TECHNICAL
UPDATE
THE CURRENT STATE OF ADS UNDER
THE TCJA AND CARES ACT
July 28, 2020 by Charles Duncan
Section 163(j)(7) Elections
The Tax Cuts and Jobs Act (“TCJA”) modified Code section 163(j) to limit business interest deductions to the sum of business interest income plus 30%7 of adjusted taxable income (“tax EBITDA”) plus floorplan financing interest. Interest deductions disallowed under this provision are carried forward. Certain taxpayers, such as real property trades or business or farmers, could make an election to take unlimited business interest deductions in the current year.8 These elections are irrevocable, and, in both cases, the unlimited interest deductions provided by these elections came at the cost of bonus and accelerated depreciation on certain assets due to the resulting ADS classification.
- For electing real property trades or businesses, ADS applies to:
nonresidential real property
residential rental property, and
- For electing farming businesses, ADS applies to property with a recovery period of ten or more years.10
Highly leveraged taxpayers in these industries often make these elections, which has spread ADS property classifications to many new taxpayers.
For more information regarding section 163(j), please refer to out technical update from April 2020 titled Rev. Proc. 2020-22 Changes to the Section163(j) Interest Limitation. In it we discuss how the new revenue procedure provides guidance allowing taxpayers to make or revoke certain elections under Code section 163(j) and also provides guidance on the implementation of the interest limitation as revised by H.R. 748, the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, Public Law No. 116-136.
Tax-Exempt Use Property
Another common type of ADS property is tax-exempt use property. Building owners encounter this bewildering MACRS provision when they lease to tax-exempt entities. Applying the ADS rules to a tax-exempt tenant involves two separate approaches, which depends on the type of asset and the facts and circumstances surrounding the lease.
- For tangible personal property and land improvements, just being leased to a tax exempt entity means that these assets must use ADS recovery periods.11
- For nonresidential real property, the taxpayer must determine whether a large enough portion of the building is leased to a tax-exempt tenant (or tenants) in a disqualified lease (or leases).12
- The taxpayer first applies a square footage test. If more than 35% of the building is leased to tax-exempt entities, then the taxpayer looks at the leases to see if they are considered “disqualified”.
- A lease is disqualified if:13
- The tax-exempt entity participated in financing the property, directly or indirectly,
using tax-exempt obligations. - The tax-exempt entity has a fixed or determinable price purchase or sale option.
- The lease is longer than 20 years, including non-FMV renewal options).14
- Or the lease is part of a sales-leaseback transaction from the tax-exempt entity (or
a related entity).
The disqualified lease rules also apply to former Qualified Leasehold Improvement Property15 and QIP.16 In both cases, these property types are analyzed alongside the underlying building.
Elective ADS Property
The final category of commonly encountered ADS property is elective ADS property. Code section 168(g)(7) allows a taxpayer to irrevocably elect the ADS. Taxpayers make this election on a classby-class basis or, for buildings, on a property-by-property basis.17 Taxpayers make the election by completing Line 20 of Form 4562 for the property or class. Unlike other ADS property, elective ADS property is eligible for bonus depreciation provided all other requirements are met.18
Bonus Depreciation and ADS
When working with ADS property, tax advisors often assume that all assets must follow ADS if some assets do. This is not necessarily the case.
Type of ADS Scenarios
Section 163(j)(7)(B) Election
Tax-Exempt Use
(property is leased to a tax-exempt
entity)
Elective ADS
What Receives ADS
§ 1250 Building
QIP
§ 1245 & Land
Improvements
ADS
ADS
Not ADS
GDS or ADS19
GDS or ADS19
ADS
Elect ADS by
Property
Elect ADS by Class
Elect ADS by Class
Opportunities for bonus depreciation, as we mentioned above, are often overlooked under the current rules.
