Imagine you’re the proud owner of Los Pollos Hermanos, a fast-food empire with 14 locations in the American southwest that you’ve built on the twin pillars of perfectly seasoned fried chicken and meticulously maintained restaurants.
The year is 2018, and you’ve noticed that a few of your establishments, including the flagship spot in Albuquerque, could use some freshening up. So you dip into the corporate coffers and pony up $1,000,000 to renovate and refurbish the interior portion of several of your restaurants. And you couldn’t wait to do it. Why is that?
Because when tax reform unfolded during the tail end of 2017, you were paying attention, and you came away with the understanding that after the Tax Cuts and Jobs Acts was enacted, that $1,000,000 you spent on your restaurants would give rise to an immediate, dollar-for-dollar, $1,000,000 deduction. That type of full deduction for building improvements has never before been available, so you jumped at the chance.
Today, however, you brought your financial information to your tax preparer, and she showed some concern at the large profit the businesses were showing. “Worry not,” you assured her, “I put $1 million into improving the restaurants that we can immediately deduct. That’ll bring us back to where we need to be.”
And it was at that moment that your tax preparer made a face that was deeply, deeply concerning. She went on to explain, “yeah, about that…you’re going to have to depreciate that $1 million over 39 years.”
How could that be? Based on your homework, you had been certain that your improvements would give rise to an immediate $1 million deduction. And you were right. But now, your trusted accountant has informed you that instead, you’ll recover that investment over nearly FOUR DECADES. And she’s right. How can both of those things be true?
To understand how you got in this mess, we’ve gotta’ travel back in time.
Prior to 2001, if you made an improvement to the interior portion of nonresidential property — think: redesigning a retail location to accommodate a new tenant — you had to depreciate those improvements over the life of the underlying building, or 39 years for nonresidential property.
After the September 11th attacks of 2001, however, Congress wanted to kick-start the economy. To that end, it added a few depreciation incentives. Most notably, Section 168(k) was added to the Code, allowing for 50% “bonus depreciation” on qualifying assets. This allowed a taxpayer to take an immediate expense equal to half the cost of a new asset, provided, in general, the asset had a life of 20 years or less.
Soon after, three new classes of assets were added to Section 168(e): qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property. These three types of property were afforded a 15-year life — rather than the customary 39-year life — a benefit that was doubly advantageous, because by giving these types of property a 15-year life, they now became eligible for bonus depreciation, as a 15-year life is less than the 20-year maximum life permitted for the 50% haircut. (Technically, only qualified leasehold improvement property was initially eligible for bonus depreciation, but over time, the other two classes would join the party).
This obviously, was great news for landlords who renovated their retail spaces, restaurants, or other property rented to tenants. There was a downside however: fitting within one of these three classes of assets was a nightmare. There were lease requirements. Related party prohibitions. Square footage rules. And the building had to be at least three years old before any improvements could pass the test. As a result, the rewards for refurbishing your leased space weren’t quite as great as they sounded.
Recognizing this to be the case, as part of the PATH Act of 2015, Congress added a FOURTH class of assets to Section 168(e): qualified improvement property (QIP). This class was to be free of all of those pesky definitional hurdles that plagued the other three classes: QIP was defined simply as any improvement made to the interior portion of a nonresidential building ANY TIME after the building was placed in service. No three-year waiting period. No square footage requirement. This was nice and clean.
The benefit of qualifying as QIP, however, were a bit of a unicorn in the tax law. QIP continued to have a 39-year life, but Section 168(k) was amended to allow bonus depreciation not only on assets with a life of 20 years or less, but also on property meeting the definition of QIP. So yes, QIP, despite having a 39-year life, was the rare 39-year asset that was eligible for bonus depreciation.
Then tax reform rolled around. And one of the main goals of the TCJA was to simplify the Code. And so Cong…what’s that? Stop laughing! No seriously, they wanted to make it more simple, I swear! They put it in writing and everything! Ok, ok…have your laugh. Can we move on now?
Where was I…oh yeah, so to make things more simple, Congress eliminated qualified leasehold, retail, and restaurant property, and consolidated everything into nice, easy QIP. And QIP, in turn, would be given a shiny new 15-year life.
Once again, this would be doubly beneficial, because as part of the TCJA, bonus depreciation was increased from 50% to 100%. This means that yes, had things worked out the way they were designed, the $1 million you spent to clean up your Los Pollos locations would have qualified as QIP, been granted a 15-year life, and thus been eligible for 100% bonus depreciation.
