Qualified Improvement Property: Beware of a Potential Tax Trap

In the current economic environment, cash flow is a precious commodity. Construction companies need to make the most of depreciation deductions that can reduce their tax bills. Fortunately, several provisions of the CARES Act can help you do just that.  One of these provisions fixed a technical glitch, retroactive to 2018, that deprived many taxpayers of 100% bonus depreciation for qualified improvement property (QIP). This is good news for commercial property owners that invested in eligible building interior improvements over the last three years.

However, it also sets a dangerous tax trap for those that elect not to claim bonus depreciation for QIP — potentially resulting in the permanent loss of future depreciation deductions.

What is Qualified Improvement Property?

Generally, improvements to nonresidential commercial buildings are depreciated over 39 years, which is the depreciable life of the real property being improved. But, in recent years, Congress has allowed taxpayers to depreciate improvements to certain types of property more quickly.

Until 2017, these included qualified leasehold improvement, restaurant and retail improvement properties. However, that year, in the Tax Cuts and Jobs Act (TCJA), Congress eliminated those categories in favor of a single category — Qualified Improvement Property — effective in 2018.

QIP is an improvement made by a taxpayer to the interior of an existing nonresidential building, including installation or replacement of:

  • Drywall,
  • Ceilings,
  • Interior doors, fixtures and plumbing, and
  • Mechanical, electrical and fire protection systems.

Certain improvements are excluded from the definition of QIP, including enlargement of a building and improvements to elevators, escalators or the internal structural framework.

What was the glitch?

Congress intended to establish an accelerated, 15-year depreciable life for QIP. This would have made it eligible for 100% bonus depreciation, which is available for depreciable assets with a recovery period of 20 years or less. But the TCJA inadvertently classified QIP as 39-year property, making it ineligible for bonus depreciation.

By correcting this error, the CARES Act allowed commercial property owners to claim significant bonus depreciation deductions for building improvement expenses. And, because the fix was retroactive to the beginning of 2018, it provided an opportunity for owners that made such improvements in 2018 and 2019 to amend their returns for those years, claim the deductions they missed, and seek a refund of any tax overpayments. Alternatively, some owners may be able to file Form 3115 (“Application for Change in Accounting Method”) and claim “catch-up” deductions.

Where’s the trap?

The technical correction made by the CARES Act created a potential tax trap for owners that placed QIP in service in 2018 or 2019 but choose not to claim the depreciation deductions they missed in those years.

There are several possible reasons for doing so. Some commercial property owners, depending on their tax situations, may enjoy little or no benefit from additional depreciation deductions in those years. Others may want to avoid the administrative complexity and expense associated with amending previous tax returns — especially if they’re structured as partnerships or S corporations. Or perhaps reducing taxable income in a previous year would have a negative impact on other tax benefits.

Whatever the reason, failure to act can lead to unwelcome tax consequences. Why? Because the IRS now views depreciation of QIP placed in service after 2017 using a 39-year recovery period as an impermissible accounting method. Moreover, 100% bonus depreciation is mandatory for QIP unless a taxpayer opts out in favor of depreciation over 15 years.

Here’s the problem: The tax code and regulations require you to reduce the basis of depreciable property by the amount of depreciation that’s “allowed or allowable,” regardless of the actual amount of depreciation you claim. So, for example, if you placed QIP in service in 2018 and didn’t opt out, you must reduce its basis by 100% to reflect allowable bonus depreciation — even if you’ve been depreciating the property over 39 years.

If you’re required to reduce the depreciable basis of QIP by the amount of previously allowable but unclaimed bonus depreciation, you lose the ability to claim that depreciation in the future. In addition, should you sell the property, you may owe taxes on recaptured depreciation deductions that you never used.

Due date for amended returns

If you’re considering filing an amended return for 2018 or 2019, be sure you know when it’s due. Generally, an amended return that results in a tax refund is due by the later of:

  • Three years after the original return was timely filed (including extensions), or
  • Two years after the tax was paid.

So, for example, if you filed and paid your 2018 tax return by its April 15, 2019, due date, the due date for an amended return would be April 15, 2022 — even if you filed your original return early. Note: If you obtained an extension to October 15, 2019, but filed your return before that date, the due date for an amended return would be three years from the actual filing date.

What’s the next step?

If your construction company owns commercial property, placed QIP in service in 2018 or 2019, and have been depreciating it over 39 years, doing nothing isn’t an option. To avoid the potentially costly tax trap, file the necessary paperwork with the IRS to either 1) claim missed 100% bonus depreciation deductions for those years, or 2) opt out of bonus depreciation and claim the additional depreciation deductions you would have taken had you used a 15-year recovery period.

In the case that your construction business doesn’t own property, you might be able to build goodwill with clients by informing them of the Qualified Improvement Property tax trap. Contact us for more information.

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