Type of ADS Scenarios
Section 163(j)(7)(B) Election
Tax-Exempt Use
Elective ADS
What Receives ADS
§ 1250 Building
QIP
§ 1245 & Land
Improvements
No Bonus
Not Bonus
Bonus
No Bonus
Maybe Bonus19
No Bonus
No Bonus
Bonus20
Bonus20
Real World Examples
Example 1:
Currently, the taxpayers most often affected by ADS are those that have made the real property trade or business election under Code section 163(j)(7)(B). Many tax preparers properly make the real property trade or business election but apply ADS to classes of property where it is not required. The most common examples are 15-year land improvements classified under asset class 00.3 of Rev. Proc. 87-56 and section 1245 5-year and 7-year property. Since ADS was elected for these assets, they would still qualify for bonus depreciation. In our experience, when ADS is accidentally elected for a class of property, the taxpayers did not claim bonus depreciation on the original tax returns.21 Under Rev. Proc. 2020-25, taxpayers can elect to withdraw section 168(g)(7) ADS elections for the 2018-2020 tax years to fix this problem.
Example 2:
Another very common situation is the taxpayer that leases to a tax-exempt entity without knowing the tax depreciation consequences. In this situation, taxpayers are very surprised to learn that they may have lost bonus or accelerated depreciation. Due to this unpleasant surprise, it is very important to establish that the tenant is a tax-exempt entity. While this is a foregone conclusion for vernment tenants, landlords should ask for a copy of the enant’s tax-exempt determination letter from the IRS or look up the tenant on guidestar.org to see if they actually are tax-exempt. (Even then the tax-exempt tenant may be involved in an Unrelated Business Income Taxes (“UBIT”) activity, which would not involve tax-exempt use property.)
If the tenant is tax-exempt, it is often easier to work through the disqualified lease tests before applying the square footage test. (If there are no disqualified leases, the square footage is irrelevant, which can save a great deal of analysis in a multi-tenant situation.) If there are no disqualified leases, the taxpayer would use a 15-year recovery period for the tax-exempt tenant’s QIP and receive bonus depreciation if qualified. Unfortunately, tangible personal property and land improvements leased to the tax-exempt tenant would use ADS and remain ineligible for bonus depreciation.
Example 3:
A less common ADS user is the taxpayer that wants to use a longer recovery period for its assets with less accelerated depreciation. In this situation, the taxpayer often applies hindsight to decide that they wanted accelerated deductions. Much like the inadvertent ADS user, this taxpayer often fails to elect out of bonus depreciation properly, allowing them to file a Form 3115 to accelerate depreciation. In other situations, the taxpayer has only made the ADS election for one class of property or one property. Since ADS elections are made on the basis of class (or property for buildings), the shorter life property identified in cost segregation studies generally would qualify for GDS depreciation unless the taxpayer elected ADS for property of the same class in the same year.
1 See I.R.C. § 168(g).
2 See Rev. Proc. 87-57, § 3.02.
3 I.R.C. § 168(g)(2)(A).
4 I.R.C. § 168(g)(2)(B).
5 See I.R.C. § 168(g)(2)(C).
6 See I.R.C. § 168(k)(2)(D).
7 Or 50% for taxable years beginning in 2019 or 2020 (with limitations for partnerships).
8 See I.R.C. § 163(j)(7).
9 I.R.C. § 168(g)(8).
10 I.R.C. § 168(g)(1)(G)
11 I.R.C.§ 168(h)(1)(A); see also CCA 201436048 (Sep. 5, 2014).
12 I.R.C. § 168(h)(1)(B)(i).
13 I.R.C. § 168(h)(1)(B)(ii).
14 See I.R.C. § 168(i)(3)(A)(i).
15 CCA 201436048 (Sep. 5, 2014).
16 I.R.C. § 168(h)(1)(B)(iv).
17 I.R.C. § 168(g)(7).
18 I.R.C. § 168(k)(2)(D)(i).
19 See two-part test above.
20 If no election out of bonus for this class of property.
21 As we understand it, this is sometimes due to software errors.