One of the key provisions of the newly enacted Coronavirus Aid, Relief and Economic Security (CARES) Act that will provide immediate current cash flow benefits and relief to taxpayers, especially those in the retail, restaurant, and hospitality industries, is the long sought-after fix to the “retail glitch.” Based on a technical correction under the new legislation, qualified improvement property (QIP) placed in service in 2018 and after is now 15-year property and is eligible for 100% bonus depreciation, providing many taxpayers with significant tax savings opportunities and incentivizing taxpayers to continue to invest in improvements.

Summary

QIP refers to any improvement made by a taxpayer to an interior portion of an existing building that is nonresidential real property (residential rental property is excluded). Examples of such qualifying improvements include installation or replacement of drywall, ceilings, interior doors, fire protection, mechanical, electrical and plumbing. Excluded from the definition are improvements attributable to internal structural framework, enlargements to the building, and elevators or escalators.

As originally intended in the Tax Cuts and Jobs Act of 2017, QIP would be 15-year property beginning in 2018 and bonus-eligible. While likely useful to a broad base of taxpayers, the incentive was seen as a particularly meaningful boon to the retail, restaurant and hospitality industries because of the rate at which these businesses open and renovate locations. But what was intended to be a boon became a bust. Due to a drafting error, QIP was not explicitly included in the definition of 15-year property in Section 168(e)(3)(E), nor was it specifically included as “qualified property” in Section 168(k)(2)(A) when the Tax Cuts and Jobs Act was enacted. To the frustration of taxpayers, Treasury and the IRS consistently held they had no authority to correct these omissions, and until a legislative fix was made, QIP would remain 39-year property and thus ineligible for bonus depreciation. With the passage of the CARES Act, this fix has been made retroactively to January 1, 2018, and taxpayers should now take advantage.

Immediate Opportunities for Taxpayers

All industries that have constructed QIP can take advantage of this favorable change, but companies within the retail, restaurant and hospitality industries with significant new assets, in particular, should act quickly. In the immediate term, we suggest reviewing documentation related to improvements to existing commercial buildings in 2018 and 2019 to identify assets that are QIP. Cost segregation studies are essential tools in identifying eligible costs. After identification, we can help advise how best to claim the increased deductions:

• Taxpayers who constructed QIP in 2019 and who have not filed their 2019 federal income tax returns yet can treat such assets as bonus-eligible 15-year property in their 2019 federal return. The revised initial filing deadline of July 15, 2020, pursuant to Notice 2020-18 should provide some taxpayers with additional time to identify assets and make adjustments. Further, corporate taxpayers may also want to consider filing a Form 4466 by April 15, 2020, for a quick refund of estimated tax payments to the extent they were overpaid by at least 10% of their expected tax liability.
• Taxpayers who have filed their 2019 federal income tax returns treating QIP constructed in 2019 as bonus-ineligible 39-year property and filed for extension may file a superseding 2019 return prior to the due date (including extensions) and claim bonus depreciation. However, if no extension was filed, then such taxpayers may file an amended 2019 return to claim the bonus depreciation.
• Taxpayers who constructed QIP in 2018 and who have filed their 2018 federal income tax return treating the assets as bonus-ineligible 39-year property should consider amending those returns to treat such assets as bonus-eligible. For C corporations, in particular, claiming the bonus depreciation on an amended return can potentially generate net operating losses (NOLs) that can be carried back five years under the new NOL provisions of the CARES Act to tax years before 2018, when the tax rates were 35%, even though the carryback losses were generated in years when the tax rate was 21%. With the taxable income limit under Section 172(a) being removed, an NOL can fully offset income to generate the maximum cash refund for taxpayers who need immediate cash.

Alternatively, in lieu of amending the 2018 return, taxpayers may file an automatic Form 3115, Application for Change in Accounting Method, with the 2019 return to take advantage of the new favorable treatment and claim the missed depreciation as a favorable Section 481(a) adjustment. Although additional IRS procedural guidance may be issued in the near future addressing the methodology for correcting 2018 QIP, we do not believe there is a downside in taking immediate action steps to quantify the amount of additional depreciation that can now be claimed, amending the 2018 return where appropriate and speeding up cash refunds. Due to the interplay between depreciation and other provisions (e.g., uniform capitalization rules under Section 263A, interest expense limitation under Section 163(j), and the FDII and GILTI deductions under Section 250), taxpayers should carefully model the impact of adjusting their depreciation expense on all applicable provisions when evaluating alternatives to ensure that they are employing the most effective approach for their specific facts and circumstances.

A Few Notes of Caution

The QIP fix presents significant opportunities to many taxpayers. However, a few notes of caution are in order:

• To claim bonus depreciation, Section 168(k) provides several criteria that a taxpayer must meet, such as the acquisition requirement and the requirement that the original use of the property must commence with the taxpayer or used depreciable property must meet the requirements of Section 168(k)(2)(E)(ii).
• As noted, QIP relates to the construction of interior improvements to existing commercial buildings only. Cost segregation studies are vital tools that can provide a supportable breakdown between eligible and ineligible costs. Increased IRS scrutiny must be assumed.
• Under the Tax Cuts and Jobs Act of 2017, taxpayers who make the real property trade or business election under Section 163(j) must depreciate nonresidential real property, residential rental property, and QIP using the Alternative Depreciation System (ADS), and as such are not permitted to claim bonus depreciation on these assets. However, cost segregation studies can still help to identify personal property still eligible for bonus depreciation.
• For partnerships seeking to amend a prior year return, it will be necessary to consider whether the partnership is subject to the Centralized Partnership Audit Regime (CPAR). Under CPAR, the partnership files an Administrative Adjustment Request (AAR) rather than an amended return and the impacted partners will determine the potential benefit of the increased depreciation deduction for the year of change and will reflect that benefit against their 2020 tax liability (assuming the AAR is filed during the partners 2020 tax year). Certain small partnerships are eligible to elect out of CPAR each year. If a partnership validly elects out of the CPAR, the partnership may amend its Schedules K-1 after the due date of the partnership return to which the statements relate. The partners would then file amended income tax returns to claim the additional depreciation deductions.

Please call your trusted Machen McChesney advisor if you have any questions.