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Taxes: Qualified Improvement Property

By Yusi Luo and Anthony P. Curatola, Ph.D.
September 1, 2020
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Following the technical correction included in the CARES Act to address depreciation and additional first-year depreciation of qualified improvement property, the IRS has issued new guidance for late elections.

 

The coronavirus aid, relief and economic Security (CARES) Act (P.L. 116-136) makes qualified improvement property (QIP) eligible for bonus depreciation once again, fixing the glitch that resulted from the Tax Cuts and Jobs Act (TCJA) of 2017 (P.L. 115-97). As a result of the technical correction, taxpayers with QIP costs incurred since the TCJA may be using an impermissible method of accounting and may need to switch to a different (permissible) method, which generally requires permission from the Internal Revenue Service (IRS). Rev. Proc. 2020-25 provides relief to taxpayers that placed depreciable property in service during their 2018, 2019, or 2020 taxable year and filed timely federal income tax returns for the placed-in-service year of such depreciable property on or before April 17, 2020.

 

BACKGROUND

 

The TCJA amended Internal Revenue Code (IRC) §168 to allow 100% additional first-year depreciation deductions for certain qualified property, but the definitions of qualified leasehold improvement property (IRC §168(e)(3)(E)(iv)), qualified restaurant property (IRC §168(e)(3)(E)(v)), and qualified retail improvement property (IRC §168(e)(3)(E)(ix)) were inadvertently removed from the Code, which meant they would no longer be treated as 15-year recovery property but rather as 39-year recovery property.

 

Although the legislative intent of including qualified properties as 15-year property is expressed in the conference agreement of the TCJA, the legislative text failed to explicitly state this position. Hence, the U.S. Treasury Department and the IRS issued proposed regulations in REG-104397-18 (August 8, 2018) that such properties placed in service after December 31, 2017, wouldn’t qualify for the 100% additional first-year depreciation provision. As a result, the proposed regulations became finalized with some modifications in TD 9874 (September 24, 2019) but without corrected legislative text. The necessary solution was new legislation.

 

The CARES Act §2307 provides that any QIP is added to the definition of 15-year property (IRC §168(e)(3)(E)) and therefore will now qualify for 100% additional first-year depreciation. Moreover, this correction is retroactive to any qualified improvements placed in service after December 31, 2017, as if this amendment were originally included in the TCJA.

 

QIP DEFINITION

 

The CARES Act amended IRC §168(e)(6) to now define “qualified improvement property” by adding the wording “made by the taxpayer” after “any improvement.” The rest of the rules didn’t change—the improvement must be to an interior portion of a nonresidential real property and placed in service after the date the building was first placed in service.

 

QIP doesn’t include any cost related to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. QIP is depreciated by using the straight-line method with the half-year or mid-quarter convention for purposes of the general depreciation system (GDS) under IRC §168(a) for a 15-year recovery period. Rev. Proc. 2020-25 clarifies that a taxpayer treating QIP placed in service after December 31, 2017, as 39-year property is an “impermissible” method of accounting.

 

QIP LATE DEPRECIATION ELECTIONS

 

Rev. Proc. 2020-25 also allows a taxpayer to make late elections or revoke prior depreciation elections if he or she placed depreciable property in service during the taxpayer’s tax year ending in 2018, 2019, or 2020 and hasn’t withdrawn or revoked the election.

 

The first election is that a taxpayer could make an election to depreciate the same class of property placed in service by the taxpayer in the same tax year under the alternative depreciation system (ADS), using a 20-year class life. Yet such an election for nonresidential real property and residential rental property could be made on a property-by-property basis. The election must be made by the due date of the tax return (including extensions) for the taxable year in which the property is placed in service. It can be made by attaching a statement to the tax return. But once made, the ADS election is irrevocable (IRC §168(g)(7) election).

 

The second depreciation election relates to farming. It allows a taxpayer to apply the special rules to specified plants that are planted—or grafted to a plant that has already been planted—by the taxpayer in the ordinary course of his or her farming business. This election allows a taxpayer to claim bonus depreciation for specified plants in the tax year the taxpayer plants or grafts a plant instead of the date the plant is placed in service (IRC §168(k)(5) election).

 

The third election allows a taxpayer to elect out of the additional first-year depreciation for all qualified property that’s in the same class of property and placed in service during the same tax year. This election applies on a class-by-class basis (IRC §168(k)(7) election).

 

The fourth election is that 50% additional first-year depreciation (rather than 100%) could be claimed for qualified property placed in service by the taxpayer during the first taxable year ending after September 27, 2017, and placed in service during its taxable year that includes September 28, 2017. This election applies to all qualified property placed in service during that tax year rather than on a class-by-class basis (IRC §168(k)(10) election).

 

TIME FOR THE ELECTIONS AND REVOCATIONS

 

Treas. §1.168(k)-2(f)(5) provides that, in general, the late election under IRC §168(k)(5), (k)(7), or (k)(10) election, once made, may be revoked within the six-month period following the original due date of the taxpayer’s timely filed return excluding extensions, or by filing a request for a private letter ruling and obtaining the written consent of the Commissioner of Internal Revenue. Recognizing the difficulty for any taxpayer to request the Commissioner’s consent in a timely manner, the Commissioner has granted taxpayers an extension of time to revoke the IRC §168(k)(5), (k)(7), or (k)(10) election by virtue of Rev. Proc. 2020-25.

 

The taxpayer may revoke these elections by filing an amended return on or before October 15, 2021, but not later than the expiration of the period of limitations for the amended return tax year. A taxpayer may also choose to request a change in the method of accounting with an IRC §481(a) adjustment (adjustments required by changes in method of accounting) only during a limited period of time. Taxpayers that placed QIP in service in their 2018, 2019, or 2020 tax year have this option by filing Form 3115, Application for Change in Accounting Method, with their current-year return for the first or second taxable year after the taxable year that the QIP was placed in service to claim the missed depreciation.

 

Overall, the QIP not only has a 15-year recovery period, which is significantly shorter than a 39-year recovery period, but it’s also eligible for additional first-year depreciation. Therefore, taxpayers are able to correct their prior returns, claim missed depreciation, and generate carryback claims to tax years with higher tax rates for taxpayers. This is especially relevant for those in the real estate, restaurant, retail, and hospitality businesses.

 

© 2020 A.P. Curatola

 

Yusi Luo is the Vertex Fellow at Drexel University in Philadelphia, Pa.
Anthony P. Curatola, Ph.D., is editor of the Taxes column for Strategic Finance, the Joseph F. Ford Professor of Accounting at Drexel University, and a member of IMA’s Greater Philadelphia Chapter. You can reach Tony at (215) 895-1453 or curatola@drexel.edu.
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