Federal Tax Law Drafting Error Punishes Commercial Developers
By: DAVID J. PETERSEN
The Tax Cuts and Jobs Act, signed into law in December 2017, promised radical changes to the federal tax code. Many of its goodies were aimed at the real estate industry, but because of a critical drafting error, many commercial landlords and developers are feeling a serious financial pinch.
The problem focuses on depreciation of qualified improvement property such as building renovations, typically those made to attract new tenants. Prior to the new law, most build-out costs could be depreciated 50% in the first year and the balance over 15 years. The tax law intended to sweeten this already healthy pot by preserving the 15-year depreciation period while making some expenses eligible for 100% first-year bonus depreciation. But due to a drafting error, the 15-year period has become 39 years and many costs are ineligible for any bonus depreciation. Imagine a developer's surprise when the $1 million deduction it expected in the first year after making expensive improvements is really only $25,600.
The problem caused by this mistake is exacerbated by our society's rapidly changing use of commercial space. Many brick and mortar retailers are closing up due to the continued growth of e-commerce, and those that remain look to make do with less space. As a result, plenty of new space is coming back on the market. And the tenants interested in that space are not traditional retailers who can reuse what is already there – more likely, they are new users like hyperlocal retail, last mile delivery or co-working that require significant tenant improvements to make the space work for them. Because of Congress' mistake, their landlords face the double whammy of costly renovations to attract tenants and the loss of quick depreciation.
Congress is aware of the problem and the Restoring Investment in Improvements Act is working its way through the legislative process to correct the mistake. But in today's caustic political environment, even a fix to a problem that both parties agree exists is far from a sure thing. Unless and until something shakes free, many commercial property owners are realizing that their Christmas stockings of a few years ago contained a fair bit less gold and a heftier amount of coal than it seemed at the time.