Changes to Qualified Improvement Property Under the CARES Act

The recently enacted CARES Act included several changes to the Internal Revenue Code (“IRC”). One of these changes was to the depreciation recovery period for Qualified Improvement Property (“QIP”). The changes made can provide a significant acceleration of depreciation for certain qualifying improvements. It is important to note some background on QIP in order to fully understand the changes made by the CARES Act including the tax implications for a wide variety of taxpayers. Specifically, taxpayers in the real estate, restaurant, retail, and hospitality businesses can expect significant tax saving opportunities. Additionally, the importance of cost segregation studies will be apparent based on the requirements to take advantage of the change.

Background

QIP was originally defined in the IRC as a result of The Protecting Americans from Tax Hikes (“PATH”) Act of 2015. This asset category was defined to include any improvement to an interior portion of a building which was nonresidential real property if such improvement was placed in service after the date such building was first placed in service. Excluded from the definition of QIP were the enlargement of a building, any elevator or escalator, and the internal structural framework of a building. At the time QIP was enacted as a property type, other similar, yet slightly different, asset categories existed including qualified leasehold improvements, qualified retail improvements, and qualified restaurant property.

The Tax Cuts and Jobs Act of 2017 (“TCJA”) eliminated these other asset categories and left QIP as the sole remaining asset category covering non-residential improvements as defined previously. The Congressional intent was that QIP would have a 15-year recovery period and therefore be eligible for bonus depreciation (i.e., assets with a recovery period of 20 years or less are eligible for bonus depreciation). Significantly, bonus depreciation was changed to 100% of the cost of qualifying property.

Due to a drafting error, a recovery period was not assigned to QIP and therefore it defaulted to a 39-year recovery period for the General Depreciation System (“GDS”) and a 40-year recovery period for the Alternative Depreciation System (“ADS”). ADS recovery periods are required to be used by taxpayers in certain situations. As a result of the 39-year recovery period, QIP has not qualified for bonus depreciation since the effective date of the TCJA because bonus depreciation is currently only allowed for assets with a recovery period of 20 years or less.

Changes Made in the CARES Act

The CARES Act made the following three changes to the IRC in regard to QIP which have a significant impact on tax reporting and may provide immediate cash flow opportunities. The effective date of the changes is AS IF they were included as part of the original TCJA.

1. A 15-year recovery period was assigned to QIP. Not only is this a significantly shorter recovery period as compared to 39 years, QIP is now eligible for bonus depreciation.
2. The definition of QIP was changed (emphasis added):

   FROM:	Any improvement 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.
   TO:	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.

   This was a significant change because of the impact on new property acquisitions. Whereas under the old definition, a portion of the purchase price of an acquired building may have been considered QIP and thus eligible for bonus depreciation, this is no longer possible. The QIP asset category will only be applicable for improvements actually made by the reporting taxpayer.

3. The ADS recovery period for QIP has changed from 39 years to 40 years. Although this is only a one-year change, it should be considered for tax reporting updates since many entities either elect to use, or are required to use, the ADS recovery period for certain assets including QIP. One such example is taxpayers that have elected to be real property trades or businesses (“RPToBs”) in order to be exempt from the business interest limitation under IRC Sec. 163(j).

Tax Implications and Action Items

As discussed above, the most significant implication of the recovery period change is the availability for taxpayers to take advantage of bonus depreciation for QIP. The following tax implications and action items should be noted:

Tax Savings and Cash Flow Benefits

1. Since the effective date is AS IF originally included in the TCJA, bonus depreciation is available for QIP in 2018 and later years. Since bonus depreciation of 100% of an asset’s cost is allowed in 2018 and 2019, this change can provide immediate cash saving opportunities.
2. Additional bonus depreciation may create net operating losses (“NOLs”) for certain taxpayers, which can be carried back five years under the new NOL provisions under the CARES Act.
   1. Most significantly, C corporations, which are now taxed at 21% as compared to the historical 35% rate, may experience a significant tax saving opportunity. An NOL generated in 2018 or 2019 which would only provide a 21% tax benefit in future years could potentially be carried back to tax years prior to 2018 where 35% was the maximum tax rate. An NOL would therefore possibly generate a tax benefit at a higher tax rate.

Eligibility Considerations

1.  Taxpayers who previously elected to be considered RPToBs for purposes of the IRC Sec. 163(j) business interest limitation are not eligible for bonus depreciation on QIP under the statute. Furthermore, the RPToB election is deemed to be irrevocable under the statute. It is unclear whether any relief will be provided for these taxpayers that made such an election in 2018 or on already filed 2019 tax returns.
2. Many states do not allow for bonus depreciation so although a significant deduction may be available for federal tax return purposes, state income addbacks may be required and as a result generate unintended tax consequences.

Current Action Items

1. For taxpayers that have not yet filed their 2019 tax returns, an analysis of any eligible QIP should be performed immediately to identify tax saving opportunities.
2. Because classification of assets as QIP requires a careful analysis of improvements, taxpayers may want to consider obtaining cost segregation studies which allocate improvement costs amongst various asset categories including the QIP category.
3. Before taking bonus depreciation, taxpayers should consider reviewing the Tangible Property Regulations (“TPR”) under Treasury Regulation § 1.263(a) to ensure that capitalized improvements are in fact required (or even eligible) to be capitalized. The TPR provide rules on what expenditures need to be capitalized. If costs are not required to be capitalized, an immediate deduction for such costs would be taken and such treatment should be more beneficial than bonus depreciation. Both the negative state impacts noted above as well as certain depreciation recapture may not apply in such fact pattern. 

Next Steps

Taxpayers who may qualify for tax benefits under the changes to QIP should be in discussions with their tax advisors as soon as possible to identify these tax saving opportunities. As noted above, there are various tax implications that should be considered regarding bonus depreciation and some unintended consequences may result. However, the opportunity for immediate tax savings and cash flow warrants the effort to consider the action items discussed above including analyzing QIP in 2018 and 2019.

The IRS recently released multiple sets of guidance which specifically relate to the QIP changes discussed above:

1. Revenue Procedure 2020-22 provides guidance on how taxpayers can withdraw a RPToB election as well as how to make a late RPToB election.
   1. More details on this guidance can be found in the following article: IRS Provides Additional Guidance for Real Estate Businesses
2. Revenue Procedure 2020-23 provides guidance on how certain partnerships have the option to file amended tax returns for tax years 2018 and 2019 to take advantage of the benefits afforded by the CARES Act without waiting until the filing of their 2020 return.
   1. More details on this guidance can be found in the following article: The IRS Provides Welcome Relief to Partnerships Claiming Benefits under the CARES Act
3. Revenue Procedure 2020-25 provides guidance on how taxpayers should proceed to adjust depreciation on QIP due to the changes made by the CARES Act. In addition to amending tax returns, taxpayers are eligible to file for a change of accounting method using Form 3115 to correct depreciation on fixed assets affected by the CARES Act.
   1. More details on this guidance can be found in the following article: IRS Issues Guidance for Taxpayers Adjusting Depreciation on Qualified Improvement Property