On April 17, 2020, the IRS issued guidance on correcting depreciation for qualified improvement property (QIP), including catching up bonus depreciation from prior years. This guidance also provides rules for making late elections, or revoking elections, including the election out of bonus depreciation and the election to use the alternative depreciation system (ADS). Combined with previous guidance on withdrawing the real property trade or business election and amending partnership returns, taxpayers now have a much clearer picture of how to implement these changes.
Due to a drafting error in the Tax Cuts and Jobs Act (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.
All of this changed with the passage of the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which amended the Internal Revenue Code (IRC) to define QIP as 15-year property. The Act also updated the 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 the TCJA.
“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 uniform capitalization (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 QIP — unfortunately, the recent guidance does not address this question. This phrase also likely rules out bonus depreciation on used QIP.
Taxpayers that made the real property trade or business election to opt out of the business interest expense limitation now have the opportunity to withdraw the election and catch up bonus depreciation. Under IRS guidance issued on April 10, 2020, taxpayers can file an amended return to retroactively withdraw the section 163(j) election (the guidance also allows taxpayers to make a late section 163(j) election). The amended return must recalculate depreciation, the business interest expense limitation and any other collateral adjustments (such as information related to the section 199A deduction) for the year the improvements were placed in service and all succeeding years. The deadline for amended returns is Oct. 15, 2021; for partnerships subject to the centralized partnership audit regime (CPAR) the deadline to file 2018 and 2019 amended returns is before Sept. 30, 2020 (but CPAR partnerships have until Oct. 15, 2021, to make the changes on an administrative adjustment request (AAR)).
Taxpayers not revoking the section 163(j) election have a couple of options to catch up bonus depreciation on QIP or switch to shorter recovery periods. Partnerships subject to CPAR may file amended returns or AARs and must recalculate depreciation, etc., for the year the improvements were placed in service and all succeeding years. Amended returns for 2018 and 2019 must be filed before Sept. 30, 2020; CPAR partnerships may also make the changes via AAR until Oct. 15, 2021. Alternatively, CPAR partnerships may correct depreciation on QIP by filing an accounting method change (Form 3115) with a timely filed original return (including extensions). The April 17 guidance includes a new automatic method change specifically for this purpose.
All other taxpayers not changing the section 163(j) election may file amended returns for the year the improvements were placed in service year and all succeeding years. The deadline to file amended returns is Oct. 15, 2021. Taxpayers also may correct depreciation on QIP by filing a Form 3115 with a timely filed original return (including extensions) under the new automatic accounting method change procedure.
Finally, the IRS provided rules for making late elections, or revoking elections, under the depreciation rules. Specifically, the guidance addresses the election to use ADS, the election out of bonus depreciation, the election to use 50% bonus depreciation for certain property, and the bonus election for certain plants bearing fruits and nuts.
This latest IRS guidance is a welcome development and provides flexibility for taxpayers to optimize their depreciation strategy. There are still a lot of moving parts, though — 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 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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