The IRS prescribes multiple lives and methods for depreciating fixed assets, making it important and frustrating to determine which life to assign to a new purchase or to a self-produced or improved asset.
Many taxpayers assume that the recovery period, or depreciable life, for non-residential real property is a straightforward 39 years, and has been that way since the Modified Accelerated Cost Recovery System (MACRS) was updated in 1993. Companies simply depreciate property over the 39 years (or 31.5 for property put in service 1987-1993) and use a straight-line, mid-month convention. This is not precisely true, and the nuances can create opportunities for companies that have not updated their approach to certain fixed assets.
The American Jobs Creation Act of 2004 and the PATH Act of 2015
In October 2004, the American Jobs Creation Act (AJCA) was signed into law. One provision of the law encouraged the improvement of leased nonresidential real property by allowing for a quicker recovery of costs over 15 years rather than 39 years.1 The AJCA also simplified the convention by switching it to half-year (unless the mid-quarter convention applies) rather than mid-month. This shorter recovery period was available to lessees, sublessees, and lessors making improvements to the interior portion of the property as long as the following qualifications were met:
- The improvement was made under, or pursuant to a lease;
- The improvement was section 1250 property (i.e. a structural component), and not section 1245 personal property that was eligible for a shortened recovery period);
- The lease was not between related persons;
- The interior portion of the building was to be occupied exclusively by the lessee or any sublessee of that interior portion; and
- The improvement was placed into service more than three years after the date the building was first placed into service.
There were some exceptions to the types of improvements that would qualify for the shorter life. The expenditures that would not qualify include:
- The enlargement (as defined in Reg. section 1.48-12(c)(10)) of the building;
- Elevators and escalators;
- Structural components (as defined in Reg. section 1.48-1(e)(2)) that benefit a common area; or
- Internal structural framework (as defined in Reg. section 1.48-12(b)(3)(i)(D)).
Most of the provisions within the AJCA were set to expire on Dec. 31, 2006. However, a series of extenders continued to make this provision available. The Protecting Americans from Tax Hikes (PATH) Act of 2015, made permanent the 15-year recovery period for qualified leasehold improvements (or QLHI) placed into service after Oct. 21, 2004. That means that any QLHI placed into service after Oct. 21, 2004 and before Jan. 1, 2018 that was assigned the 39‑year recovery period on the taxpayer’s tax records should be changed in order to correctly record depreciation on the taxpayer's Form 4562.
For tax years beginning after Dec. 31, 2015, the PATH Act permanently extended the 15-year recovery on QLHI. The PATH act also created a new category of 39-year property subject to bonus depreciation called “qualified improvement property” (QIP). QIP is similar to QLHI, except QIP qualifies for bonus depreciation without being made under or pursuant to a lease, without the three-year waiting period, and without the “common area” restriction discussed below. However, improvement expenditures attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building are still considered 39 year property under MACRS, and excluded from bonus depreciation.
Note that the 15-year recovery period for QLHI is not elective. If a taxpayer makes improvements to leased or owned property that qualifies for the shorter recovery period, the taxpayer is required to depreciate the improvement over 15 years for tax purposes. Otherwise, the IRS could take the position that the company elected ADS (Alternative Depreciation System) for the QLHI property, and be required to use a 39-year recovery period. This would also impact any other 15-year property, such as land improvements, that was placed in service by the taxpayer in the same year as the leasehold improvements. Failure to properly depreciate QLHI over 15 years puts other 15-year property at risk for reclassification to longer recovery periods.
Structural component or common area?
On the surface, one of the bullet points under the “does not qualify” section above (structural components benefitting a common area) would seem to disqualify many leasehold improvements from utilizing the shorter 15-year life. However, a deeper look at Reg. section 1.48-1(e)(2) and Reg. section 1.168(k)-1(c)(3)(ii) reveals that the restriction is less strict than one might assume.
Structural components as defined under Reg. section 1.48-1(e)(2) include:
“such parts of a building as walls, partitions, floors, and ceilings, as well as any permanent coverings such as paneling or tiling; windows and doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of a building.”
Common area as defined by Reg. section 1.168(k)-1(c)(3)(ii) generally refers to:
“any portion of a building that is equally available to all users of the building on the same basis for uses that are incidental to the primary use of the building. For example, stairways, hallways, lobbies, common seating areas, interior and exterior pedestrian walkways and pedestrian bridges, loading docks and areas, and restrooms generally are treated as common areas if they are used by different lessees of a building.”
Attention should be paid to the final phrase: if they are used by different lessees of a building.
This distinction implies that the restriction would apply to a building with multiple lessees where a lessor, lessee or sublessee is making improvements to a leased building in an area that is used by all the tenants in the building. However, if the building is occupied by a single tenant, it follows that improvements to structural components in, for example, the lobby of the building would not be considered as made to a “common area” as defined above, and therefore may qualify for the 15-year recovery period.
Starting in Jan. 1, 2016, this common area restriction does not apply to qualified improvement property.
Leasehold improvements versus land improvements
Another misconception about the 15-year recovery period is that it is the same as that used for land improvements and therefore the same 150 percent declining balance to straight-line (150DB/STL) depreciation method applies. The terms for the two types of property are so similar that it‘s easy to confuse one with the other. However, QLHI depreciate over 15 years using the straight-line method, while land improvements such as sidewalks, parking lots and landscaping contiguous to a building use the accelerated 150DB/STL method over 15 years. Care should be taken to ensure that QLHI and land improvements are using the correct method of depreciation.
