ADS vs. GDS Depreciation and Interaction with IRC Section 163(j)

Two Depreciation Systems Under MACRS

The Modified Accelerated Cost Recovery System (“MACRS”) is currently used to depreciate business property placed in service after 1986. MACRS consists of two depreciation systems: the General Depreciation System (“GDS”) and the Alternative Depreciation System (“ADS”). These two systems depreciate property in different ways, such as by method, recovery period and bonus depreciation. The chart below shows the main differences between GDS and ADS.  

Which Applies, GDS or ADS?

Generally, taxpayers must use GDS to depreciate property. However, IRS Pub. 946 lists the following property for which the use of ADS is mandatory:

• Nonresidential real property, residential real property and qualified improvement property held by an electing real property trade or business.
• Any property with a recovery period of 10 years or more under GDS held by an electing farming business.
• Any tax-exempt use property.
• Any tax-exempt bond-financed property.
• All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect.
• Any property imported from a foreign country for which an executive order is in effect, because the country maintains trade restrictions or engages in other discriminatory acts.

Also, a taxpayer can elect to use ADS (IRC Sec. 168(g)(7)). This election must apply to all property in the same class that is placed in service during the year. In the case of nonresidential real property or residential rental property, this election may be made separately with respect to each property. Once the election is made, it is generally irrevocable.  

Whether or not to use ADS is important for business taxpayers, because depreciation expense can significantly reduce business taxes. It becomes more important and complex when interacted with IRC Sec. 163(j) interest expense deduction limitations.

TCJA Interest Expense Limitation Interaction with ADS

The 2017 Tax Cuts and Jobs Act (“TCJA”) significantly changed the deductibility of business interest expense. The amount of deductible net business interest expense under IRC Sec. 163(j) cannot exceed 30% of the taxpayer’s adjusted taxable income (“ATI”). ATI is generally taxable income computed without regard to any:

• Item of income, loss, gain or deduction that is not allocable to a trade or business.
• Business interest income or expense.
• Net operating loss deduction.
• Qualified business income deduction.
• Depreciation, amortization and depletion deductions for tax years 2018-21.

For tax years beginning after 2021, ATI is defined similarly to earnings before interest and taxes (“EBIT”). Deductions for depreciation, amortization and depletion are not added back to calculate ATI.

Example 1

For tax year 2018, a taxpayer has a trade or business that generated $2,000,000 of gross income, $800,000 of operating expense, $400,000 of business interest expense, and $300,000 of depreciation expense. Before the TJCA, the interest expense of $400,000 was generally 100% deductible, and the net income would be $500,000. However, under the TCJA, the taxpayer can only deduct $360,000 of interest expense, which is 30% of ATI. (Assume the taxpayer does not qualify for any IRC. Sec. 163(j) exemption.) The calculation below illustrates how the limitation applies:

The remaining $40,000 is Excess Business Interest Expense (“EBIE”), which is nondeductible in 2018 and can be carried forward to the following year. In 2019 or a future year, if the trade or business generates excess business taxable income (“EBTI”) or excess business interest income (“EBII”), the $40,000 of EBIE can be deducted in that year. The TCJA provides certain exemptions:

• Small business taxpayer exemption (IRC. Sec. 163(j)(3)) – Taxpayers that are not tax shelters and have average annual gross receipts of $25 million or less (the amount is subject to adjustment for inflation, $26 million for 2019 and 2020) in the previous three years are exempt from IRC. Sec. 163(j).
• Electing real property trade or business (IRC Sec. 163(j)(7)(B)) – An electing real property trade or business can elect out of the IRC Sec. 163(j) limitation, which requires using ADS for all nonresidential real property, residential rental property and qualified improvement property.
• Electing farming business – An electing farming business can elect out of the IRC Sec. 163(j) limitation, which requires using ADS for any farming property the taxpayer owns with a recovery period of 10 years or more.
• Certain utility businesses.

For the same example above, if the taxpayer qualifies for the small business taxpayer exemption, the taxpayer can deduct all $400,000 of interest expenses. If the taxpayer makes an electing real property trade or business election, it also can deduct $400,000 of interest expense.  

