Qualified improvement property and bonus depreciation

Qualified improvement property (QIP) is any improvement that is Sec. 1250 property made by the taxpayer to an interior portion of a nonresidential building placed in service after the date the building was placed in service. However, expenditures attributable to the enlargement of the building, elevators or escalators, or the internal structural framework of the building are excluded (Sec. 168(e)(6) and Regs. Sec. 1.168(b)-1(a)(5)). The requirement that the improvement be made by the taxpayer means that taxpayers cannot acquire a building and treat any cost assigned to improvements made by a previous owner as QIP.

Observation: The preamble to the final bonus depreciation regulations issued in 2020 (T.D. 9916) indicates that an improvement is made by the taxpayer if the taxpayer makes, manufactures, constructs, or produces the improvement or if the improvement is made, manufactured, constructed, or produced for the taxpayer by another person under a written contract. This is confirmed in Regs. Sec. 1.168(k)-2(b)(2)(iii), Example 9. The preamble also states that if a transferee acquires nonresidential real property in a step-in-the-shoes transaction described in Sec. 168(i)(7)(B) (such as when property is contributed to a partnership in a tax-free Sec. 721 transaction) any improvement that was previously made and placed in service by the transferor that is QIP is QIP in the transferee’s hands (but only to the extent of the transferee’s basis in the property that carried over from the transferor). However, because the transferee’s basis in such QIP is based on the transferor’s basis, it does not qualify for bonus depreciation. Apparently, the transferee steps into the shoes of the transferor’s remaining 15-year recovery period. Of course, if the transferor claimed bonus depreciation on the QIP, its basis would be zero, so the transferee would have no basis in that QIP.

Planning tip: Improvements to residential rental property are not QIP. An IRS official has informally indicated that when improvements are made to a mixed-use property (e.g., an apartment building with ground-floor retail space), whether the improvements can qualify as QIP depends on the building’s use in the year the improvements are placed in service (Richman, “Current Use Is Key to QIP Bonus Depreciation Deductions,” 168 Tax Notes Federal 721 (July 27, 2020)). For example, if the retail space is placed in service before the rental space and an improvement is made during a year that the building is nonresidential real property, the improvement could qualify as QIP. However, improvements made during a year that the building is residential real property are not QIP. (A building is considered residential real property in any year that 80% or more of the building’s gross rental income is rental income from dwelling units; see Sec. 168(e)(2)(A)(i)). Note that there could be a change in the building’s use when the residential and nonresidential portions are placed in service at different times.

A change in use is deemed to occur on the first day of the year of change. So, for example, if the retail portion is placed in service first, and, in a later year, the building becomes residential real property, the change to residential status is deemed to occur on the first day of that year, so no improvements made during that year could be QIP. Practitioners are not bound by this informal guidance and cannot rely on it as substantial authority. However, it does provide some insight on the potential issues involved. Practitioners should be alert for developments.

Claiming bonus depreciation on QIP

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 168(e)(6) to define QIP for property placed in service after 2017. But the TCJA (apparently inadvertently) did not add the newly defined QIP to the list of property assigned a 15-year recovery period under Sec. 168(e)(3)(E). Instead, QIP fell into the 39-year recovery period, making it ineligible for bonus depreciation (Sec. 168(k)(2)(A)(i)). However, the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, provided a long-awaited technical correction to assign QIP a 15-year recovery period (20-year for the alternative deprecation system (ADS)), as if such provision had been included in the TCJA (Sec. 168(e)(3)(E)(vii)). Therefore, QIP placed in service after 2017 can qualify for bonus depreciation. If the taxpayer elects out of bonus depreciation for QIP, it is depreciated straight line over a 15-year recovery period (Sec. 168(b)(3)(G)).

Planning tip: Note that QIP is also eligible (at the taxpayer’s election) for Sec. 179 expensing. In addition, taxpayers can elect to treat certain improvements to nonresidential real property that fall outside the definition of QIP (roofs; heating, ventilation, and air conditioning property; fire protection and alarm systems; and security systems), and are therefore not eligible for bonus depreciation, as Sec. 179 property (Secs. 179(d)(1)(B)(ii) and (e)).

Claiming bonus depreciation on QIP placed in service in 2018, 2019, or 2020

Rev. Proc. 2020-25 provides guidance on how taxpayers who placed QIP in service in prior years (when such property was assigned a 39-year recovery period) can take advantage of the CARES Act change that makes such QIP 15-year property eligible for bonus depreciation. Also, recognizing that this retroactive reclassification of QIP may affect elections that taxpayers made (or failed to make), the IRS is allowing taxpayers to make certain late elections regarding depreciation and/or to revoke elections they previously made.

Rev. Proc. 2020-25, Section 3, provides that taxpayers who placed QIP in service after 2017 in tax years ending in 2018, 2019, or 2020 (their 2018, 2019, or 2020 tax years) can depreciate such property straight line over a 15-year recovery period and, provided all requirements are met, claim bonus depreciation. A change to using a 15-year recovery period or claiming bonus depreciation is a change from an impermissible accounting method to a permissible method.