Things, however, did not work out the way they were designed. Because when the authors of the Code got around to actually changing the statutory language, they forgot one rather important thing: to amend Section 168(e) and give QIP a 15-year life. No seriously…it never happened….go look for yourself. It ain’t there.
So if QIP doesn’t have a 15-year life, what happens? It continues to have a 39-year life, that’s what. But that’s not the end of the world, is it? After all, QIP is bonus eligible, and now that bonus depreciation has increased to 100%, you still get our full, immediate deduction, right?
Wrong. And it’s wrong because the drafters of the statute did their job half right. Think about this: prior to the TCJA, under Section 168(k) — defining those assets eligible for bonus depreciation — there was one line item for:
- assets with a life of 20 years or less,
…and another for:
This was necessary, of course, because QIP had a 39-year life. But after passage of the TCJA, when QIP was supposed to have a 15-year life, this second bullet was completely redundant and, therefore, unnecessary. So Congress removed it, as they should have.
But consider the mess that created. Due to the part Congress got wrong, QIP has a 39-year life. And due to the part Congress got right, QIP was removed from the list of bonus-eligible assets. That means that based on the way Section 168(k) is written right now, those improvements to your chicken joints are stuck being depreciated over damn near 40 years.
And here’s the ultimate kick in the pants: when Congress screws up the tax law, it doesn’t get the luxury of simply grabbing some Wite-Out and making the Code say what it was intended to say. Nope; instead, Congress has to pass a “technical corrections bill,” a bill that requires 60 votes for passage in the Senate, where Republicans currently have control, but of only 52 seats. That means Congress would need — GOOD GOD…bipartisan agreement. And that, of course, is hard to come by, particularly when you consider something very important: the TCJA was drafted only by Republicans and voted for only by Republicans, o this is their bill, for good or bad. And this part is very, very bad. As a result, where is the motivation for 8 Dem Senators to cross the aisle and vote for a bill that allows the GOP to fix the mess they’ve created? There is none, of course.
But it’s the taxpayers who are left holding the bag, and the results are extremely painful, as evidenced by our little Los Pollos example. But understand, this little Section 168(k) was not the only error in the TCJA; far from it. In fact, a full listing of technical corrections — published by Kevin Brady a few months ago — comes out to 91 pages. And since Brady released that draft report, there has been no movement forward on a technical corrections bill, meaning many taxpayers are now filing their 2018 returns without the benefits promised to them, and with no reason to believe that the mistake will get fixed any time soon.
But finally…finally…we may have a ray of hope. Earlier today, a bi-partisan bill introduced by Senators Pat Toomey (R-PA) and Doug Jones (D-AL) — wait…that’s gotta’ be a typo. A Dem Senator from Alabama? How did that hap…ohhhhh, right. Roy Moore — would take a simple approach. It would ignore, for the time being, all of the other required corrections and endeavor to fix the QIP issue, and only the QIP issue.
The bill, which can be read here, would give QIP its promised 15-year life for regular tax purposes, as well as a 20-year life for ADS purposes. (ADS depreciation on QIP is required any time a “real property trade or business” elects out of the new interest limitation rules of Section 163(j). The ADS life of QIP had historically been 40 years, but the TCJA changed it to 20 years. Or, I should say, was supposed to change it to 20 years, but that, too, was missed when modifying Section 168. You can read about that here).
Most importantly, the bill would make the change retroactive to the intended to January 1, 2018, meaning taxpayers may want to extend their 2018 returns in the hopes that this bill becomes a reality in the next six months. Alternatively, taxpayers could file and then amend the return later should the bill become law.
Of course, if you remember your episodes of Schoolhouse Rock, legislation needs to start in the House, so at this point, the Toomey/Jones bill is more of a symbolic gesture, notifying those in the House that the Senate has some level of bipartisan support to get this mistake fixed. A symbolic gesture may not feel like much, but it’s more than we had 24 hours ago.
Now we have to play the waiting game, or if we get bored with that, perhaps a little Hungry Hungry Hippos. But its encouraging to know that at least a few members of Congress are inclined to deliver on the TCJA’s promise to businesses like Los Pollos Hermanos, and fix a mistake that is causing no shortage of heartache this tax season.