Bonus depreciation on qualified improvement property

[Updated April 9, 2020, for issuance of Rev. Proc. 2020-23]

We have good news and we have bad news.

The good news is that as part of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress fixed the so-called “retail glitch,” and made qualified improvement property (QIP) eligible for bonus depreciation retroactive to 2018. This is a big relief for taxpayers, especially those in the retail and restaurant industries, which have been forced to close or severely cut back operations because of the coronavirus outbreak. This provision may allow many taxpayers to obtain tax refunds related to expenditures for renovation projects completed in the last few years.

The bad news is that since the relief is retroactive to 2018, the provision has the potential to unleash a storm of administrative complexity in the form of amended returns, superseding returns, and accounting method changes (Form 3115). In other words, actually claiming bonus depreciation two years after the Tax Cuts and Jobs Act (TCJA) may be easier said than done in many situations. And perhaps the worst news is that taxpayers in real property trades or businesses who elected out of the business interest deduction limitation cannot take bonus depreciation on QIP. Unfortunately, election is irrevocable, so unless Congress changes the statute, those taxpayers are stuck with a long recovery period for QIP.

Background

The retail glitch

Due to a drafting error in the TCJA, QIP placed in service after Dec. 31, 2017, was not eligible for bonus depreciation — this was known as the “retail glitch.” Congress intended for QIP to be bonus-eligible; however, the TCJA did not specifically include a 15-year recovery period for QIP. Therefore, after the tax reform dust settled, QIP was nonresidential real property with a recovery period of 39 years, not eligible for bonus.

CARES Act technical correction

All of this changed with the passage of the CARES Act, which amended the Internal Revenue Code (IRC) to define QIP as 15-year property. The Act also updated the alternative depreciation system (ADS) recovery period for QIP to 20 years. Finally, the Act updated the definition of QIP to include any improvement “made by the taxpayer” (see discussion below). These changes are retroactive to 2018 — i.e., to the passage of TCJA.

QIP definition

“Qualified improvement property” means 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. QIP does not include expenditures attributable to: (i) enlargement of the building; (ii) any elevator or escalator; or (iii) the internal structural framework of the building.

The CARES Act added the phrase “made by the taxpayer” to the definition of QIP. Presumably, rules similar to the existing UNICAP regulations, which address property produced by or for the taxpayer, will apply to determine if QIP is “made by the taxpayer.” The inclusion of this language may mean that partnership basis adjustments arising when a partner sells their interest, may not qualify for bonus depreciation for the portion of the purchase price allocable to QI. We will have to wait for clarification from the IRS on this issue. This phrase also likely rules out bonus depreciation on used QIP.

Catching up bonus depreciation on QIP

Taxpayers that made the real property trade or business election to opt out of the business interest deduction limitation cannot take bonus depreciation on QIP. We do not believe the Treasury Department can provide administrative relief here since this election is irrevocable under the IRC. So, unless Congress changes the statute, taxpayers cannot undo the election and retroactively claim bonus. These taxpayers can, however, benefit from the shorter ADS life provided by the CARES Act.

Under Rev. Proc. 2020-23 (issued April 8, 2020), partnerships subject to the centralized partnership audit rules (CPAR) are now permitted to amend their 2018 and 2019 returns. This new procedure gives CPAR partnerships another option to catch up bonus depreciation.

For other taxpayers, the procedure to claim bonus depreciation on QIP depends on when the improvements were placed in service, and if they have filed and/or extended their 2019 return. Options include an accounting method change (Form 3115) or an amended return. The simplest situation, of course, is for taxpayers that completed an improvement project last year and have not yet filed for 2019. They can just follow the new rules on the 2019 return without worrying about filing accounting method changes or amended returns.

Final thoughts

There are a lot of moving parts to consider in determining the optimal strategy. Obviously, it is important to identify QIP placed in service in 2018 and 2019, and quantify the potential benefit of claiming bonus depreciation. Taxpayers also must analyze the interaction of bonus depreciation with the changes to the net operating loss (NOL) rules, the delay of the excess business loss limitation imposed on noncorporate taxpayers, and state conformity to the bonus depreciation rules (some states may not automatically conform to these changes).

We anticipate Treasury and the IRS will issue procedures in the months ahead to streamline the process and help taxpayers take advantage of these new rules. That said, there may be limited situations where it makes sense to proceed using the current rules and procedures.

We encourage you to reach out to your Baker Tilly tax advisor to discuss how these changes may affect your tax situation.

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