The change to a permissible method can be made by filing an amended return for the placed-in-service year and any affected succeeding years on or before Oct. 15, 2021 (or if earlier, before the statute of limitation for that year expires). Alternatively, the taxpayer can file a Form 3115, Application for Change in Accounting Method, to request an automatic accounting method change under Rev. Proc. 2015-13. The Form 3115 is filed with a timely filed income tax return for the year of change. See Section 6.03(1) of Rev. Proc. 2020-25 for details on this accounting method change, including relaxation of the prohibition against making an accounting method change more than once in a five-year period, a reduced filing requirement, and rules for making concurrent method changes. The negative Sec. 481(a) adjustment resulting from claiming more depreciation in the affected years than claimed under the impermissible method is taken into account in the year of change.

Generally, an accounting method is not adopted until a taxpayer has used it for at least two years. However, taxpayers who only claimed impermissible depreciation on QIP for a single year can include such depreciation in their accounting method change. Or they can correct the depreciation for such “one-year property” by filing an amended return.

Caution: Rev. Proc. 2020-25 does not apply to QIP if the taxpayer deducted the cost of the property as an expense. Also, any changes to depreciation of QIP due to a late election out of the Sec. 163(j) limit on business interest expense, or due to the revocation of such an election, are made under Rev. Proc. 2020-22.

Making late depreciation elections

In general, taxpayers must make the following depreciation-related elections on a timely filed return for the year the property is placed in service:

• Election to use the ADS (Sec. 168(g)(7)).
• Election to treat certain plants as placed in service (for bonus depreciation) in the year they are planted or grafted (rather than in the later year that they become productive) (Sec. 168(k)(5)).
• Election out of bonus depreciation (Sec. 168(k)(7)).
• Election to apply the 50% (rather than the 100%) bonus depreciation rate to certain property placed in service in the taxpayer’s first year ending after Sept. 27, 2017 (Sec. 168(k)(10)).

Rev. Proc. 2020-25, Section 4.02, extends the deadline for a taxpayer that places depreciable property in service in the 2018, 2019, or 2020 tax year, timely files a return for the placed-in-service year, and wants to make an election described in the first three items of the preceding list. Likewise, a taxpayer that timely filed a return for the tax year that includes Sept. 27, 2017, and wants to make the election described in the fourth item of the list above, can make a late election. Late elections are made by filing amended returns for the placed-in-service year and any affected succeeding tax years by Oct. 15, 2021 (or, if earlier, before the statute of limitation for that year expires). Alternatively, the election can be made by filing a Form 3115 with the taxpayer’s timely filed original return (1) for either the first or second tax year after the year the property is placed in service or (2) that is filed after April 17, 2020, and on or before Oct. 15, 2021. See Rev. Proc. 2020-25, Section 6.03(2), for details on requesting this automatic accounting method change.

Note: The Sec. 168(k)(7) election out of bonus depreciation is made with respect to a class (or classes) of assets and applies to all assets in that class placed in service during the year for which the election is made. QIP placed in service after 2017 is in the 15-year property class and is not a separate class of property, unlike QIP placed in service before 2018, which is a separate class of property (Regs. Sec. 1.168(k)-2(f)(1)(ii)(D)).

Observation: Rev. Proc. 2019-33 allowed taxpayers to make late elections under Secs. 168(k)(5), 168(k)(7), and 168(k)(10). Rev. Proc. 2020-25 extends the time for making such elections even further for certain taxpayers.

Revoking or withdrawing certain depreciation elections

Rev. Proc. 2020-25, Section 5.02(2), allows a taxpayer that placed depreciable property in service during the 2018, 2019, or 2020 tax year and made the Sec. 168(k)(5) election for specified plants, the Sec. 168(k)(7) election out of bonus depreciation, or the Sec. 168(k)(10) election to use the 50% bonus depreciation rate for certain assets for the tax year including Sept. 28, 2017 (where the election was made on a timely filed original return filed on or before April 17, 2020, or on a late election under Rev. Proc. 2019-33 before that date), to revoke those elections by filing amended returns for the placed-in-service year and any affected succeeding years on or before Oct. 15, 2021 (or, if earlier, before the statute of limitation for that year expires). The elections can also be revoked by filing a Form 3115 to request an automatic accounting method change. See Section 6.03(2) of Rev. Proc. 2020-25 for details on filing Form 3115. For certain taxpayers, Rev. Proc. 2020-50, Section 6, extends the period for revoking these elections until Dec. 31, 2021, generally using similar procedures.

Likewise, under Rev. Proc. 2020-25, Section 5.02(3), a taxpayer that elected to use the ADS method for assets placed in service during the 2018, 2019, or 2020 tax year can revoke that election by filing amended returns for the placed-in-service year and any affected succeeding years.

This case study has been adapted from PPC’s Tax Planning Guide — Closely Held Corporations, 34th Edition (March 2021), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2020 (800-431-9025; tax.thomsonreuters.com).