The IRS recently concluded in CCA 201310028 that HVAC units located on either the roof of a building or a concrete pad adjacent to the building were not qualified leasehold improvement property (QLIP) for depreciation purposes. As a result, the HVAC units were subject to depreciation over a 39-year recovery period instead of 15 years.
QLIP includes interior improvements made at least three years after the building was placed in service and made pursuant to the lease by the lessee or lessor, with the exception of elevators, escalators, structural components benefitting a common area, the internal structural building framework, or enlargements of the building. Accordingly, one of the requirements to be considered QLIP is that the improvement must be made to an “interior” portion of a building that is nonresidential real property. In this case, while it was clear that the HVAC units were being installed by the lessee on leased nonresidential real property (i.e., the taxpayer leased a large, stand-alone commercial building used for retail sales) and that almost all of the other requirements to be considered QLIP were met, the narrow question addressed was whether the installation of an HVAC unit on either the roof of a building or a concrete pad adjacent to the building constituted an improvement to the “interior” of the building.
Noting that there was no guidance in the statute, the legislative history, or in Reg. section 1.168(k)-1(c) regarding the meaning of “interior portion,” the IRS looked to the dictionary meaning of “interior” and concluded that it meant “being within the limiting surface or boundary.” Applying this definition, the IRS determined that the HVAC units installed on either the roof of a building or a concrete pad next to the building were not improvements to the “interior” portion of the building and, therefore, did not qualify as QLIP. Instead, the improvements were considered non-residential real property subject to straight-line depreciation over a 39-year recovery period. Notably absent from the ruling is the representation or discussion of how much of the HVAC system was located inside the stand-alone commercial building, as well as whether the interior versus exterior portions of the system should be depreciated differently.
Although not discussed in the ruling, failure to meet the definition of QLIP also precludes leasehold improvements from being eligible for bonus depreciation under section 168(k). Similarly, qualified retail improvement property, which is also eligible for a 15-year recovery period if placed in service prior to Jan. 1, 2014, must constitute “interior” improvements (see section 168(e)(8)). Alternatively, qualified restaurant property is not restricted to “interior” improvements (see section 168(e)(7)). However, neither qualified retail improvement property nor qualified restaurant property is eligible for bonus depreciation if the property does not also meet the definition of QLIP. The differing tax treatment of various leasehold improvements, depending on where and to what type of building construction occurs, highlights the importance of involving cost segregation professionals in determining the proper classification and depreciation of such assets.