Update: CARES Act: Technical Correction for Qualified Improvement Property Provides Retroactive Tax Relief

This Tax Release is an update to a prior release published on April 1, 2020 to include a discussion of recently issued guidance which intersects with the CARES Act technical correction for qualified improvement property. 

The CARES Act provides a long-awaited technical correction for qualified improvement property (QIP), enabling taxpayers to claim 100% bonus depreciation on eligible QIP. The amendments are retroactive to the effective date of the Tax Cuts and Jobs Act (TCJA) and are applicable to property placed in service on or after January 1, 2018. Taxpayers may either file an amended return for 2018 and 2019 taxable years or file a Form 3115, Application for Change in Method of Accounting, to reflect the cumulative amount of QIP depreciation (including bonus depreciation) to which the taxpayer is now entitled.

Following the enactment of the CARES Act, IRS issued the following guidance:

• Revenue Procedure 2020-23 to allow BBA partnerships to file an amended tax return and Schedule K-1s in lieu of an administrative adjustment request (AAR). 
• Revenue Procedure 2020-22 to allow real estate and farming businesses to withdraw their real property or farming trade or business election made under Sec. 163(j) in order to utilize the new CARES Act provisions surrounding QIP.
• Revenue Procedure 2020-25 providing procedures allowing taxpayers to change the amount of depreciation taken for QIP and to make or revoke certain depreciation elections for 2018 or 2019. 

CARES Act Amendments

Although the TCJA had intended QIP to qualify for bonus deprecation, an error in drafting the legislation erroneously classified QIP as 39-year property making it ineligible for bonus depreciation beginning January 1, 2018. This oversight required a technical correction in order to align with Congressional intent of the TCJA provisions. The CARES Act amended Sec. 168 to classify QIP as 15-year property under MACRS, with a 20-year class life under ADS. The Act also amended the definition of “qualified improvement property” to clarify that such improvements must be made by the taxpayer in order to qualify (i.e., the definition of QIP does not include improvements made by a prior owner). As a result, used or acquired improvements do not qualify for the 15-year recovery period or for bonus depreciation. Any improvements that do not qualify will continue to be subject to a 39-year recovery period.

The amendments made as part of CARES Act are applicable to property placed in service on or after January 1, 2018. For property placed in service before January 1, 2018, the applicable property already qualifies for bonus depreciation. After enactment of TCJA, it was initially unclear how the bonus depreciation provisions applied to property that was placed in service after September 27, 2017, but before January 1, 2018 and that was previously eligible (qualified leasehold improvement property, qualified retail improvement property, and QIP) for bonus depreciation. IRS and Treasury confirmed that the removal of qualified leasehold improvements (QLIP), qualified retail improvement property (QRIP), and qualified restaurant (QRP) property definitions from Sec. 168 was applicable for property place in service after December 31, 2017. Further, they confirmed that QIP was not removed from the definition of bonus-eligible property until after December 31, 2017. As a result, property placed in service on or before December 31, 2017 and classified as QLIP, QRIP, or QIP was eligible for bonus depreciation (100% or 50%, depending on the acquisition date).

Differences between the August 2018 proposed bonus depreciation regulations and September 2019 final and proposed regulations may create additional opportunities for 100% bonus depreciation with respect to QLIP, QRIP, QIP and other types of bonus-eligible property placed in service after September 27, 2017. Guidance regarding the transition from the August 2018 proposed regulations to the September 2019 final and proposed regulations for property placed in service in prior years is still pending.

Making Late or Revoking Depreciation Elections

Rev. Proc. 2020-25 also allows taxpayers to make late elections or revoke prior depreciation elections for the following elections for 2018 or 2019 tax returns timely filed on or before April 17, 2020:

• Election to use ADS (Sec. 168(g)(7))
• Election to take bonus depreciation for certain plants bearing fruits and nets (Sec. 168(k)(5))
• Election to not take bonus depreciation for a class of property (Sec. 168(k)(7))
• Election to apply 50% bonus depreciation in lieu of 100% for a taxpayer’s first TCJA year (Sec. 168(k)(10))

This guidance provides taxpayers with a significant opportunity to reevaluate their depreciation elections on previously filed 2018 and 2019 returns.

Correcting Previously Filed Returns

Taxpayers generally may correct their previously filed returns to reflect the corrected depreciation methods for QIP, including 100% bonus depreciation, by filing an amended return, AAR, or Form 3115. Similarly, taxpayers generally may make any of the above elections, or may revoke any of the above elections, by filing an amended return, AAR, or Form 3115. However, a taxpayer wishing to revoke a prior election to use ADS under Sec. 168(g)(7) may only do so by filing an amended return or AAR and may not revoke such election using a Form 3115.

