A common frustration for small business owners has historically been their inability to recover nonresidential commercial real estate costs through depreciation in a reasonable amount of time. Nonresidential real property has been relegated to a 39-year straight-line recovery life, with no opportunity for accelerated deductions. This unfavorable depreciation period and disappointing annual deduction has led real estate investors to spend time and resources to optimize current year deductions. Congress has recognized these inefficiencies, and attempted to provide some relief with the introduction of Qualified Improvement Property.
Qualified Improvement Property (QIP) is a fixed asset category first established in the Protecting Americans from Tax Hikes (PATH) Act of 2015. Under Section 168(k)(3), improvements to non-residential real estate now qualify for accelerated depreciation (bonus depreciation), except for improvements that enlarge the building, involve elevators or escalators, or change the internal structural framework of the building. Though the assets are still subject to a 39-year life, the act afforded them bonus depreciation eligibility starting with the 2016 tax year.
Bonus depreciation is a specific type of accelerated cost recovery that is available in the first year that new assets are placed in service. While it has traditionally been restricted to assets with class lives of 20 years or less, the PATH Act made an exception for QIP. QIP assets placed in service before September 27, 2017, are eligible for bonus depreciation on 50% of their unadjusted basis, while qualifying assets acquired and placed in service between that date and December 31, 2022, are eligible for 100% bonus. No elections or forms are required to claim the benefits of QIP; its characteristics are simply applied to individually qualifying assets. These broad limitations have allowed for significantly quicker cost recovery on small business assets.
In order to understand the benefits of QIP, it is important to recognize the previous system’s limitations. Although the 39-year life was not ideal, the real benefit of QIP stems from the ease with which assets can qualify for bonus depreciation. Prior to the introduction of QIP, Qualified Leasehold Improvements offered a 15-year life, but the underlying building had to be at least 3 years old and the construction needed to be completed pursuant to a lease. Moreover, it could not be a lease involving related parties, and all qualifying improvements had to be made to leased space only (not ‘common areas’). Qualified Retail Improvements and Qualified Restaurant Property also offered a 15-year life, but only for equipment meeting specific operational standards in specific industries. For instance, the restaurant in question had to utilize at least 50% of their square footage for preparation of meals and on-site consumption of prepared meals. QIP has replaced all of these categories with simple regulations and a comparatively broad standard for commercial real estate owners or lessors to follow. QIP can also come in handy for taxpayers required to use the Alternative Depreciation System (ADS), rather than the General Depreciation System (GDS). This group can include certain farm property, tangible property used mainly outside the US, listed property used 50% or less in a qualified business, and property of businesses electing out of the new business interest limitation rules.
One legislative wrinkle to keep an eye on involves the specific text of the Tax Cuts and Jobs Act of 2017 (TCJA) passed last December. While the previously mentioned bonus depreciation benefits are assured, the initial version of the law left some unintentional ambiguity as to whether or not QIP will be reduced from a 39- to 15-year life starting in 2018. The Congressional legislative committee responsible for drafting the bill has signaled their intention to correct this section to clearly provide a 15-year life with a technical corrections bill, but it has not yet been passed. There are also some moderate risks associated with taxpayer interpretation of the phrases ‘structural components’ and ‘common area’ as they apply to QIP eligibility. However, Reg. sections 1.48-1(e)(2) and 1.168(k)-1(c)(3)(ii) provided some helpful guidance on these terms.
Overall, the introduction of QIP has simplified fixed asset depreciation decisions. Whereas the 2014 Tangible Property Regulations introduced numerous frameworks and operational guidelines related to the depreciable lives of new construction, QIP has eliminated much of this analysis and facilitated an easy 100% bonus depreciation option. While the current bonus depreciation rules and related property classifications are set to expire at the end of 2022, these interim years should provide significant benefit for taxpayers conducting new nonresidential construction projects.
Give us a call if you have questions about QIP.
Gregory M. Ward, CPA, is a tax supervisor and joined Dalby, Wendland & Co.’s Glenwood Springs office in August of 2013. He attended the University of Illinois at Urbana-Champaign and attained a bachelor’s degree in accounting, with highest honors. Greg works in the areas of individual taxation, estates and trusts, small business taxation, tax-exempt organization reporting, and foreign reporting. He is a member of the American Institute of CPAs, Colorado Society of CPAs, National Eagle Scout Association, and volunteers his time as the treasurer for the Colorado Society of Certified Public Accountants Roaring Fork Chapter.