Overlooked tax strategies can yield savings for real estate developers

Large swaths of the construction industry halted as a result of the COVID-19 pandemic adversely affecting timetables, profitability, and tax strategies.

As construction projects begin to pick up steam, often overlooked tax and contracting strategies may yield significant savings — both in budgeting for new developments and in recouping costs for completed or in-progress buildings.

Qualified improvement property

One tax strategy may entail the recent correction of an error in the tax code that now allows for immediate accelerated deductions, known as bonus depreciation, for qualified improvement property (QIP). This deduction previously had been stretched over 39 years prior to the change.

For more details, please see How qualified improvement property changes can create cash flow benefits.

What constitutes QIP, and the way the new rules are applied, must be carefully considered — particularly in development.

Restrictions

Assume a developer is building a 100,000 square-foot building with spec tenant improvements or suites. The building structure and interior improvements — such as drywall, restroom fixtures, and lighting — generally wouldn’t be eligible for bonus depreciation and would be recovered over 39 years.

This means that if the interior improvements cost $1 million, the first-year depreciation would be less than $25,000.

Eligible improvements

Let’s say the same developer is constructing the same building, but they decided to complete the building as a warm shell with limited interior improvements, placed it in service, and offered it for lease in that condition. Then, a separate contract with a general contractor for the interior was executed once a tenant or plans were finalized.

Because QIP is applicable to certain interior improvements constructed after a building is placed into service, the same assets recovered over 39 years in the initial scenario — drywall, restroom fixtures, and lighting — could be fully deductible for federal income-tax purposes.

In other words, the interior improvements that cost $1 million in the first scenario would be fully deductible. This provides an increase in depreciation over the first scenario of $975,000 and potentially reduces the developer’s tax bill by $292,500 at a 30% tax rate. State-tax conformity varies.