Editor: Greg A. Fairbanks, J.D., LL.M.
Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, assets that meet the definition of qualified improvement property (QIP) under Sec. 168(e)(6) have been corrected to have a recovery period of 15 years and be eligible for bonus depreciation. Previously, due to a drafting error in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, taxpayers had to depreciate QIP as nonresidential real property over 39 years without bonus depreciation. The technical correction in the CARES Act not only addressed the oversight, but it also allows this correction to be made retroactively, meaning that QIP placed in service after Dec. 31, 2017, is eligible for the shorter recovery period and the additional first-year depreciation.
However, identifying the QIP that is now eligible for bonus depreciation can be a substantial effort for many tax departments, particularly for taxpayers that have placed in service a large volume of assets in 2018 and later.
Statistical sampling and estimation can be an efficient solution to determine the amount of basis that can now be assigned a 15-year recovery period and to claim bonus depreciation. These estimated amounts may be used to file the Form 3115, Application for Change in Accounting Method, (or amended return) with a favorable Sec. 481(a) adjustment, which will result in a reduction of income in the current year.
What is QIP?
Prior to the enactment of the TCJA, QIP under Sec. 168 was treated as having a recovery period of 39 years (the recovery period for nonresidential real property), and a special provision allowed QIP to qualify for bonus depreciation. Also prior to the enactment of the TCJA, Sec. 168 provided for other types of "qualified" property, including qualified leasehold improvement property (QLIP), that had a recovery period of 15 years and, therefore, generally qualified for bonus depreciation.
The TCJA amended Sec. 168(e) to remove QLIP (and the other types of qualified property) and replaced them with a single category: QIP. At the same time, the special rule allowing QIP to be eligible for bonus depreciation was removed. The TCJA failed, however, to provide a 15-year recovery period for QIP, as intended by Congress, which resulted in QIP's having a recovery period of 39 years and not being eligible for bonus depreciation.
The technical correction in the CARES Act fixed the error in the TCJA and opened up a large taxpayer benefit for those that had made qualified capital improvements.
QIP includes "any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service." However, any enlargement of the building, improvement to the internal structural framework, or work on elevators or escalators is not included in QIP.
What do taxpayers do now?
Interestingly, because the technical correction is effective back to the original enactment of the TCJA, taxpayers that followed the statute and filed tax returns depreciating QIP using a 39-year recovery period may have adopted an impermissible method of accounting (or have an error). Therefore, taxpayers will need to follow one of the corrective actions outlined in Rev. Proc. 2020-25, which generally allows for either amending the affected tax returns or filing a method change on Form 3115 to both correct the life of the asset and claim the applicable bonus depreciation.
Example: Company A, a calendar-year taxpayer, acquired and placed in service assets that may qualify as QIP in 2018 worth $5 million. On its 2018 and 2019 returns, Company A treated those assets as nonresidential real property and depreciated them as 39-year property without the additional first-year depreciation. Under the CARES Act, Company A should now depreciate this property as QIP with a 15-year recovery period and the applicable bonus depreciation. It will create a significant deduction or net operating loss for Company A, but Company A must either amend its 2018 and 2019 returns or file a Form 3115 to claim it.
The problem for many taxpayers is identifying QIP from among their 39-year property. The effort can be overwhelming when looking back across multiple years, which can take a great deal of time and effort. This is where sampling can help.
How sampling works
The best approach is to use well-established statistical methods that have been used in cost-segregation studies for decades. The IRS recognizes these methods in its Audit Techniques Guides and formally addressed the audit of taxpayer-conducted samples for estimation of federal tax values in Rev. Proc. 2011-42.
Sampling works this way:
- The assets (currently under 39-year property) with the potential to be reclassified as QIP are identified and listed. The list should be restricted to assets placed in service after the building containing them was placed in service.
- For convenience of review, the list may be summarized at the asset level, project level, or by location.
- Then this listing is sampled — randomly. Sample design and estimation methods control the variability of the random sample to allow for more accurate estimation.
- Only the sampled items need to be reviewed to determine whether they are QIP and eligible for the additional first-year depreciation deduction.
- Statistical estimation methods are used to take the quantity of QIP found in the sample to extrapolate the QIP amount for the entire listing, from which the revised total depreciation deduction can be computed.
The use of sampling can greatly reduce the effort required by taxpayers to identify and claim the benefit of QIP from prior and current years. That is especially true of taxpayers that have multiple locations or a large volume of assets, such as real estate investment trusts; banks; hotel chains; and retail chains such as stores, restaurants, and gyms.
For example, a retail chain that has 150 stores with potential QIP sitting in a 39-year recovery period for assets placed in service in 2018 and 2019 and after the stores' openings may be required to review only the assets in a random sample of 10 stores to make the QIP determinations and accurately estimate QIP for all 150 stores. Another taxpayer with a listing of 1,200 39-year assets that may contain some QIP might need to review a random sample of only 50 assets to obtain a stable QIP estimate for the entire listing of 1,200 assets. Even smaller taxpayers can benefit from sampling. A retail chain with only 20 stores may require a sample of only eight stores. An asset listing of a few hundred assets may require a sample of only 20 or 30 assets.
Due to their homogeneity, chains most often find that the percentage of their 39-year assets that is QIP is highly consistent from store to store. This consistency allows them to use smaller sample sizes to achieve precise estimates. However, whether a taxpayer is a retail chain or not, these examples illustrate just how much work can be reduced via the use of sampling methods that the IRS has accepted for years. Since the CARES Act, many taxpayers have taken advantage of this statistical sampling approach to file their methods change for tax year 2019.
Words of caution
While the IRS readily accepts estimates based on statistical samples, it does scrutinize the statistical methods to ensure valid and sound techniques were employed. Subtle nuances can cause an approach to be statistically invalid. In addition, the IRS does not set sample size requirements. Instead, it stipulates the precision of taxpayer-produced estimates. Inaccurate estimates reduce taxpayers' benefits. Therefore, it is best to involve a statistician familiar with the IRS's accepted approaches who is also knowledgeable of strategies to statistically achieve accurate estimates without unduly large sample sizes. This will result in lower effort for greater benefit.
While the assets are being reviewed, taxpayers may also take this opportunity to look over those 39-year assets to identify any other prospective favorable changes. Taxpayers often find personal property or other property with shorter recovery periods that can be carved out as part of the statistical sampling, for which an accounting method change could also be filed. Often for only a little additional work, the scope of a QIP review may also be expanded to look for assets that were capitalized for book purposes but that may be deducted as a repair for tax purposes. The opportunity to use statistical sampling for fixed assets is great, and taxpayers should evaluate whether their list of assets, projects, or locations to review could be shortened and simplified through the use of a random sample.
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or email@example.com.
Contributors are members of or associated with Grant Thornton LLP.