The long-awaited technical correction to the retail glitch contained in the Tax Cuts and Jobs Act (TCJA) has finally arrived via the Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
What most people thought would be a quick fix issued early in 2018 turned out to be a political football that required a worldwide pandemic in 2020 to get to the end zone.
This correction, which accelerates the tax depreciation deduction for certain improvements to real estate, is of particular benefit to: landlords and tenants who make improvements to leased space; restaurant, hotel and retail businesses that regularly refresh the interiors of their properties; and taxpayers who make improvements to their owner-occupied business premises. When considered together with other pro-taxpayer provisions in the CARES Act and related IRS guidance, this change has the potential to generate significant cash flow opportunities.
Prior to 2016, the tax code had three categories for certain improvements made to real property:
- Qualified leasehold improvement property
- Qualified restaurant property
- Qualified retail improvement property
Each of these categories had its own unique requirements, often making the analysis overly complicated, especially since those requirements changed frequently over the years. While building improvements were generally depreciable over 39 years for income tax purposes, improvements that fell into one of these three categories were potentially eligible to be depreciated over 15 years and potentially eligible for bonus depreciation, depending upon the category and the year placed in service.
The PATH Act of 2015 added a fourth category for improvements placed in service beginning on January 1, 2016: qualified improvement property (QIP). This property was eligible for bonus depreciation, with the remaining 50% depreciated over 39 years.
This new category’s requirements were far less restrictive than the other three. Eligibility did not require that the improvements be made under a lease or be used in a qualifying restaurant or retail-related activity. This QIP category also did not require a three-year lag between when the building was first placed in service and when the improvement to that building was placed in service. Instead, the improvement was simply required to be:
- An improvement to the interior portion of a non-residential building
- Placed into service after the building was first placed into service (even a one-day separation between the two placed in service dates was sufficient)
- And not attributable to the enlargement of the building, an elevator or escalator, or the internal structural framework of the building
In the TCJA, Congress attempted to simplify this area of the tax code by consolidating these four categories of real property improvements into a single category that would have a 15-year depreciable life and be eligible for bonus depreciation, which was increased from 50% to 100%.
Unfortunately, a drafting error was made during the last-minute rush to ready the legislation for vote. As a result, commonly known as the “retail glitch,” the four previous categories were correctly consolidated into one category, but that category was given a 39-year depreciable life and was not eligible for bonus depreciation. While Congress’ intent was clear, the IRS was not able to fix the glitch — it required a technical correction to be passed by Congress.
Finally, on March 27, 2020, Congress passed the CARES Act to speed relief to taxpayers negatively impacted by the COVID-19 pandemic. Included in the CARES Act was the technical correction for QIP depreciation that taxpayers had been anxiously awaiting.
The CARES Act officially changed the depreciable life of QIP from 39 years to 15 years, thereby making QIP eligible for 100% bonus depreciation. In addition, the CARES Act clarified that in order to qualify for QIP treatment, the improvements must have been made by the taxpayer claiming the bonus depreciation. This clarification was perhaps required because the TCJA had expanded the application of bonus depreciation to include not only new property but also used property. Congress may have wanted to make it clear that this expansion of bonus depreciation to used property did not apply to used QIP.
Property that qualifies as QIP remains the same as under the PATH Act. Common examples of qualifying improvements include the installation or replacement of drywall, ceilings, flooring, interior doors, fire protection, mechanical, electrical, and plumbing.
Improvements attributable to the building’s internal structural framework (such as roofs, rooftop HVAC units, exterior windows, load-bearing walls and supports) do not qualify as QIP. Also excluded are enlargements to the building (increased footprint), and elevators or escalators. Finally, tax-exempt property also does not qualify as QIP.
Taking advantage of the fix
As a result of the legislative fix made via the CARES Act, taxpayers may now claim bonus depreciation for QIP placed in service in 2018 and 2019. Taxpayers who have already filed their tax returns for those years using a 39-year life and no bonus depreciation have several potential options available:
- File amended tax returns for affected prior years to capture the appropriate amount of depreciation deductions in the applicable year. Partnerships that consider amending prior returns will need to consider the administrative adjustment request (AAR) rules for partnerships subject to the centralized partnership audit rules and recently-issued guidance that allows qualifying partnerships a short window of opportunity to avoid those rules.
- File superseding tax returns for affected prior years to capture the appropriate amount of depreciation deductions in the applicable year. Superseding returns effectively replace an originally filed return and must be filed before the due date of the original return, including extensions.
- File a Form 3115, Application for Change in Accounting Method, to claim “catch up” depreciation deductions in the year the Form 3115 is filed.
In addition to these three potential options, taxpayers will also need to consider the interplay of the new QIP rules on the computation of the limitation on their business interest expense limitation, including whether or not they made an election to avoid the limitation by depreciating certain assets over a longer depreciable life. Any planning strategy will also need to consider the impact of increased depreciation deductions on the creation of net operating losses and whether the state(s) where the taxpayer files conform to these new federal rules.
With the possibility of significant tax savings, the retroactive nature of the QIP fix, and the interaction of other tax provisions, obtaining the maximum benefit requires a thorough, multi-year analysis. Please contact a Wipfli tax professional for assistance in determining the best options for your business.
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