Bonus depreciation on and section 179 expensing of qualified leasehold improvement property
There is another benefit related to QLHI, it is eligible for bonus depreciation under IRS code section 168(k)(2)(A)(i)(II), whereas the asset would be ineligible for bonus under its former 39-year life (except for special carve outs such as Liberty Zone or Gulf Opportunity Zone expenditures). This includes the 100 percent bonus depreciation that was available from Sept. 9, 2010 until Dec. 31, 2011. The Tax Cuts and Jobs Act of 2017 (TCJA) allowed 100% bonus depreciation on QLHI acquired after Sept. 27, 2017 and placed in service before Jan. 1, 2018 (the bonus depreciation rate for this property was 50% if the QLHI assets was acquired before Sept. 28, 2017 and placed in service before Jan. 1, 2018). As is the case with the 15-year life, bonus is not elective in the years that QLHI was bonus-eligible.
As for section 179 expensing, a temporary exception allowed the expensing of QLHI, subject to a threshold, if the improvements were placed in service in a tax year beginning in 2010, 2011, 2012, 2013, 2014 or 20152, even though the QHLI retains its status as section 1250 property. Usually section 1250 property is ineligible for section 179 expensing. With the passage of the PATH act, taxpayers are again allowed to expense QLHI for section 179, but can now utilize the same threshold ($500,000 allowed on the first $2,000,000 spent on qualified fixed asset purchases) that is available for other eligible MACRS property. The TCJA made QIP eligible for section 179 expensing, subject to the $1,000,000 expensing and $2,500,000 spending limitation starting on Jan. 1, 2018.
The Tax Cuts and Jobs Act of 2017
The tax reform bill commonly known as the Tax Cuts and Jobs Act (TCJA) was signed into law on Dec. 22, 2017. During negotiations leading up to its passage and signing, Congress signaled its intent to eliminate three non-residential real property categories (qualified leasehold improvement, qualified restaurant, and qualified retail improvement) and have just one category, Qualified Improvement Property (QIP), that would include interior improvements to non-residential real property (except to elevators and escalators, interior structural components, and expansions of the interior space outside of the existing footprint), and be bonus eligible because QIP would have a 15 year life. So the TCJA eliminated the three categories, deleted the language in section 168(k) that allowed QIP to be bonus eligible as 39 year property, and was supposed to have language added to section 168(e) that added QIP as a category under 15 year property. But that language did not get added to the final bill, so we had QIP as a separate category of non-residential real property, but as of Jan. 1, 2018, has a 39 year GDS life and no bonus eligibility. The only way that QIP could have its bonus eligibility re-established was through a technical correction, and that had to be accomplished through the normal legislative process. The final bonus regulations (TD 9874) that were issued on Sept. 13, 2019 confirm that QIP is not eligible for bonus depreciation. However, there was an opportunity for smaller taxpayers to take immediate deductions on QIP. The TCJA added QIP as a category of property under section 179 that is eligible for immediate deduction, when a taxpayer elects to include QIP costs in its section 179 deduction calculation. So, even though there was no bonus depreciation eligibility for QIP, there was still an opportunity to deduct costs related to QIP for smaller taxpayers.
The CARES Act of 2020
On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law. Section 2307 of the CARES Act amended sections 168(e)(3), (e)(6) and (g)(3)(B) to add QIP to the list of property treated as 15 year property, provided that QIP must be improvements made by the taxpayer, and changed the ADS life of QIP from 40 years to 20 years. These changes are effective for assets placed in service after 12/31/2017. QIP assets acquired after 09/27/2017 and placed in service after 12/31/2017 are eligible for 100% bonus depreciation expensing per the TCJA, assuming that the requirements under section168(k) are met. For assets acquired before 09/28/2017 and placed in service after 12/31/2017, the bonus depreciation rates under the PATH Act rules apply. The IRS released Revenue Procedure 2020-25 with procedures for correcting the recovery periods and claiming missed bonus depreciation on QIP assets placed in service after 12/31/2017. These procedures allow taxpayers to claim additional depreciation either through an amended return, an administrative adjustment request (AAR), or a section 481(a) with a Form 3115.
The confusion of different qualifying property and different years enacted may be a reason taxpayers have missed this opportunity to accelerate depreciation by 24 years. Taxpayers may have assumed that their leasehold improvements would not qualify for the shorter life because the expenditures weren’t related to restaurant or retail property improvements. However, any QLHI is eligible for the shorter recovery period, and taxpayers don’t have to improve restaurant or retail space to qualify.
Taxpayers with QLHI should comb through their fixed asset systems for assets misclassified and using 39-year recovery periods. To the extent taxpayers find these assets, they should consult with their tax advisors to file a Form 3115 with a section 481(a) adjustment to catch-up any unclaimed depreciation. This may include bonus depreciation if the taxpayer did not elect out. Taxpayers should also ensure that, when the 15-year life is applied to QLHI, the straight-line method is used rather than the 150% Declining Balance method used for land improvements. A quick fixed asset review and filing a Form 3115 could have a significant impact on a taxpayer’s current year taxable income.
For those who did not track these assets since 12/31/2017, there is now an opportunity to go back to your asset listing to determine what assets previously listed as 39 year property that are now 15 year property. And if you are a smaller taxpayer, tracking QIP separately will still help identify costs to deduct under section 179.