This information was accurate as of 5/05/20.
CARES Act Makes Favorable Changes to “Qualified Improvement Property” QIP
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on March 27, 2020 contains a beneficial change in the tax rules for many improvements to an interior portion of a nonresidential building. This is referred to as Qualified Improvement Property (QIP). The correction retroactively allows real property owners to depreciate QIP faster than before. Here’s how it could lower your tax bill for 2018 and beyond.
The Tax Cuts and Jobs Act (TCJA) in 2017, eliminated definitions for 1) qualified leasehold improvement property, 2) qualified restaurant property, and 3) qualified retail improvement property. It replaced them with one category called Qualified Improvement Property (QIP). QIP is defined as an improvement to an interior portion of a nonresidential building that’s placed in service after the date the building was first placed in service.
Members of Congress made it clear that they intended to allow 100% first-year bonus depreciation for QIP placed in service in 2018 through 2022. Congress also intended to give you the option of claiming 15-year straight-line depreciation for QIP placed in service in 2018 and beyond.
Due to an inadvertent drafting mistake made by Congress, however, the intended 100% first-year bonus depreciation and 15-year recovery period for QIP never made it into the actual statutory language of the TCJA. Therefore, the cost of QIP had to be deducted over a 39-year period rather than entirely in the year the QIP was placed in service. Also, for many taxpayers, decisions were made as it related to the Real Property Trade or Business election, or elections out of bonus, that were considered irrevocable elections on 2018 or 2019 returns. The only way to fix the mistake was to make a so-called technical correction to the statutory language.
Congress Fixes the Error
The CARES Act corrects the TCJA drafting error for QIP. As a result, QIP is now included in the Internal Revenue Code’s definition of 15-year property. In other words, it can be depreciated over 15 years for federal income tax purposes. In turn, that classification makes QIP eligible for first-year bonus depreciation which means real estate owners can now claim 100% first-year bonus depreciation for QIP that’s placed in service in 2018 through 2022. Remember, the technical correction has a retroactive effect for QIP that was placed in service in 2018 and 2019.
For not-yet-filed returns, we can simply reflect the favorable treatment for QIP on the return.
On Friday, April 10th the IRS issued Rev. Proc. 2020-22 to answer the first of these questions. Under the TCJA, taxpayers were limited in their ability to deduct interest. This limitation was set at 30% of the adjusted taxable income (ATI) of the taxpayer for the year, this was adjusted to 50% under the CARES Act. However, taxpayers could opt out by electing to be treated as a “Real Property Trade or Business”. This election was to be considered irrevocable and would require that all real property and QIP be depreciated utilizing the Alternative Depreciation System (ADS) Rules. Under the ADS rules, QIP is not eligible for bonus depreciation.
This created an issue as many taxpayers made this election when QIP was not bonus eligible. Now that the CARES Act makes these assets bonus eligible, taxpayers may find it more advantageous to revoke this election. Under Rev. Proc. 2020-22, the IRS provides taxpayers the ability to withdraw this election to take advantage QIP.
Additionally, the IRS released Rev. Proc. 2020-25 on April 17th that addresses the qualified improvement property (QIP) technical correction contained in the CARES Act. This revenue procedure allow taxpayers to file an amended return, file an Administrative Adjustment Request (AAR) or file federal Form, “Application for Change in Accounting Method” subject to IRC Sec. 481 for QIP placed in service during the 2018, 2019 or 2020 tax years. Also, the IRS allows taxpayers to revoke elections out of bonus depreciation made under 168(g)(7), (k)(5), (k)(7) or (k)(10).
Special complicated rules apply to partnerships and LLC’s that are treated as partnerships for income tax purposes. Consequently the IRS released Rev. Proc. 2020-23 on April 8th which provides partnership income tax return relief.
Combining these new revenue procedures with the changes recently made to the Net Operating Loss carryback provisions create new tax planning opportunities for taxpayers.
To Amend or Not to Amend?
Amending a 2018 or 2019 return to claim 100% first-year bonus depreciation for QIP placed in service in those years may result in a lower bill for the tax year the QIP was placed in service. It may even generate an NOL that can be carried back to a prior tax year to recover taxes paid in that prior year.
You could also amend a 2018 or 2019 return to claim 15-year straight-line depreciation for QIP placed in service in those years. That might not create an NOL for 2018 or 2019, but it would still lower your tax bill for those years.
What Hasn’t Changed
Improvements related to the enlargement of a building, any elevator or escalator, or the building’s internal structural framework continue to not qualify under the definition of QIP.
15-Year Depreciation vs. 100% First-Year Bonus Depreciation
Claiming 100% first-year bonus depreciation for QIP expenditures makes sense if your primary objective is to minimize taxable income for the year the QIP is placed in service. But should that be your primary objective? The rules are complex. But there are three reasons you might choose to depreciate QIP over 15 years, rather than claim 100% first-year bonus depreciation:
1. You may qualify for a lower tax rate on the gain from depreciation when you sell the property. When you sell property for which you’ve claimed 100% bonus depreciation for QIP expenditures, any taxable gain up to the amount of the bonus depreciation is treated as high-taxed ordinary income rather than capital gain. Under the current federal income tax regime, ordinary income recognized by an individual taxpayer can be taxed at rates as high as 37%.
In contrast, if you depreciate QIP over 15 years using the straight-line method, the current maximum individual federal rate on long-term gain attributable to that depreciation is “only” 25%. The gain is so-called “unrecaptured Section 1250 gain,” which is basically a special category of long-term capital gain. Higher income individuals may also owe the 3.8% net investment income tax on both ordinary income gain and long-term gain attributable to real estate depreciation.
The point is, claiming 100% bonus depreciation for QIP expenditures on a property can cause a higher tax rate on part of your gain when you eventually sell the property. Of course, if you don’t anticipate selling for many years, this consideration is less important.
2. Depreciation deductions may be more valuable in future years, if Congress increases tax rates or you’re in a higher tax bracket. When you claim 100% first-year bonus depreciation for QIP expenditures, your depreciation deductions for future years are reduced by the bonus depreciation amount. If tax rates go up, you’ve effectively traded more valuable future-year depreciation write-offs for a less-valuable first-year bonus depreciation write-off. Of course, there’s no certainty about where future tax rates are headed.
3. Claiming 100% bonus depreciation may lower your deduction for qualified business income (QBI) from a so-called “pass-through” entity, such as a sole proprietorship, partnership, limited liability company or S corporation. An individual taxpayer can claim a federal income tax deduction for up to 20% of qualified business income (QBI) from an unincorporated business activity. However, the QBI deduction from an activity can’t exceed 20% of net income from that activity for the year, calculated before the QBI deduction.
Net income from the activity of renting out nonresidential rental property will usually count as QBI. But claiming 100% first-year bonus depreciation for QIP expenditures for the property will lower the net income and potentially result in a lower QBI deduction.
In addition, the QBI deduction for a year can’t exceed 20% of your taxable income for that year, calculated before the QBI deduction and before any net capital gain (net long-term capital gains in excess of net short-term capital losses plus qualified dividends). So, moves that reduce your taxable income — such as claiming 100% bonus depreciation for QIP expenditures — can potentially have the adverse side effect of reducing your allowable QBI deduction.
Important: The QBI deduction may be a use-it-or-lose it proposition, because it’s scheduled to expire after 2025. And it could disappear sooner, depending on political developments. If you forgo claiming bonus depreciation, your QBI deduction may be higher — and the foregone depreciation isn’t lost. You’ll just deduct it in later years when write-offs also might be more valuable because tax rates are higher.