Tax Strategy: QIP post-CARES Act
The tax issues involved in making nonresidential property improvements have been in a state of confusion since the enactment of the Tax Cuts and Jobs Act at the end of 2017. The TCJA had intended to combine leasehold improvement property, retail improvement property, and restaurant property under the title of Qualified Improvement Property and make QIP eligible for 15-year depreciation and, therefore, for 100 percent first-year bonus depreciation. A drafting error in the language of the TCJA, however, resulted in QIP only qualifying for 39-year depreciation, even worse than the 15-year depreciation that lessees were entitled to before the TCJA.
Efforts to get Congress to act were hampered by political wrangling. The Democrats wanted something in return for correcting errors in legislation passed without their support. The Internal Revenue Service declined to correct the error, saying that only Congress could correct the legislative language. Lessees turned to efforts such as cost segregation analyses to try to get more rapid depreciation for some of the expenditures.
Finally, over two years after enactment of the TCJA, the CARES Act included a retroactive technical correction as if it were included in the TCJA originally. The CARES Act permits Qualified Improvement Property to qualify for 15-year depreciation and therefore be also eligible for 100 percent first-year bonus depreciation.
The IRS has now provided guidance in Rev. Proc. 2020-25 on retroactively claiming bonus depreciation on QIP.
Qualified Improvement Property is defined as any improvement made by a taxpayer to an interior portion of a nonresidential building placed in service after the building was placed in service. It excludes expenditures for the enlargement of the building, elevators and escalators, or the building’s internal structural framework.
QIP can include roofs, heating and air conditioning equipment, and fire protection and security equipment. In order to qualify for bonus depreciation, the QIP must be new property in the hands of the taxpayer, not used property.
Rev. Proc. 2020-25
Under Revenue Procedure 2020-25, QIP qualifies for 100 percent first-year bonus depreciation if it was acquired after Sept. 27, 2017, and placed in service after Dec. 31, 2017, in a tax year ending in 2018, 2019 or 2020. Under current law, 100 percent first-year bonus depreciation starts to phase down in 2023.
Taxpayers changing to 15-year depreciation or 100 percent first-year bonus depreciation from 39-year depreciation are viewed by the IRS as changing from an impermissible to a permissible method of accounting. This qualifies for the automatic change of accounting method procedures.
Taxpayers have until Oct. 15, 2021, to file an amended income tax return or Form 1065 for the placed-in-service year of the QIP, but in no event later than the applicable period of limitations on assessment for the tax year for which the amended return is being filed.
Partnerships subject to the partnership audit rules are granted special permission under Rev. Proc. 2020-23 to file amended Form 1065s and K-1s with respect to the placed-in-service year. The partnership may alternatively file an administrative adjustment request with respect to the placed-in-service year.
The AAR is to reflect the resulting changes to taxable income or tax liability resulting from the depreciation adjustment to QIP as well as any collateral adjustments — e.g., if the depreciation change results in changes to other business tax deductions, for the placed-in-service year and affected succeeding tax years. Alternatively, a Form 3115 may be filed with a timely return under the automatic change of accounting method procedures.
An electing real property trade or business or an electing farming business were eligible under the TCJA to elect out of the business interest deduction limitation in the TCJA if they depreciated property under the Alternative Depreciation System. QIP is 20-year life property under the ADS. Taxpayers who made this election are therefore not eligible for 15-year depreciation or for 100 percent first-year bonus depreciation.
Factors to consider
Given that many businesses have been adversely affected by the COVID-19 business shutdown orders, amending 2018 tax returns to shift from 39-year depreciation to 100 percent first-year bonus depreciation could result in significant tax savings and a tax refund that could be very helpful in 2020. Either amending 2019 tax returns if already filed or claiming bonus depreciation now as 2019 tax returns are filed could result in similar benefits.
Corporations receive the additional possible benefit, if the increased expensing results in a net operating loss for 2018 or 2019, of utilizing the five-year net operating loss carryback provisions of the CARES Act to get refunds of taxes as far back as the 2013 tax return, when tax rates were higher.
On the other hand, claiming additional first-year depreciation, or even claiming 15-year depreciation, versus 39-year depreciation, could have a negative impact on other business deductions claimed during the placed-in-service year. Taxpayers will want to consider the impact on the uniform capitalization rules, the business interest expense limitation, and some of the international tax deductions, if applicable, that could be adversely impacted by additional depreciation expensing.
Many of the provisions of the CARES Act were structured to get cash into the hands of taxpayers quickly to help businesses and individuals deal with the adverse impacts of the COVID-19 pandemic. The long-delayed changes to the depreciation rules for QIP present the possibility to taxpayers to obtain refunds for the 2018 tax year, reduced taxes for the 2019 tax year, and, for corporations, possible refunds for tax years going back to 2013. Taxpayers and their advisors should review carefully the alternatives to produce not only the optimal tax result but also the result that might get cash into