• Amend 2018 Tax Return (or 2019 Tax Return if Filed). Taxpayers may file an amended tax return to correct the recovery period and claim 100% bonus depreciation, if applicable, on QIP property that was placed in service during the taxable year. Taxpayers can also make or revoke the depreciation elections listed above. The amended return must include all collateral effects of the change for QIP or the depreciation elections above, and must be filed by October 15, 2021, but no later than when the statute of limitations expires. IRS previously provided relief to BBA partnerships in Rev. Proc. 2020-23 in which BBA partnerships may elect to file amended returns for taxable years beginning in 2019 and 2020 under which the amended Form 1065 and amended Schedule K-1s must be filed before September 30, 2020. 

• File a Form 3115, Application for Change in Method of Accounting, for 2019 or 2020. Alternatively, taxpayers have the option to file a Form 3115 under the automatic consent procedure in order to correct the recovery period on QIP to claim bonus depreciation, and to make and revoke certain depreciation elections where applicable. The accounting method change procedures have been amended to include change #244 for QIP depreciation and #245 for applicable changes to depreciation elections and can be filed with the tax return for the selected year of change (2019 or 2020). The method change would be implemented with a Sec. 481(a) adjustment and thus the cumulative amount of additional depreciation for prior years would be deducted on the tax return for the year of the change. The automatic method change for making or revoking certain depreciation elections is only available if made for the taxpayer’s first or second year succeeding the property subject to the election was placed in service, or, if later, for any taxable year for which an original return is filed by October 15, 2021. These method changes, as well as other concurrent changes from an impermissible to a permissible method for depreciation, may be filed on a single Form 3115. 

Business Interest Expense Limitations

Taxpayers that made an election out of the business interest limitation under Sec. 163(j) as an electing real property or farming trade or business are required to use the 20-year ADS depreciation period for QIP and are not eligible for bonus depreciation for QIP. Taxpayers may have made the election based on the assumption that QIP would not be eligible for bonus depreciation and the QIP correction may change the economics of this analysis. The election out of Sec. 163(j) for real property trades or businesses, once made, is generally irrevocable.  IRS granted relief in Rev. Proc. 2020-22 for taxpayers that made the real property or farming trade or business election under Sec. 163(j)(7).  Under this procedure an electing real property or farming trade or business may revoke the otherwise irrevocable election for 2018 and 2019 tax years by filing an amended return or AAR along with an election withdrawal statement. The amended return or AAR must be filed by October 15, 2021, but no later than the applicable period of limitations on assessment for the year the amended return is being filed. BBA partnerships may temporarily utilize the relief provided in Rev. Proc. 2020-23 to file an amended return in lieu of an AAR if the amended return is filed before September 30, 2020. 

Identifying QIP & Additional Depreciation Deductions

Taxpayers who have not already identified QIP additions in 2018 and 2019 should review their fixed asset records to identify eligible property. The changes in the CARES Act make clear that QIP can only relate to new property placed in service by the taxpayer and does not apply to any used property. Taxpayers also should consider cost segregation studies to identify other shorter-lived property that may be eligible for bonus depreciation or a shorter recovery period. 

Net Operating Losses

The additional depreciation deductions generated by filing an amended return or Form 3115 may create or increase a net operating loss (NOL) position for 2018, 2019 or 2020 that could be carried back up to five years under the CARES Act. Taxpayers should evaluate NOLs and potential refund claims when determining which avenue to pursue, and if filing a Form 3115, which year in which to make the change.

The Takeaway

The correction made by the CARES Act for QIP provides a significant opportunity for taxpayers to generate additional tax deductions, possibly resulting in NOLs with a five-year carryback, and increase cash flow. In addition, the guidance provided in Rev. Proc. 2020-25 provides taxpayers with a unique opportunity to revisit a prior year depreciation election that might otherwise be irrevocable and reconsider such elections in light of the CARES Act technical correction and subsequent TCJA guidance that may have been released after the return was filed. Taxpayers should consider whether to implement the technical correction, or the depreciation elections, by amending their 2018 tax return or filing a Form 3115 for a subsequent year. The temporary relief procedures provided to BBA partnerships and electing real property or farming trades or businesses requires immediate action if the partnership wishes to file an amended return in lieu of an AAR. Careful consideration is required as it may have an impact on other areas of the tax return, such as the Sec. 163(j) interest limitation and NOL generation or utilization. Andersen’s accounting methods specialists are prepared to assist with analysis and to identify appropriate strategies.