed in service more than three years after the date the building was first placed in service.

Qualified Restaurant Property

This category covers both restaurant building and improvement costs. Over 50 percent of the building’s square footage must be devoted to the preparation of meals and seating for on-premises consumption of meals.

Qualified Retail Improvement Property

This category covers non-residential building interior costs for a building that is open to the general public and used in a retail business of selling tangible personal property to the general public. Certain interior costs are excluded, such as elevators and interior structural frameworks of buildings. The improvements must be placed in service more than three years after the date the building was first placed in service.

Business Income Limitation and Carryover Rule for Disallowed Section 179 Deductions from Qualified Real Property Costs

Section 179 deductions that exceed the taxpayer’s net business income for the tax year cannot be deducted in that year. This business taxable income limitation is intended to prevent taxpayers from using Section 179 deductions to create or increase net operating losses (NOLs) that can then be carried back to earlier tax years.

Normally, any Section 179 deduction that is disallowed by the business income limitation can be carried forward indefinitely to future tax years until the disallowed amount can be deducted.

However, a special, and much more restrictive, rule applies to disallowed Section 179 deductions from qualified real property costs. Such disallowed deductions can only be carried forward to tax years that begin before 2014. Therefore, disallowed deductions from qualified real property placed in service in tax years beginning in 2010 through 2012 can only be carried forward to tax years beginning in 2013. No carryovers are allowed for disallowed deductions from qualified real property costs that are placed in service in tax years that begin in 2013.

To the extent the taxpayer has disallowed deductions that cannot be deducted in the tax year that begins in 2013, no Section 179 deduction will ever be allowed. Instead, the disallowed deduction amounts are treated as if no Section 179 election had been made, and are then depreciated under the standard depreciation rules that apply to the real property. This involves using a placed in service date of the first day of the tax year that begins in 2013.

Potential for High-Taxed Ordinary Income Recapture upon Sale

The most important element of the guidance in Notice 2013-59 is the clarification that claiming Section 179 deductions for qualified real property can result in ordinary income recapture when the property is later sold. The maximum amount of Section 1245 ordinary income recapture is limited to the allowed Section 179 deduction claimed for the property. As explained earlier, the annual limit on Section 179 deductions for qualified real property is $250,000.

Notice 2013-59 says taxpayers can use any reasonable method to determine the amount of gain that is treated as ordinary income recapture upon the sale or other disposition of qualified real property. Notice 2013-59 goes on to explain two specific methods that are considered reasonable by the IRS.

Conclusion: Strings Attached

As explained earlier, ordinary income recapture can be triggered on the sale or other disposition of real property for which Section 179 deductions have been claimed. Such ordinary income recapture can be taxed at a federal rate of up to 39.6 percent when it’s recognized by individual business owners, such as partners, LLC members, S corporation shareholders, and sole proprietors. In addition, ordinary income recapture recognized by individuals may get hit with the new 3.8 percent Medicare surtax on net investment income.

The ordinary income recapture threat does not necessarily make claiming Section 179 deductions for qualified real property a bad idea. However, the advisability of claiming Section 179 deductions must be carefully examined at tax return time. Consult with our Naples CPAs and Marco CPAs for full details.
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