Sec.174 Amortization Update

With Legislation Building Support, What Should Taxpayers Do NOW?

Introduction
Everyone’s asking — Will mandatory Sec. 174 amortization be repealed? Business owners, the scientific community, and tax professionals all hope the answer is yes, but there is still a way to go. Three different bills are making waves in Congress — and bipartisan support is encouraging — but for the moment, the amortization requirement remains in effect.

As we continue to watch Congress for updates, taxpayers must seek expert guidance who can advise them of their options during this waiting game.

The Situation: Mandatory Amortization of Sec. 174
Before the Tax Cuts and Jobs Act (TCJA) of 2018 was passed, taxpayers could choose to immediately deduct their Section 174 Expenses or to capitalize and amortize them over a period of 5 years.

The TCJA contained a provision mandating that – beginning in Tax Year 2022 – Section 174 expenses must be amortized over 5 years or 15 years. Section 174 Expenses may no longer be immediately deducted.

By amortizing the deduction over 5 years, taxpayers will see a higher net taxable income initially. Generally, taxpayers will pay more taxes in year 1 and year 2, but not more overall. In fact, most taxpayers will “break even” by year 3 and pay little to no tax in that year and beyond. Smaller firms and start-ups will likely feel the impact of the increased tax liability more deeply, even if it is only short-term.
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Listen To Audio Podcast: What CPAs Must Know About Mandatory Amortization Of Section 174 Expenses

This audio segment is produced by the Capstan Tax team led by Bruce Johnson and Terri Johnson, Partners, Capstan Tax.

Capstan R&D Tax Credit experts Lindsey King and Carly Coker return to the pod to discuss the implications of Sec. 174 amortization.

Interplay Between Sec. 174 and Sec. 41

The Way We Were (i.e. Sec. 174 treatment before TY 2022)

The Current Situation

Rev. Proc. 2023-11 and What Makes it Taxpayer-Friendly

The Impact of Mandatory Amortization

What the IRS Will Be Looking For

The R&D Tax Credit as a Mitigating Factor

Follow This Link To Listen To This Audio Podcast Anytime

How To Calculate The Federal R&D Tax Credit

The Federal Research and Development (R&D) Tax Credit is an activities-based tax credit for companies that that incur R&D expenses in the United States.

Eligible taxpayers may claim qualifying expenses – wages, supplies, contract research, cloud hosting – for a dollar-for-dollar reduction in tax liability.

The Credit may be calculated using the Regular Research Credit (RRC) Method, or the Alternative Simplified Credit (ASC) Method.

The choice of Method shouldn’t be taken lightly, and taxpayers are encouraged to consult an R&D provider to advise based on specific facts and circumstances.

​​Regular Research Credit Method (RRC) [Section A, Form 6765]
Under the RRC Method, the Federal Credit is 20% of a Company’s Current Year QREs that exceed a Base Amount.

The calculation is quite complex:

Step 1: Determine the time period from which you will be gathering data — the “Base Period.”

In a base analysis all companies start as “80s Base Companies.”

1984 is your starting point. Ask these two questions:
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Rev. Proc. 2023-11 And The Mandatory Amortization Of Section 174 Expenses: What CPA's Must Know

Summary
174 Research and Experimentation (“R&E”) Expenses paid or incurred in taxable years beginning after 12/31/2021 cannot be immediately deducted. They must be amortized over 5 years, or 15 years in the case of foreign R&E. There are several implications to this change:

1) This mandatory change will result in a short-term increase in taxable income;

2) Since there was previously no difference between Section 162 and Section 174 deductibility, many businesses will not even realize they are now affected;

3) Taxpayers have a limited time to take advantage of Rev. Proc. 2023-11 and avoid filing the complex Change of Accounting Form 3115;

4) While a change in these rules is generally expected eventually, in the immediate term taxpayers will have to account for these changes on their 2022 tax returns; and

5) The Section 41 Research and Development (“R&D”) Tax Credit is an excellent way to mitigate the effects of mandatory amortization under Section 174.

The Background: Section 174 and Section 41
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How to Determine R&D Tax Credit Eligibility: 4 Part Test

Takeaways

Since the R&D Tax Credit is activities-based, eligibility is determined by testing the research activities a company performs.
In order to qualify for the Credit, a research activity must pass all four parts of the Four-Part Test:

Part #1: The research activity must be related to developing a new or improved business component for a “qualified purpose”—i.e. related to new or improved functionality, quality, reliability, or performance. The development or improvement doesn’t have to be brand new or vast in scope.

Part #2: The research activity must be undertaken for the purpose of eliminating some uncertainty related to appropriate design, method, or capability. Even research that is ultimately unsuccessful in eliminating uncertainty may still qualify.

Part #3: The research activity must involve some Process of Experimentation designed to resolve the uncertainty. The “Substantially All” Test adds a quantitative aspect to Part #3.

Part #4: The research activity must fundamentally rely on principles of physical sciences, biological sciences, computer science, or engineering, or their applications.

