Construction Industry Financial Update and ABI Check

As we get to mid February many of our contractors 2018 numbers are rolling in, with results showing it was a good year for most.  Net profit margins are above average, with the majority reporting solid financial results for the year.  The challenge isn’t so much finding new work, it’s more finding qualified labor to execute on the abundance of work that is out there.

In construction, we get to see what is ahead in the short/intermediate term by virtue of the backlog as well as bid log, new contracts right around the corner.  Backlogs in our market today are strong, with work being scheduled filling out the balance of 2019 for many contractors with some work being slated for 2020 and even 2021 in some cases in our portfolio.  Prices used to bid new work today are generally designed to yield above average margins with the capacity being limited by already booked backlog.  Times are good for most right now and we should see positive results yet again for the whole of 2019.

The commercial construction market tends to lag the overall economy, which remains strong across the nation by most measures today.  A widely followed leading indicator for the industry is the Architecture Billing Index (ABI).  For more on that index click here… On a national level, the index for December 2018 was 50.4.  For the West region, the score was 49.2, trending up since October 2018.  In a nutshell, billings are reasonably steady, but not growing in the West in Q4 2018.  However activity, especially for those contractors with solid reputations and relationships, has been good in recent times so steady from that vantage point is not a bad thing.  It is interesting to note, however, that the trend line relating to architectural billings from the beginning of 2018 to the end in the West is down.

For 2019 it seems steady as we go with the relative strength we've been enjoying, with an always cautious eye for when the outlook doesn’t seem as rosy.  Always have that “what if the stuff hits the fan” budget ready for sharp revenue declines so you aren’t reactionary when things get tough.

Tax Depreciation Limits

I wanted to share this handy summary for any interested parties, I hope you find it useful…

Changes to Depreciation (2018 and Beyond)

Bonus Depreciation

Under new tax law, tangible personal property placed in service after 9/27/17 is eligible for 100% bonus depreciation.  Also, the property can be used.  Bonus depreciation drops to 50% in 2023.

Used property eligible for bonus does not include property received as a gift or inherited, or acquired from a related party or common control taxpayer.

Section 179 Depreciation

For tax years beginning after 12/31/17 maximum Section 179 depreciation increases from $500,000 to $1,000,000.  The maximum asset placed in service phase out increases from $2,000,000 to $2,500,000.  For assets placed in service after 12/31/17 Sec 179 is mostly redundant since Bonus Depreciation offers the same 100% depreciation without various limitations (exceptions for QIP and QRP).

Luxury Auto Limitations

These limits have been increased for passenger autos placed in service after 12/31/17 for tax years beginning after 12/31/17.  The depreciation has been increased from $3,160 to $10,000 in the 1^st year, $5,100 to $16,000 in the 2^nd year, $3,050 to $9,600 in the 3^rd year, and $1,875 to $5,760 in the 4^th and subsequent year.  For passenger autos eligible for bonus depreciation, the increase in 1^st year depreciation remains at $8,000.

Heavy SUVs (Gross Vehicle Weight over 6,000 pounds)

The $25,000 Section 179 limit remains but is inflation indexed.

However, bonus depreciation for these vehicles acquired and placed in service after 9/27/17, new or used is 100%.

Pick-Up Trucks qualify as a Heavy SUV if they weigh 6,100 to 7,050 pounds and the truck bed interior length is under six feet.

Qualified Real Property – 4 Categories

Due to the PATH Act of 2015, there are four categories of qualified real property, each with its own set of requirements and limitations, effective 1/1/16.  Note that none of these apply to residential real estate. The four categories are discontinued after 12/31/17.

Leasehold Improvements, retail improvement, and restaurant improvement property are 39 years for California (for all years).

  

Qualified Improvement Property – (After 12/31/17) This is a new category of property This property is not subject to the limitations in #1, 2, and 3 below.  Instead, the improvement must be placed in service after the date the building was first placed in service (even the very next day is fine).

Conference Report changed life to 15 year property and allowed bonus.  

However actual new law states 39 years and does not allow bonus (but does include Section 179.) Technical correction is required to allow Bonus and change to 15 year property. 

Not to be confused with 15 year land improvements in which Bonus depreciation is allowed.

Qualified Leasehold Improvement Property – (No longer exists for property placed in service after 12/31/17) This property is eligible for Sec 179 expensing, bonus depreciation, and 15-year depreciation.  This is an improvement to an interior portion of a building:

1.    Pursuant to a lease that is not between related parties, and used by either lessee or lessor.

2.    The improvement is placed in service more than three years after the building is first placed in service.

3.    Does not include common area of the building.

4.    Cannot include enlargement of the building, escalator or elevator, or internal structure of the building.

QRP (Qualified Real Property) also qualifies as QIP (after 12/31/17) and includes roofs, HVAC property, fire protection and alarm systems, and security systems.

After 1/1/18 a restaurant building does have a special 25 year life but is no longer eligible for Section 179.

Changes in Depreciation if electing out of Business Interest Deduction Limitations 163(j)

A real property trade or business electing out of the business interest limitation must depreciate

any nonresidential real property, residential real property and qualified improvement property in accordance with ADS (Alternative Depreciation System).

Nonresidential real property has an ADS class life of 40 years.  QIP property in this class is not eligible for bonus depreciation under ADS (this would be applicable if there is a technical correction in the law).  Residential real estate under ADS is 40 years if placed in service 2017 and earlier and 30 years if placed in service 2018 and later.

Existing residential real property that is required to be depreciated under ADS will have their depreciation lengthened from 27.5 to 30 years if originally placed in service 1/1/18 or later.  If originally placed in service 2017 or earlier the depreciation is lengthened from 27.5 to 40 years.  Nonresidential real property depreciation increases from 39 to 40 years.  This change to ADS depreciation will likely be the case for most of our real property trades or businesses that have interest expense.

An electing business must depreciate both existing property and new property under ADS in the election year and in subsequent years.  If this is properly done then a form 3115 for change in accounting method is not required because a change in computing depreciation for the election year for existing property is not a change in accounting method.