Tax issues

Job Creation Act Increases Tax Savings for Commercial Property Owners

In March, Congress passed the Job Creation and Worker Assistance Act of 2002. While the act contains provisions affecting many industries, it may offer commercial real estate property owners and companies specific tax-saving benefits.

Bonus Depreciation Provision Under the act, taxpayers receive an additional first-year depreciation deduction equal to 30 percent of the adjusted tax basis of qualified business property acquired after Sept. 10, 2001, and before Sept. 11, 2004. This applies to business equipment such as computers, software, and furniture, as well as leasehold improvements to real property.

To qualify for this deduction, the property must meet the following requirements. It must be subject to general modified accelerated cost recovery system depreciation rules. The taxpayer must purchase the property during the applicable period, and the original use of the property must begin with the taxpayer on or after Sept. 11, 2001. The property also must be placed in service before Jan. 1, 2005.

In addition, the property must meet one of these conditions: It must have a depreciation life of 20 years or less, or must be a water utility property, computer software, or a qualified leasehold improvement.

Qualified leasehold improvements include any improvements to the interior portion of nonresidential real property, provided they are made under a lease by the lessee, sublessee, or lessor and are placed in service more than three years after the building itself was placed in service. The lessee or sublessee must occupy the improved portion of the building. Excluded are any expenditures attributed to enlarging the building, adding elevators, escalators, or structural components to common areas, or improving the internal structural framework.

The balance of the depreciation deductions for the tax year and subsequent tax years is determined by adjusting for the 30 percent depreciation allowance. The provision is granted for both regular and alternative minimum tax purposes for the tax year the property is placed in service.

The following example illustrates the additional first-year depreciation deduction. Assume that on March 1, 2002, a calendar year taxpayer acquires and places in service $100,000 worth of qualified property. Under regular MACRS depreciation rules, his deduction would be $20,000 (20 percent of $100,000). Now, however, the taxpayer can claim an additional first-year depreciation deduction of $30,000 (30 percent of $100,000). The remaining $70,000 adjusted basis is recovered under general MACRS rules. Thus, in 2002, the taxpayer would claim a first-year depreciation of $30,000 and an additional $14,000 for regular MACRS depreciation (20 percent of $70,000) for a total of $44,000.

As the example illustrates, the taxpayer's deductions for 2002 have increased by $24,000, which translates to about $8,400 assuming a flat 35 percent tax rate.

As discussed above, this provision applies to business property placed in service after Sept. 10, 2001. Accordingly, the 30 percent allowance is the default rule unless the taxpayer elects out. Government guidelines for opting out of the 30 percent bonus depreciation are expected to be issued soon.

Liberty Zone Provisions The act also grants special provisions to qualified New York Liberty Zone properties. The Liberty Zone is a government-designated area bordered by Canal Street, East Broadway, and Grand Street in Lower Manhattan.

Owners of commercial or residential rental properties in the Liberty Zone that were damaged or condemned as a result of the terrorist attacks are eligible for a time extension to receive a 30 percent bonus depreciation deduction. Instead of having to place their properties in service by Jan. 1, 2005, these property owners have until Dec. 31, 2009, to place their properties in service.

The act also allows Liberty Zone leasehold improvements to be recovered over five years, instead of the usual 39 years, using the straight-line depreciation method. Leasehold improvements qualify if the property is located within the designated area, if the improvement is placed in service after Sept. 10, 2001, and before Jan. 1, 2007, and if the improvement is not made under a binding contract in effect before Sept. 11, 2001. However, New York Liberty Zone qualified leasehold improvements are not eligible for the additional first-year depreciation deduction.

Additional Benefits The act extends the carryback period for net operating losses from two years to five years for tax years ending during 2001 and 2002. Businesses effectively may forego the extension of the carryback period, so long as the election is made by the due date (including extensions) for filing the return for the tax year of the operating losses; however, the election is irrevocable. The method for filing the election to forego the extension period will be established by the U.S. Treasury in the near future.

This extension creates a potential refund and the opportunity to apply such a refund against current estimated tax liability for corporate commercial real estate companies; however, multiple limitations on the ability to use a net operating losses carryback still should be analyzed before any actual benefit can be determined. These limitations include Separate Return Limitation Years rules that limit the use of pre-affiliation losses to offset income of other members of a consolidated group, rules that limit the amount of allowable loss utilization following an ownership change, and rules that deny loss carryback deductions arising from interest deductions attributable to corporate equity reduction transactions.

Further, the act also temporarily suspends the 90 percent limit on certain operating losses carryovers under the alternative minimum tax. Absent this suspension, tax law requires operating losses to be recalculated to reflect alternative minimum taxable income and limits the deductibility of net operating losses to 90 percent of alternative minimum taxable income. The act temporarily suspends this 90 percent limitation on operating losses for tax years ending during 2001 or 2002. Consequently, taxpayers that have paid or would have paid alternative minimum tax because of the 90 percent limitation on the use of operating losses to offset alternative minimum taxable income can utilize this provision to obtain a refund.

Property owners should review actual or projected net operating losses arising in tax years ending in 2001 and 2002 to determine whether they can take advantage of the five-year carryback provision. Additionally, taxpayers that have paid alternative minimum tax by virtue of the 90 percent limitation also may be able to benefit from the new legislation. 

Jin H. Bahk and Steven M. Friedman

Jin H. Bahk is a manager in the Baltimore office of Ernst & Young. Contact him at (410) 783-3736 or jin.bahk@ey.com. Steven M. Friedman is a tax partner in the McLean, Va., office of Ernst & Young. Contact him at (703) 747-1000 or steve.friedman@ey.com.

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