Astute real estate professionals should be taking advantage of several tax-saving provisions of the American Jobs Creation Act of 2004. The act was signed by President Bush last October to spur economic development and investment.
The primary components of the Amer ican Jobs Creation Act include increased depreciation deductions on leasehold improvements, greater flexibility for real estate investment trusts, modification of expensing rules for equipment and vehicles, and a reduction in the tax rate for domestic manufacturing activities.
The new law allows landlords to depreciate qualified leasehold improvements to non-residential real property over 15 years. Qualified leasehold improvement property is an improvement to the interior portion of a building made pursuant to a lease by the lessor or lessee. The improvements must be placed in service before Jan. 1, 2006, and more than three years after the building was originally placed in service.
Under the prior rules, leasehold improvements were depreciated over 39 years. If a tenant received a $50-persquare-foot improvement allowance for a 5,000-square-foot space, the annual depreciation expense for the $250,000 allowance would be $6,410. Assuming a 35-percent tax rate, the annual tax savings would be $2,244.
The new law increases the annual depreciation expense to $16,667 for the first 15 years and results in annual tax savings of $5,833. Over the life of the asset, the total depreciation claimed remains $250,000. However, the accelerated depreciation deductions create increased cash flow in the early years of a lease. Assuming a 6-percent interest rate, the present value of the increased future cash flow is $23,115, or 9.2 percent of the cost of the improvements.
As an added benefit, qualified leasehold improvements placed in service in 2004 from Oct. 22 to Dec. 31 qualify for the 15-year treatment and the 50-percent bonus depreciation deduction that was part of the 2003 Jobs and Growth Tax Relief and Reconciliation Act. The first-year depreciation deduction for a $250,000 qualified leasehold improvement placed in service on Nov. 1, 2004, would be $129,167, resulting in a tax savings in excess of $45,200.
Real estate investment trusts
The new law also includes a number of real estate investment trust reforms. REITs are corporations that are exempt from corporate-level income tax assuming they meet numerous restrictions on their operations, assets and dividend distributions. Failure to meet these restrictions can result in the assessment of taxes, penalties, inter est and the revocation of REIT status.
New provisions would allow a REIT to avoid disqualification for certain failures to meet the requirements of REIT status, provided the failure was due to reasonable cause and not willful neglect, measures are taken to correct the problem, and any applicable penalties are paid.
Equipment and vehicles
Included in the tax law was an extension, through 2007, of the $100,000 expense limitation provided under Section 179. This provision allows businesses to expense, in the first year, up to $100,000 for purchases of equipment, furniture and machinery.
The amount is indexed to increase with inflation, but is also phased out for businesses that purchase more than $400,000 in qualifying property in a single year.
In prior years, taxpayers could apply Section 179 to the purchase of large sport utility vehicles. This allowed businesses to expense the entire cost of a new vehicle in a single year.
A new limitation was included in the tax act and the maximum deduction allowable for large SUVs was reduced to $25,000.
One of the most extensive provisions of the tax act is an effective reduction tax rate cut for domestic manufacturing activities. By allowing an additional deduction for various manufacturing activities, the new law provides a 3-percent reduction in the tax rate applied to manufacturing business. As defined by the congressional committee report, "manufacturing activities" include architecture, engineering and certain construction projects. Developers and property owners should take this adjustment into account when budgeting new projects and awarding contracts.
Congress limited another tax strategy involving property acquired via a like-kind exchange. In a like-kind exchange, a taxpayer is able to defer the gain on the sale of investment property by purchasing a new investment property of equal or greater value. Many times, the replacement property will be a residential property in a vacation or resort area. By renting the property for a short time and converting the property to a primary residence for two years, savvy investors could subsequently sell the property and permanently exclude up to $250,000 of gain ($500,000 if filing jointly). Under the new law, any property acquired in a like-kind exchange and converted to a personal residence must be held for at least five years to qualify for the gain exclusion.
As with any significant legislation, the American Jobs Creation Act of 2004 contains both favorable and unfavorable provisions. However, real estate investors should view the changes in a positive light overall and as part of a legislative trend in support of investment and development.
Fritton is the principal in charge of the Real Estate Services Group of Indianapolis-based Somerset CPAs PC. Views expressed here are the writer's.