ADS Depreciation: The Lesser of Two Evils?
July 05, 2022
By Ralph Estel
More taxpayers are going to be negatively impacted by the interest limitation rules, set forth by the Tax Cuts and Jobs Act of 2017 (TCJA). The limitation on interest applies to interest in excess of 30% of the taxpayer’s adjusted taxable income. Starting in 2022, in calculating adjusted taxable income, depreciation and amortization expenses are no longer being added back thereby reducing the income used to calculate the allowable interest deduction. Some taxpayers engaged in real estate trades or businesses may be able to avoid this limitation by making an election. As a result of this election, the taxpayer must change their method of depreciation to the alternative depreciation system (ADS) in lieu of the general depreciation system (GDS) for assets with class lives of 20 years or more. However, there are negative consequences to this election and, since the election is irrevocable, an assessment needs to be made as to which limitation is less onerous.
In selecting ADS, taxpayers would relinquish a major benefit of GDS: bonus depreciation on some assets.* Currently, bonus depreciation is the 100% deduction for the cost of certain land improvements and “qualified improvement property” (QIP); most tenant fit-outs and common area improvements qualify as QIP.
Considering that point, taxpayers would then need to determine whether they should make the ADS election. The assessment is as follows:
- They are subject to the interest limitation if their revenue is over $25 million or they are considered a tax shelter. Most real estate companies would generally only be considered a tax shelter if more than 35% of their losses are allocated to partners who are not involved in the management of the company. However, there is a caveat: Taxpayers are only considered a “tax shelter” in a year they generate losses. In a year they have income they would not be considered a tax shelter and would be able to deduct all current year interest and all prior year(s) disallowed interest.
- If a taxpayer determines they are subject to the interest limitation, they need to then determine the amount of the interest limitation. Interest is limited to 30% of adjusted taxable income (ATI), which is calculated by taking taxable income plus interest expense, plus nonbusiness income, less nonbusiness deductions, less interest income. Any interest over 30% of ATI is not deductible in the current year.
- The taxpayers should calculate the forgone depreciation under the ADS method. Taxpayers should look at their anticipated capital improvements for the foreseeable future and identify what would qualify for bonus depreciation, and then determine the depreciation for those improvements under the ADS method. The difference between the two numbers is the depreciation limitation. It should be noted that bonus depreciation is scheduled to slowly decrease from 100% to 0% over the next five years. Of course, Congress does have the ability to eliminate or reverse those decreases at any time.
Once taxpayers gather the above information, they can then decide which limitation to move forward with.
If they choose to make the ADS election, it must be made on the company’s tax return and include the taxpayers name, address, EIN, principal business activity code, a description of the taxpayer’s business, and a statement that the taxpayer is making an election under IRC Sec. 163(J)(7)(b) or (c). The company then must recalculate depreciation on all assets using the ADS method. This is done by taking the adjusted basis of all assets and depreciating them over the remaining ADS life that would have been left had the assets been depreciated using the ADS method the entire time.
The fact that taxpayers do not have to change prior depreciation leads to an interesting planning opportunity. They could purchase a property in year one, have a cost segregation study** done, take a substantial bonus depreciation deduction in the first year, then in year two elect to have ADS apply. Taxpayers would essentially get a huge bonus depreciation deduction in the first year and not have the interest limitation apply for years two and forward.
As you can see some companies are put in the position that they must determine the lesser of two evils and choose if they want to limit their interest deduction or their depreciation deduction. The election cannot be taken lightly since it is irrevocable, and these companies will have to spend considerable resources predicting future interest costs and capital improvements.
*ADS also has longer depreciable lives and generally less aggressive depreciation calculations.
*A cost segregation study is an engineering study that allows for a certain amount of property’s purchase price to be allocated to personal property or qualified improvement property, thus allowing bonus depreciation.