Qualified Improvement Property Under the CARES Act
May 27, 2020
EisnerAmper Real Estate Tax Partner Michael Torhan discusses Qualified Improvement Property (QIP) and how the CARES Act has impacted the depreciation recovery for certain qualifying improvements to property.
KL: Before we dive in too deep, can you give us the backstory on QIP? Where did the depreciation rules stand before this legislation and how has the CARES Act altered it?
MT: QIP was originally defined in the internal revenue code as a result of the Protecting Americans from Tax Act or what was called the PATH Act of 2015. Definition of QIP has historically been any improvement to an interior portion of a nonresidential building if the improvement was placed in service after the date the building was first placed in service. There were a few exclusions from the definition which are the enlargement of a building, any elevator or escalator work, and the internal structural framework of a building. When QIP was originally defined, there were a few similar categories of assets, including one which was very well known, qualified leasehold improvements. If we fast forward a few years, the Tax Cuts and Jobs act of 2017 eliminated some of these other categories and left QIP as one broad category covering improvements to the interior portion of nonresidential property.
At this time, the congressional intent was that QIP would've had a 15 year recovery period, and with a 15 year recovery period, bonus depreciation would have been available. Bonus depreciation, as many taxpayers know, is additional depreciation that's allowed for certain assets, and for example, assets with a recovery period of 20 years or less are eligible for bonus depreciation. Congress wanted QIP to have a 15 year recovery period and bonus depreciation would've been allowed, but unfortunately, due to a drafting error, the 15 year recovery period never made it into the law, and by default, a 39 year recovery period was assigned to QIP.
As a result, QIP was not eligible for bonus depreciation from that time, from the Tax Cuts and Jobs Act, until now when the CARES Act was just passed. The CARES Act, which is effective retroactively, made two main changes. First, a 15 year recovery period was assigned to QIP which allows for a shorter depreciation recovery period, or as I just mentioned, a bonus depreciation is now available. The second main change that the CARES Act made was that the definition of QIP was changed to include the words "Are made by the taxpayer," and like I mentioned earlier, QIP covers interior improvements to nonresidential property. The reason that Congress included the words "Made by the taxpayer" is that a taxpayer can't just purchase a new building and then call all of the interior improvements a QIP and take bonus depreciation, right? The improvements need to be made by the taxpayer in order to be called qualified improvement property.
KL: This has been changing and developing for a while then. Michael, is all QIP equal under the CARES Act? What are the guidelines for adjusting depreciation for different kinds of depreciable property?
MT: Those are two great questions. First, in terms of whether all QIP is equal under the CARES Act, there's a couple of items that need to be noted here. As I mentioned, the changes are effective retroactively to the 2018 tax year since that's when the Tax Cuts and Jobs Act would have made it effective. Also, the taxpayers may have made elections in the last two years, right? Since it's retroactive to 2018, taxpayers have already filed their tax returns for 2018 and some have already filed for 2019. Certain elections may not have been made by taxpayers that would affect depreciation in one way or another. Just to give an example, a taxpayer might have made an election to be a real property trader business, and a lot of taxpayers made that election to avoid the interest expense limitation.
If you make that election, you are not subject to that interest expense limitation. However, the caveat is with that election, you're not eligible to take bonus depreciation on QIP. However, for the taxpayers that have made or have not made those elections, the IRS has released guidance which allows taxpayers to now withdraw or revoke certain elections, as well as make elections on a late basis. Generally, you have to make an election on a timely filed tax return. The IRS is now allowing taxpayers to make certain late elections under the recent guidance. In regards to your second question, regarding how taxpayers may adjust depreciation for these changes, the IRS has also released guidance recently, really giving a couple of options for taxpayers.
First, taxpayers have the opportunity to go back and amend tax returns to make the changes, or if taxpayer don't want to amend, taxpayers could also file for what we call the change in accounting method and the taxpayer would use form 3115 to essentially apply the changes on the current year of tax return. Also, taxpayer would look back to see how much depreciation was taken, how much would've been taken under the changed rules, and that net adjustment would be made on a courier return in what's called Section 481, adjustment. Which option a taxpayer chooses is really a business decision, and this is because of the number of factors to consider. For example, when they argue that if you amend a prior tax return, you could get cash flow benefits from prior years.
However, amending prior returns may require additional tax reporting. Just to give you an example there, if a partnership amends prior returns, all of those partners will get amended K-1's and then they have to file amended tax returns as well. So clearly, there's an administrative cost for amending returns. Taxpayer really need to take the various options and really weigh the pros and cons of each.
KL:The QIP's treatment in the Tax Cuts and Jobs Act was once referred to as the retail glitch, but this clarification seems to offer some significant tax savings for restaurant, retail, and hospitality businesses among others, but given the effect of the pandemic on the economy and specifically these sectors in real estate, how do you see benefits playing out now?
MT: You're correct. Unfortunately, the ongoing corona virus pandemic has really had a detrimental impact on the economy. I know many of these sectors that you mentioned, the restaurant, the retail, the hospitality sectors have really been hurt by the pandemic. As you mentioned, retail glitch has been the nickname for a number of years for this drafting error, but as we've been discussing, there are many taxpayers in many industries that can benefit from the changes to the treatment of QIP. Industries such as the restaurant, retail, hospitality industries tend to make a lot of improvements to their interior spaces. Clearly, they have the opportunity to apply bonus depreciation to a lot of these improvements, but just from a general perspective, any taxpayer that owns or leases nonresidential property and makes improvements to that property may be eligible to obtain tax benefits under the changes.
