More improvement categories bring more confusion and more opportunity

Jul 05, 2017

At first glance, the Protecting Americans from Tax Hikes (PATH) Act of 2015 looks like an effort by Congress to make permanent, several temporary provisions of the federal income tax code, including shorter lives for certain types of non-residential real property and the higher section 179 deduction limits, in order to provide some certainty to taxpayers. But the PATH Act also yielded a few surprises, one of which was the application of bonus depreciation, which was extended by the Act through 2019, to a new category of assets.   

The PATH Act made permanent the 15-year life assigned to qualified retail improvements, qualified restaurant property, and qualified leasehold improvement property[1]. It also introduced a new asset category, qualified improvement property (QIP), to be eligible for bonus depreciation beginning Jan. 1, 2016[2]. QIP is broadly defined as interior improvements to non-residential real property placed into service after the building is originally placed into service. The types of improvements that are eligible for QIP treatment are somewhat similar to qualified leasehold improvement property (QLI), with several exceptions:

  • There is no requirement that the improvements be related or pursuant to a lease;
  • The building to which the  improvements are being made can be less than three years old; and
  • The improvements can be made to common areas used by all of the building’s occupants.

Expenditures attributable to any elevator or escalator, the enlargement of a building, or the internal structural framework of the building are not eligible for QIP treatment. These limitations are similar to ones for QLI.

So, with the introduction of QIP, the IRS now has specific treatment for four types of improvements to non-residential real property:

  1. Qualified Retail Improvements [3]
  2. Qualified Restaurant Property (was Qualified Restaurant Improvement property until the rules were changed 1/1/2009 to allow the purchase of a restaurant building to qualify for the shorter 15 year life vs. 39 years) [4]
  3. QLI [5], and
  4.  QIP

Understandably, many taxpayers struggle with differentiating between these different types of “qualified” property, determining if the costs are eligible for bonus depreciation, and applying the proper recovery period (the IRS term for tax life) to the capitalized costs.

To help clear up confusion about the different types of qualified property, below is a table which can help determine what treatment to use for each type of property. Please note the following is as of Jan.  1, 2016.

More improvement categories bring more confusion and more opportunity table
More improvement categories bring more confusion and more opportunity table

Any non-residential real property that does not qualify for any of the above treatments would default to the 39-year life, straight-line method and mid-month convention normally associated with non-residential real property.

Please note that the 15 year life for the above properties in not elective. If the asset falls into one of the above categories, then it must use the 15-year life. Otherwise, taxpayers run the risk of putting all of their 15-year property, including 15-year land improvements, into ADS. Putting all of building property into 39 year lives, without regard to the type of building property it is and without making a formal election, can be an example of electing by doing. To avoid this potential, be sure to take the correct life assigned to your class of property. Otherwise, it’s ADS with no bonus depreciation.

However, there is the option of electing the most advantageous treatment for building improvements. For example, say that a taxpayer acquired a free-standing restaurant that needs some renovation. If all qualifications are met, the exterior of the restaurant could be put into 15-year property taking no bonus, while the interior renovations could take 39-year with bonus depreciation as qualified improvement property.

Then there is the example of an owner of a multi-tenant building that wants to renovate the building lobby. Under the rules for QLI, the lobby renovations would not be eligible for the 15-year treatment. But, if all qualifications are met, the renovations would qualify for bonus under QIP.

Another consideration is bonus depreciation. Bonus is not elective, therefore it is the default method of depreciation for those classes of property that qualify for bonus depreciation. Taxpayers must elect out of bonus in order to not take it, and that election is done on a class-by-class basis. Class in the case of bonus depreciation is defined as MACRS life[6], so one could elect out of bonus for all 5 year MACRS property, but take bonus on 7 year MACRS property. However, QLI property is specifically its own class for electing out of bonus depreciation[7]. So there could be a situation where a taxpayer takes bonus on 15-year qualified retail improvements (as long as the improvements don’t also qualify as QLI) and 15-year land improvements, but elect out of bonus on QLI property, and vice versa.

As taxpayers drill deeper into these types of scenarios, it’s best to consult with a tax advisor, preferably one with experience in dealing with tax fixed assets and the tangible property regulations. The tangible property regulations are complex, especially the parts dealing with these special classes of property, so it’s best to have someone with the right experience guiding you through the regulations to produce the result that best fits the circumstances. Otherwise, the confusion surrounding these new rules could lead to lost opportunities for tax savings.

[1] Code Sec. 168(e)(3)(E).
[2] Code Sec. 168(k)(3).
[3] Code Sec. 168(e)(8).
[4] Code Sec. 168(e)(7).
[5] Code Sec. 168(e)(6).
[6] Reg. Sec. 1.168-1(e)(2)(i), Code Sec. 168(e)(1).
[7] Reg. Sec. 1.168-1(e)(2)(iv).