However, there are “costs” for using the ADS depreciation method instead of GDS: (1) ADS generally has a longer recovery life than GDS; (2) no bonus depreciation deduction can be claimed with ADS; and (3) ADS applies to both existing property and newly acquired property.

Residential property placed in service before January 1, 2018, would have less depreciation expense each year, because its recovery period changes from 27.5 to 40 years.

Example 2

Assume that a taxpayer owns a commercial Building C and a residential Building R. The difference in deprecation under GDS and ADS is:

CARES Act and IRC Sec. 163(j)

On March 27, 2020, Congress enacted The Coronavirus Aid, Relief, and Economic Security (“CARES”) Act. On April 10, 2020, the IRS released Revenue Procedure 2020-22, and on April 17, 2020, the IRS released Revenue Procedure 2020-25. The CARES Act retroactively changes TCJA IRC Sec. 163(j) for tax years 2019 and 2020, and the IRS revenue procedures provide additional guidance for real property trades or business to re-evaluate the impact of business interest expense limitation. The main changes include:

• The amount of deductible net business interest expense increases from 30% to 50% for 2019 and 2020 (partnerships have special rules).
• Qualified improvement property is classified as 15-year property under GDS and 20-year property under ADS. It is qualified for bonus depreciation.
• Taxpayers can withdraw previous elections under IRC Sec. 168, such as the election to depreciate assets under ADS and the election out of bonus depreciation (IRC Sec. 168(k)(7)).
• Taxpayers can make an electing real property trade or business election by attaching an election statement to the taxpayer’s timely filed federal income tax return (including extensions). 
• The CARES Act has special partnership rules. The ATI limitation increases to 50% for tax years beginning in 2020. For tax years beginning in 2019, a partnership’s ATI limitation remains at 30%, but 50% of excess business interest expense allocated to a partner can be deductible without limitation on the partner’s 2020 tax return.

Example 3

A taxpayer owns a commercial Building C and a residential Building R. He also made qualified improvements on Building C in 2019. Under the CARES Act, the depreciation on assets under GDS and ADS is:

The CARES Act allows taxpayers who previously made the IRC Sec. 163(j)(7)(B) real property trade or business election to revoke this election. The taxpayer should recalculate and analyze 2019 and 2020 interest expense (50% limitation) together with the amount of decrease in depreciation. The decision may vary by case.

Using the same Example 1 above, assume the taxpayer is disqualified for the small business taxpayer exemption and made an IRC Sec. 163(j)(7)(B) real property trade or business election for the tax year of 2018 to deduct all interest expense. For 2019, income and loss remain the same as 2018, except $100,000 is paid for qualified improvement property. With the IRC Sec. 163(j) real property trade or business election, the $100,000 qualified improvement is not entitled to bonus depreciation, and it should be depreciated over 40 years. (Assume it was placed in service on 1/1/2019, with mid-month convention, $100,000/40=$2,500 x 11.5/12=$2,396.) The taxable income is calculated as below:

After the CARES Act, the taxpayer can revoke the previous IRC Sec. 163(j)(7)(B) real property trade or business election and is entitled to bonus depreciation on the qualified improvement property. The calculation is illustrated as:

The entire interest expense of $400,000 is fully deductible in 2019. Therefore, the taxpayer should revoke the previous 163(j)(7)(B) election.

Final and New Proposed Regulations Issued Under IRC Sec. 163(j)

On July 28, 2020, the IRS and the Treasury Department issued final regulations under IRC Sec. 163(j) and new proposed regulations (REG-107911-18). These regulations finalize most of the proposed regulations under IRC Sec. 163(j) and provide additional guidance and clarification.

• The final regulations allow taxpayers to make the real property trade or business election regardless of whether they are subject to the small-business exemption.
• It allows taxpayers who own and rent triple net-lease property to make the real property trade or business election under IRC Section 163(j)(7)(B).
• The final regulations allow any depreciation, amortization or depletion that is capitalized into inventory under IRC Sec. 263A to be added back to calculate ATI for tax year beginning before January 1, 2022.

After the enactment of the TCJA and the CARES Act, whether to elect ADS in connection with a real property trade or business becomes an essential question for each business taxpayer to consider. It may require sophisticated analysis—in consult with your trusted business advisor—to make that decision.