The Coronavirus Aid, Relief, and Economic Security (CARES) Act passed at the end of March introduced provisions of economic relief, tax measures, and more. There was a lot to unpack and there continues to be. However, as the size of the stimulus package dominated the headlines, the CARES Act also brought about a change that taxpayers have sought for the last two years – a correction to the so-called ‘retail glitch.’ By rectifying a technical error in the Tax Cuts and Jobs Act of 2017 (TCJA), the CARES Act made qualified improvement property (QIP) eligible for bonus depreciation retroactive to 2018.
This correction comes as significant relief for taxpayers, particularly those in the real estate, hospitality, retail and restaurant industries, as they have been forced to close or severely reduce operations because of the coronavirus outbreak. This new qualified improvement property provision effectively allows many taxpayers to collect tax refunds related to expenditures for renovation projects completed in the last few years.
What’s in this article?
- Is there a catch?
- How did 2017 tax reform affect qualified improvement property?
- How did the CARES Act fix the problem?
- How does the Internal Revenue Service now define qualified improvement property?
- How do I catch up on bonus depreciation on qualified improvement property?
- Final Takeaways
- How can Squar Milner help?
Is there a catch?
The trouble comes in the form of administrative complexity. Since the relief is retroactive to 2018, the provision has the potential to unleash a flood of administrative challenges in the form of amended returns, superseding returns, and accounting method changes (Form 3115, Application for Change in Accounting Method).
In other words, actually claiming bonus depreciation two years after the TCJA may be easier said than done in many situations. Even more devastating is that taxpayers in real property trades or businesses who previously elected out of the business interest deduction limitation cannot take bonus depreciation on qualified improvement property. Unfortunately, the election is irrevocable, so unless Congress modifies the statute, those taxpayers are stuck with a long recovery period for qualified improvement property.
How did 2017 tax reform affect qualified improvement property?
In 2017, as part of broader changes to the bonus depreciation deduction, the TCJA created a new category of real property – qualified improvement property. Qualified improvement property encompasses several types of property previously eligible for bonus depreciation, including qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. Prior to the TCJA, these types of property were eligible for a 15-year cost recovery period and IRC Sec. 179 expensing. Any other type of property outside of these categories had a cost recovery period of 39 years.
However, in instituting the new qualified improvement property category, the TCJA failed to assign a depreciable life to it. Effectively, this meant that all qualified improvement property defaulted to a 39-year cost recovery period and, as a result, was not eligible for bonus depreciation. Bonus depreciation generally allows for faster depreciation of assets with class lives of 20 years or less. Under the legislative changes to bonus depreciation, businesses can now take a 100% deduction on their cost basis in qualifying property until January 1, 2023. The missing class life for qualified improvement property – dubbed the “retail glitch” for the sector most affected by the oversight – meant that qualified improvement property was not eligible for bonus depreciation. Companies holding significant qualified improvement property or making qualified improvements missed out on substantial tax saving opportunities.
How did the CARES Act fix the problem?
With the passage of the CARES Act came a technical correction for the ‘retail glitch.’ The Act amended the IRC to define qualified improvement property as 15-year property, and updated the alternative depreciation system (ADS) recovery period for qualified improvement property to 20 years. Finally, the Act also updated the definition of qualified improvement property to include any improvement “made by the taxpayer.” These changes are retroactive to 2018 – i.e., to the passage of the TCJA.
How does the Internal Revenue Service now define qualified improvement property?
“Qualified improvement property” means any improvement made by the taxpayer to an interior portion of a building which is nonresidential real property, if such improvement is placed in service after the date such building was first placed in service. Qualified improvement property does not include expenditures attributable to (i) enlargement of the building, (ii) any elevator or escalator, or (iii) the internal structural framework of the building.
The CARES Act introduced the phrase “made by the taxpayer” to the definition of qualified improvement property. Presumably, rules similar to the existing UNICAP regulations, which addresses property produced by or for the taxpayer, will apply to determine if qualified improvement property is “made by the taxpayer.”
The inclusion of this language may mean that partnership basis adjustments arising when a partner sells their interest would not qualify for bonus depreciation for the portion of the purchase price allocable to qualified improvement property. For the time being, we will have to wait for future clarification from the IRS on this issue.
How do I catch up on bonus depreciation on qualified improvement property?
First and foremost, please note that taxpayers that made the real property trade or business election to opt out of the business interest deduction limitation cannot take bonus depreciation on qualified improvement property.
It is unlikely that the Treasury Department can provide administrative relief here since the IRC deems this election irrevocable. Thus, unless Congress changes the statute, taxpayers cannot undo the election and retroactively claim bonus depreciation. However, these taxpayers can benefit from the shorter ADS life provided by the CARES Act.
Under Rev. Proc. 2020-23, issued April 8, 2020, partnerships subject to the centralized partnership audit rules (CPAR) are now permitted to amend their 2018 and 2019 returns. This new procedure gives CPAR partnerships another option to catch up bonus depreciation.
For other taxpayers, the procedure to claim bonus depreciation on qualified improvement property depends on when the improvements were placed in service, and if they have filed and/or extended their 2019 return.
Options include an accounting method change (Form 3115) or an amended return. The simplest situation, of course, is for taxpayers that completed an improvement project last year and have not yet filed for 2019. They can just follow the new rules on the 2019 return without worrying about filing accounting method changes or amended returns.
There are a lot of moving parts to consider in determining the optimal strategy regarding qualified improvement property. Obviously, it is important to identify qualified improvement property placed in service in 2018 and 2019, and quantify the potential benefit of claiming bonus depreciation. Taxpayers also must analyze the interaction of bonus depreciation with the changes to the net operating loss (NOL) rules.
The NOL provisions introduced by the CARES Act provide that losses arising in 2018, 2019 and 2020 shall be an NOL carryback to each of the prior five taxable years, including tax years with higher rates. The application of bonus depreciation to qualified improvement property may have significant impact on the NOLs of many taxpayers during the COVID-19 pandemic.
Any planning related to qualified improvement property must also consider other measures introduced by the CARES Act, including the delay of the excess business loss limitation imposed on noncorporate taxpayers, and state conformity to the bonus depreciation rules (meaning, some states may not automatically conform to these changes).
For instance, California does not conform to the federal treatment of bonus depreciation. Instead, the state provides its own set of rules for calculating depreciation and requires an addition modification for bonus depreciation deducted at the federal level. Similarly, the CARES Act modifications for NOLs do not apply for California income and franchise tax purposes.
With the new provisions related to qualified improvement property, taxpayers may be able to reduce taxes, increase liquidity, and generate carryback claims to tax years with higher rates. All of this offers substantial help to taxpayers, especially those in some of the most affected industries, during our current economic downturn.
How can Squar Milner help?
As we continue to emphasize, there is a lot to unpack with the CARES Act and understanding the changes to the retail glitch and options available to you. With the possibility of significant tax savings, we want to help you take advantage of the technical correction.
Our team of real estate and other tax professionals are here to help. We are ready and willing to answer any questions, as well as provide practical advice to help you keep your business moving in a positive direction.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.