Certain activities are automatically excluded from Credit eligibility, including foreign and funded research.
Thorough documentation is required to demonstrate compliance with all Four Parts of the Test. The recent Little Sandy Coal case serves as a cautionary tale.

​​Introduction: An Activities-Based Credit

The Federal Research and Development (R&D) Tax Credit is an activities-based tax credit for companies that incur R&D expenses in the United States. Based on IRC § 41 & § 174, the Credit is intended to incentivize innovation and experimentation.
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The Inflation Reduction Act

Webinar Is Today! You Can Still Register As Webinar Begins In Less Than One Hour
Date: April 26th
Time: 12:00PM EST
Webinar Title:The Inflation Reduction Act of 2022: Transforming 179D and 45L
CPE Credit For Attendees: 1 CPE Credit
Field of Study: Taxes
Program Level: Beginner/Intermediate
Cost: Compliments Of Capstan Tax, Complimentary Education

Description:
The passage of the Inflation Reduction Act of 2022 (IRA) has transformed energy-efficient tax incentives for commercial real estate. The IRA will alter and amplify both the 179D Deduction and the Section 45L Tax Credit. In this all-new webinar, we will compare the current version of each incentive to the “IRA Version” of the incentive, addressing changes to reference standards, calculation of incentives, documentation procedures, and more. New exciting initiatives including utility sales tax recovery, C-PACE, and more will also be discussed. Numerous real-life case studies will be reviewed, and a variety of reference tables will be provided.

Learning Objectives:
• Compare the requirements for claiming the 179D deduction under both the old and new laws
• Understand how the 179D deduction is calculated under the Legacy Program and under the IRA
• Recognize other changes to 179D under the IRA, including the elimination of partial deductions and theestablishment of deduction reset
• Compare the requirements for claiming the 45L Tax Credit under both the old and new laws, and theassociated differences for single-family and multifamily dwelling units
• Become familiar with solar energy incentives, the benchmarking process, and C-PACE
• Learn about NYC’s Carbon Emissions Bill, and recognize potential implications in New York and beyond
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How To Claim The R&D Tax Credit

Key Take Aways
– The activities-based Federal R&D Tax Credit allows qualified businesses to obtain a dollar-for-dollar reduction in tax liability.
– Qualifying activities include the development or improvement of products, processes, software, formulas, and more. Businesses in many different industries may claim the Credit.
– If research activity passes the Four-Part Test, it qualifies for the Credit.
– Qualified Research Expenses(QREs) include wages, supplies/materials, cloud hosting, and third-party contractors. The determination of QREs is a nuanced endeavor.
– A rough estimate of Credit amount can be easily calculated, but is dependent on the accuracy of the QREs employed. It can be quite difficult to determine accurate QRE values – there are
multiple caveats and nuances involved. Credit estimates are only as good as the QRE values used to obtain them. Online Credit Calculators are subject to the same inherent flaw.
– The Credit should be calculated by an R&D specialist, who will select between the Regular Research Credit (RRC) Method and the Alternative Simplified Credit (ASC) Method.
– The Credit is claimed using IRS Form 6765, and “sufficient documentation” is required.
– The Payroll R&D Credit is a modified version of the R&D Tax Credit for Qualified Small Businesses (QSBs).
– The Federal credit is permanent. It may be claimed back 3 years, and carried forward for 20 years.
– Claiming the Federal R&D Tax Credit does not increase the likelihood of an audit.
– Over 40 states have their own state-specific R&D Tax Credits, which can be used in conjunction with the Federal Credit.

​​What is the Federal Research and Development (R&D) Tax Credit?
The Federal Research and Development (R&D) Tax Credit — also known as the Research and Experimentation (R&E) Tax Credit — is an activities-based tax credit for companies that incur R&D expenses in the United States. Based on IRC § 41 & § 174, the Credit is intended to incentivize innovation and experimentation.
Eligible taxpayers may claim qualifying expenses – wages, supplies, contract research, cloud hosting – for a dollar-for-dollar reduction in tax liability.
The Credit has undergone quite an evolution over the years.

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Real Estate Tax Incentives And Strategies

The wide variety of real estate tax opportunities available can be overwhelming. To make sure you’ve considered all potential sources of benefit, review our expansive checklist.

​​☐​ Accelerated Depreciation

Look-back studies via 3115, best results achieved for properties in service under 15 years
Recall depreciation potential inherent in 754 Step Ups and 1031 Exchanges, as well as tax-exempt property

​​☐​ Bonus Depreciation
100% for properties placed-in-service between 9/28/17-12/31/2022
Acquired assets eligible under the TCJA

​​☐​ Bonus-Eligible QIP (Qualified Improvement Property)
QIP placed-in-service on or after 1/1/2018 is 15-year property and bonus-eligible – major implications for renovations/retrofits

​​☐​ Expensing Options under the Tangible Property Regulations (TPRs)
DeMinimus Safe Harbor (Itemized invoices will be helpful)
Small Taxpayer Safe Harbor
Routine Maintenance Safe Harbor (via 3115)
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Tax Cuts And Jobs Act (H.R.1) of 2017

The Tax Cuts and Jobs Act was signed into law on December 22, 2017. This marked the first comprehensive tax law reform since 1986, and has had an impact on every American taxpayer and industry. The TCJA brings new opportunities, as well as some challenges, to the commercial real estate community. Most of the legislation became effective January 1, 2018, with two important exceptions.

