Welcome to Kreischer Miller's Tax Season Construction Series, a four part in-depth look at the changes in the Tax Cuts and Jobs Act that affect businesses in the construction industry. In part one of the series, we examined the new rules for meals and entertainment tax deductions. Our second article examines depreciation and the new rules and return on investment for future purchases. In the coming weeks, we'll explore topics related to Section 199A and construction accounting methods.
For a high-level summary of the Tax Cuts and Jobs Act and how it applies to the industry, download our Tax Planning Opportunities for the Construction Industry whitepaper here.
The Tax Cuts and Jobs Act (TCJA) significantly modified depreciation methods and rules for taxpayers. Taxpayers can accelerate depreciation more aggressively in order to receive an up-front tax deduction for tangible asset purchases as well as real property improvements through bonus depreciation and enhanced Section 179 expensing.
The depreciation incentives will help taxpayers manage their tax bill and offer a quicker return on investment on asset purchases. Although on the surface this appears to provide taxpayers with immediate expensing for all asset purchases, there are traps that will need to be considered.
This chart compares the options available to taxpayers under bonus depreciation and Section 179.
If you have been considering updating your business facility or your machinery and equipment, now may be an optimal time to begin strategizing and laying the groundwork for the upgrade. Contractors can benefit from additional real property improvements that are now eligible for Section 179 expensing under the new law.
When purchasing machinery and equipment, especially large equipment, contractors should be mindful of determining whether or not the asset should be depreciated or if the expenditure can be categorized as an expense for tax purposes. If rehabbing or upgrading a machine or piece of equipment, the expenditure may be classified as a repair expense for tax purposes.
Highlighted below are the top three things contractors should consider when making purchasing decisions in 2019 and beyond.
1. Improvements to Owner-Occupied Real Estate
- Consider certain improvements to real property such as upgrades to your entire HVAC system, roofs, improvements to interior portions of the building, alarm systems, and fire protection, which are now eligible as an immediate deduction under and enhanced Section 179.
- If the real estate entity pays for these qualified improvements, you may be unable to utilize the immediate expensing under Section 179 expensing and will be required to expense them over 39 years. Therefore, it is very important to consider what entity will pay for the improvements.
- The operating entity as opposed to the real estate entity may want pay for these qualified improvement costs as a leasehold improvement since operating companies will qualify for the immediate deduction under section 179.
- Building enlargements, internal framework, elevators, and escalators are excluded from the Section 179 deduction and still must be expensed over a 39-year life no matter who pays for the improvements.
2. Large Purchases of Machinery and Equipment
- Contractors upgrade machinery and equipment on a yearly basis and Section 179 and bonus depreciation can have an impact beyond taxable income, depending on the tax decision.
- Bonus depreciation can create a taxable loss but there are loss limitations at the shareholder level that can permanently reduce the benefit of the deduction under the new tax law, which could significantly minimize the tax benefit.
- Bonus depreciation can significantly reduce a shareholder’s taxable income to the point where some of their income will be taxed at the lower end of the tax brackets. This could make the bonus depreciation deduction not as valuable and tax inefficient.
- Section 179 offers more flexibility for taxpayers to choose which fixed assets to immediately expense. This allows the shareholder the ability to better manage their taxable income to ensure the depreciation deduction is offsetting income in the higher income tax brackets and preserving the deduction on the other fixed assets to future years where it could offset income at a higher income tax rate. This strategy can create a permanent tax savings!
- Careful planning is required to ensure the decisions made for depreciation at the business entity level do not negatively impact the shareholders ability to fully utilize the depreciation deduction on their personal tax returns.
3. Financing Considerations
- Consider potential future fixed asset purchases, as accelerating depreciation in one year will affect the impact in future years should the business be inconsistent with fixed asset purchases year over year especially if the fixed assets are financed.
- The issue pertaining to cash flow issues in the context of matching the current year depreciation deduction to the future cash outflow on the debt service will not coincide since the financed fixed assets will be paid for over the next few years.
- If the company makes a significant investment in fixed assets, that are financed, in year 1 and plans to make minimum investments in fixed assets in the following years this could present a scenario where you could have a higher tax bill in the future with minimum amount of cash to pay the taxes.
- If the above scenario presents a challenge to a contracting business, then consideration should be given to not take bonus or section 179 depreciation in the current year. This would allow the depreciation deduction to match the cash outflow on the debt service more evenly through the years.
Section 179 and bonus depreciation offers a wide range of options to taxpayers to accelerate expenses in order to reduce taxable income. Impacts at both the business and shareholder level should be considered by contractors before making a decision regarding purchasing equipment or making improvements to their property. Kreischer Miller can help assist you in determining the return on investment from the accelerated depreciation options available to your business.
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Look for part three in our Tax Season Construction Series – last minute planning opportunities under the new Section 199A pass-through deduction– coming soon!
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.