Just to give you an example, an accounting firm that leases space in an office building. If that accounting firm undertake a significant renovation of its space, it too may be able to recognize benefits from the changes to qualified improvement property.
KL: So many people could be affected by this, that's interesting. When it comes to depreciation, of course, timing is everything. Now that this fix is in, when are those changes effective for tax reporting?
MT: Kristen, you're right, timing is important. Time is really of the essence here in regard to the changes. Like we discussed earlier, the changes under the CARES Act are retroactive for the 2018 tax year. The change really has the ability to provide for a significant tax saving and cash flow opportunity for taxpayers. As I mentioned, bonus depreciation is one of the new available tax benefits, and since a bonus depreciation is 100% of an asset's cost, taxpayers that had head qualifying property in 2018 and/or 2019, the change can have immediate tax saving opportunities for those taxpayers. Just to give you an example, if you paid $100 for a qualifying improvement, you could take a write off of $100 immediately. Whereas historically before the CARES Act, you would have had to depreciate that $100 over 39 years. When you add a couple of zeroes, the $100 that we mentioned could be a big cash flow and tax saving opportunity.
KL:That adds up pretty quickly. When you talk about cash flow, how do these changes impacted in the broader picture?
MT: Additional depreciation or additional bonus depreciation, most adults will allow for a decrease in taxable income for any tax periods with qualifying property, and as your taxable income goes down, your tax liability will decrease as well, and in turn that lets taxpayers retain more of their cash flow, especially in this ongoing pandemic. Also to note is additional bonus depreciation may create net operating losses for certain taxpayers. Net operating losses are losses that are created for a taxpayer, such in effect, excess of all their income. Net operating losses can now be carried back for five years under the new provisions under the CARES Act. Before the CARES Act, they could only be carried forward. Changes are made a couple of years ago.
So now the taxpayers can carry back net operating losses for five years. Taxpayers can utilize those losses in prior years and obtain refunds for taxes they already paid. Clearly there's cash flow opportunities there from prior year taxes that they already paid. Another significant thing to note from this change is for C corporations. C corporations are now taxed at a 21% tax rate. Historically, C corporations were taxed at 35%. Before the change to NOL carry back periods, let's say a C corporation would carry forward an NOL. Let's say a C corporation had an NOL in 2019, it carried that forward to 2020 and it would get a 21% tax rate, right? If I had a $100 NOL, it'd get a $21 tax benefit in 2020. Now that a C corporation can carry back an NOL, it could possibly carry it back for a year where the rate was still 35%, and that $21 that we just spoke about would now be $35. Again, if we add a couple of zeros in the numbers, clearly the tax savings could be significant.
KL:What type of evaluation needs to be done to classify assets as QIP?
MT: When we talk about QIP, the broad definition again is interior improvements to nonresidential property. At first glance, it might seem like a pretty clear definition, but like I mentioned, there's certain exceptions that apply and certain taxpayers may undertake very large renovation projects and allocating between what's qualifying, what isn't qualifying. That could certainly be a difficult process as well as a timely process, right? If a taxpayer is undertaking millions of dollars of renovations, going through all of those influences and all of those budgets and descriptions could certainly be a time consuming process. Like we spoke about a couple of minutes ago, now is the time to start the process. Taxpayers should be in discussions with their tax advisers really as soon as possible to start considering these opportunities.
Another option to consider is obtaining a cost segregation study. Kristen, historically, taxpayers have obtained these cost segregation studies when they acquire new properties to allocate the purchase price between different types of improvements, whether it's the building, land improvements, furniture and fixtures. Now, we can change this to qualified improvement property, taxpayers may want to consider cost segregation say for renovations, right? Being able to allocate a certain amount of renovations to qualified improvement property, like we've said, taxpayers will be able to get 100% bonus depreciation if they qualify.
KL: So if I think I may be eligible for these tax benefits, what should my next steps be?
MT: There's a couple of steps to consider now. The first of which is definitely starting an analysis of any improvements made, like we've been talking about 2018 is the first year to consider. Taxpayers definitely want to go back and look at their fixed asset schedule starting with 2018 tax year to see if there's any improvements that may qualify. Taxpayers also want to think about whether they choose to amend or not to amend tax returns. Like we mentioned, there's a couple of options that IRS has provided to us. In doing this analysis, you're initiating discussions with your internal accounting team and your external tax advisor are really important. The analysis of qualified improvement property is complex as are the requirements to implement the changes. I feel like over the last couple of weeks, we've been getting new guidance. Sometimes almost on a daily basis, so certainly the requirements to implement these changes, it's quite complex and so those discussions should going on an ongoing basis.
We might be talking about just analyzing your books and records that may be eligible. You may have other investments such as joint venture deals. We need to talk with their accounting teams and their tax preparers as well if they need to be doing this analysis on their side. Here at EisnerAmper, we've definitely been working with many of our clients to start the process of analyzing improvements as well as evaluating the different options and changes that may be possible under the new guidance, and in doing these analysis and these discussions, the tax and cash flow benefits are really readily apparent in many of these cases. The investment that needs to be made here to do the analysis and to have these discussions can certainly be rewarding for many taxpayers.
KL:That's a lot to consider but I think there's a definite benefit that folks can look into, and cash flow assistance in times like these is definitely important. Michael, thank you so much for improving our understanding of qualified improvement property, and thank you for listening to Breaking Ground, real estate insight from EisnerAmper. Join us for our next podcast and visit EisnerAmper.com/RE for more real estate news.