Capstan Tax Strategies is at your service as we navigate these changes together. We’ve done a thorough review of the TCJA- Tax Cuts and Jobs Act and analyzed the legislation most likely to have a major impact on our clients and colleagues. (Click HERE if you’d like to read the Act in full).

Corporate Tax Rate
The top corporate tax rate of 35% was reduced to 21%. Corporate AMT was eliminated.
Interest Deduction Limitation
For years beginning 1/1/2018, companies are subject to a limitation on deductible interest expense. The deductible amount is capped at 30% of adjusted taxable income, after certain adjustments.
Companies that are “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business” may “elect-out” of this limitation. However, any company that elects-out of the interest limitation will be required to depreciate its real property using the Alternative Depreciation System (ADS).

For a company electing-out for tax years after 12/31/17, the ADS lives below are applicable:
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Cost Segregation And Multifamily Property: Busting The Myths

In J.P. Morgan’s 2023 Commercial Real Estate Outlook, multifamily property is designated as the highest performing of all asset classes. A recent study commissioned by the National Multifamily Housing Council and National Apartment Association revealed that the U.S. needs to build 4.3 million new apartments by 2035. The demand for multifamily units clearly remains strong, reinforcing its reputation as a “safe” investment.

Investors may initially be drawn to this vertical for safety, scalability, and predictable income, but they often stay for the significant tax benefits. Multiple tax strategies are available, including accelerated depreciation, which can be used to offset a portion of that predictable rental income. Cost segregation is the vehicle for these tax savings.

So why doesn’t every multifamily property owner consider cost segregation? Some simply aren’t aware of it, while others have been misinformed. Let’s debunk some of the common myths holding multifamily investors back from potential opportunity.

1. You can only do cost segregation studies on commercial property, not residential rental real estate.

[ False ]
Cost segregation can be performed on residential real estate, from multifamily to single family rental properties, and in fact multifamily properties are considered great candidates for cost segregation.

2. There aren’t a lot of assets to reclassify in a multifamily property.

[ False ]
While the exact yield will vary based on projects details, layout, and location, between 20-35% of assets in multifamily properties may be accelerated.

Without cost segregation, residential real estate capital assets are assigned a 27.5-year Class Life.

With cost segregation, these are just some of the asset categories that can be moved into much shorter Class Lives:
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What CPAs Must Know About Rev. Proc. 2023-11 And The Mandatory Amortization Of Section 174 Expenses

Summary

174 Research and Experimentation (“R&E”) Expenses paid or incurred in taxable years beginning after 12/31/2021 cannot be immediately deducted. They must be amortized over 5 years, or 15 years in the case of foreign R&E. There are several implications to this change:
1) This mandatory change will result in a short-term increase in taxable income;

2) Since there was previously no difference between Section 162 and Section 174 deductibility, many businesses will not even realize they are now affected;

3) Taxpayers have a limited time to take advantage of Rev. Proc. 2023-11 and avoid filing the complex Change of Accounting Form 3115;

4) While a change in these rules is generally expected eventually, in the immediate term taxpayers will have to account for these changes on their 2022 tax returns; and

5) The Section 41 Research and Development (“R&D”) Tax Credit is an excellent way to mitigate the effects of mandatory amortization under Section 174.

The Background: Section 174 and Section 41

In order to understand the impact of this legislation, it’s crucial to understand the relationship between Section 174 Expenses and Section 41 Expenses.

Section 174 Expenses are known as Research and Experimentation, or R&E Expenses. The expenses that fall under Sec. 174 can be divided into two categories, based on how essential each is to the activity being performed.

Section 41 Expenses are known as Research and Development, or R&D Expenses. These are known as “Direct Research Expenses,” and are what usually come to mind when you imagine research and development. Wages, supplies/materials, cloud hosting, and fees paid to 3rd party contractors are expenses integral to the research process.
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Industry Alert: Notice 2022-61 Clarifies Prevailing Wage And Apprenticeship Requirements Under The IRA

On November 30, 2022, the IRS issued Notice 2022-61, providing initial guidance on the wage and apprenticeship requirements included in the Inflation Reduction Act of 2022.  The IRA established increased benefit levels for energy-efficient incentives related to EPAct 179D and 45L that may only be obtained when prevailing wage and apprenticeship requirements are satisfied.  This Notice provides additional detail regarding these requirements, associated recordkeeping, and project timing.   

The prevailing wage and apprenticeship requirements delineated in the Notice will apply to facilities for which construction begins on or after 1/30/2023.   

PREVAILING WAGE RATE REQUIREMENTS  

The “Prevailing Wage” requirement states that mechanics and laborers must be paid no less than the prevailing wages required to be paid for federal construction work.  (The wage will vary based on exact job description and geographic location.)   

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