Posted by Todd Keator
Historically, real estate investors looking to defer federal income taxes have relied on Section 1031 exchanges to exchange one real estate investment for a different real estate investment in a tax-deferred manner. More recently, some investors have used the “qualified opportunity zone” rules to achieve a similar result by reinvesting capital gains (from any source) into qualified projects within a qualified opportunity zone in order to defer recognizing those gains. But in addition to these two mainstream techniques, a third possibility for achieving significant tax deferral exists for investors who purchase gas stations or convenience stores that have significant retail gasoline operations (“C-Stores”). By purchasing a qualified C-Store, the investor generally is eligible for 100% bonus depreciation on the entire purchase price (excluding any portion allocable to land or goodwill). These bonus depreciation deductions then can be used to offset the investor’s income or gains from other sources, resulting in the desired tax deferral.
In December 2017, Congress passed the “Tax Cuts and Jobs Act” which, among many other changes, enacted 100% bonus depreciation for certain “qualified property” placed in service after September 27, 2017 but before January 1, 2023.[1] Significantly, both new and previously used qualified property now are eligible for bonus depreciation (provided the taxpayer was not previously the user of such property). Generally, “qualified property” includes depreciable property having a “recovery period of 20 years or less.”[2] Under Section 168(e)(3) of the Internal Revenue Code (the “Code”), which was in effect long before the TCJA, there are many categories of property, mostly consisting of personal property, that meet the foregoing 20-year recovery period test. However, certain types of real estate also meet the test, including “any section 1250 property which is a retail motor fuels outlet (whether or not food or other convenience items are sold at the outlet).”[3] The Code does not define the meaning of a “retail motor fuels outlet.” However, under applicable IRS guidance, in order to qualify as a retail motor fuels outlet, a C-Store must be used to a substantial extent in the retail marketing of petroleum (or petroleum products) and meet any one of the following three tests:
- 50% or more of the C-Store’s gross revenues are derived from petroleum (e.g., gasoline or motor oil) sales,
- 50% or more of the floor space in the C-Store (including restrooms, counters, and other areas allocable to traditional service station services) are devoted to the petroleum marketing activity, or
- The C-Store consists of 1400 square feet or less (regardless of qualification under either 50% test).[4]
The determination of whether a C-Store meets one of the above 50% tests generally will be made in the year the property is placed in service. However, the test may be applied in the subsequent taxable year if the property is placed in service near the end of the taxable year and the use of the property during such short period is not representative of the subsequent use of the property. Also, for purposes of the 50% revenue test, “gross revenue” is defined as the revenue generated by the sale of the product to the consumer and includes all excise and sales taxes.
Notably, a C-Store can qualify as a retail motor fuels outlet regardless of whether the owner is also the operator.[5] Thus, where a C-Store is leased, it is the lessee’s use of the property that determines qualification under one of the 50% tests.[6] In addition, in applying the 50% revenue test, the owner of a C-Store must aggregate the gross revenues of all businesses operated in the building whether or not such businesses are operated by the owner.
Thus, following the 2017 TCJA, the purchaser of a qualified C-Store meeting the above requirements for a “retail motor fuels outlet” generally is eligible for 100% bonus depreciation on the purchase price (excluding the cost of the land and any goodwill associated with the C-Store). Whether a C-Store qualifies as a retail motor fuels outlet, however, is highly fact specific and will depend on the particular facts and circumstances of the store at issue. Prospective investors seeking to purchase a C-Store in order to garner the 100% bonus depreciation deduction will need to perform adequate due diligence in order to ensure compliance with the legal requirements.
Finally, it should be noted that by taking 100% bonus depreciation on a C-Store, the investor’s basis in the C-Store will be reduced to zero. Thus, upon a future sale of the C-Store, the investor generally would realize 100% of the sales proceeds (including any debt relief) as taxable gain on sale. However, even in this circumstance, the investor may be able to structure the disposition as a tax-deferred Section 1031 exchange by trading into other “like kind” real estate (such as land, apartments, office, retail, industrial, or any other qualified real estate investment) that the investor may be more accustomed to owning and operating. Thus, in this scenario, the investor would be able to shelter current year income and gain by purchasing the C-Store and taking advantage of 100% bonus depreciation, but then within a reasonable period of time, the investor ultimately could sell the C-Store and transition to a more traditional real estate investment in a tax-deferred manner using a Section 1031 exchange.
Please contact the above author or the Thompson & Knight attorney with whom you regularly work if you have any questions.
[1] See An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, Pub. L. No. 115-97, 131 Stat. 2054 (2017) (sometimes referred to as the “Tax Cuts and Jobs Act” or “TCJA”).
[2] IRC § 168(k)(2)(A)(i)(I).
[3] IRC § 168(e)(3)(E)(iii) (emphasis added). Notably, “section 1250 property” generally refers to depreciable real property (such as a building and other inherently permanent structures), but would not include land (which is non-depreciable) and goodwill.
[4] See ISP Paper for Petroleum and Retail Industries Convenience Stores (Apr. 2, 1997). See also S. Rep. No. 281, 104th Cong., 2nd Sess. 15 (1996). In addition, the C-Store must have been placed in service on or after August 20, 1996, or for C-Stores placed in service prior to such date, the taxpayer must make an affirmative election.
[5] Rev. Rul. 97-29, 1997-2 C.B. 22.
[6] Notably, because the status of a leased C-Store as a retail motor fuels outlet depends on the lessee’s use of the property, the owner/lessor may lack specific information to determine qualification under the 50% revenue test. In this case, the owner/lessor should seek to compel the lessee to provide such information through the lease agreement or other means (such as third party reports).
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