A scrivener’s error in the Tax Cuts and Jobs Act (TCJA), meant that qualified improvement property (QIP) intended to have a useful life of 20 years or less, and qualifying for 100% bonus depreciation, fell outside of this provision, missing bonus depreciation eligibility. The CARES Act corrected this error by including QIP as 15-year property (and a 20-year class life for property subject to the Alternative Depreciation System (ADS)), retroactive to the enactment of the TCJA. Taxpayers with questions about how to take advantage of the new provision have a new resource with the recently-released Revenue Procedure 2020-25.
Rev. Proc. 2020-25 describes how to implement this new provision. To capture the retroactive bonus depreciation for QIP, the revenue procedure allows taxpayers to choose whether to file an amended tax return for the taxable year that such property was placed in service or to file a change in accounting method. Rev. Proc. 2020-25 also allows a taxpayer to complete either an automatic accounting method change or amend tax returns (AARs for partnerships) to file a late election or to revoke a previously-filed election impacted by the CARES Act correction.
As a taxpayer considers implementation, it is important to evaluate the results both approaches offer for past, present, and future tax positions. While an amended return may provide immediate cash and/or reduce taxes from a prior tax year, an accounting method change may allow a taxpayer to determine the tax year in which the change is taken into account. Depending on the taxpayer’s circumstances, claiming missed bonus depreciation may be used to maximize a net operating loss (NOL) and secure a permanent tax rate benefit by carrying the NOL back to a pre-TCJA taxable year. This alert provides an overview of the CARES Act technical correction as well as Rev. Proc. 2020-25, but also considerations to keep in mind when evaluating how to utilize the available procedures.
OVERVIEW OF THE LAW
Bonus Depreciation and TCJA Changes to Section 168
Prior to 2001, an improvement to the interior of nonresidential property was depreciated over the life of the building. As part of stimulus provisions in 2001, tax code Section 168(k) was enacted, allowing for 50% bonus depreciation on qualifying assets. (See H.R. Rep. No. 251, 107th Cong., 1st Sess. 20 (2001); see also Section 168(k)(1)(A).) While Section 168(k) provides for the bonus depreciation deduction, Section 168(e) classifies property into various asset classes of which property may, or may not be, eligible for bonus depreciation. Subsequent to the 2001 stimulus provisions, new classes of assets were added to Section 168(e), each with a 15-year life and qualifying for bonus depreciation: qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property. Each of these classes of assets was defined differently and had separate qualifying requirements.
In 2015, the PATH Act added another class of assets to Section 168(e), qualified improvement property (QIP). (Protecting Americans from Tax Hikes (PATH) Act of 2015, P.L. 114-113, (Dec. 18, 2015).) The PATH Act defined QIP simply as “any improvement made to the interior portion of a nonresidential building any time after the building was placed in service.” The TCJA attempted further simplification.
Under the TCJA, Sections 168(b)(3), (e) and (k) were amended, effective for property placed in service after Dec. 31, 2017, with the intent to reinstate 100% bonus depreciation for qualified property. The definitional provisions in Section 168(e)(6) merged the historic categories of QIP, i.e., qualified retail improvement property, qualified restaurant property, qualified leasehold improvement property, and qualified improvement property, into a single grouping.
Under the TCJA, bonus depreciation is limited to qualified property with a useful life of 20 years or less; and it is clear from the legislative history that Congress intended to provide a 15-year recovery period for QIP. Nevertheless, amid the changes made during the drafting process, the TCJA did not specify a class of property under Section 168(e) for QIP placed in service after Dec. 31, 2017. Consequently, following the enactment of the TCJA, such property was classified as nonresidential real property under Section 168(e)(2)(B), with a useful life of 39 years, and not eligible for the additional first-year depreciation deduction provided under Section 168(k).
There are also a series of elections available under Sections 168(g)(7) and (k) to implement, or elect out of, the depreciation rules. Section 168(g)(7) generally allows an election to depreciate any class of property under the ADS. For nonresidential real property and residential rental property, the ADS election may be made on a property-by-property basis, otherwise the election applies to all property in the same class that is placed in service during the taxable year. The ADS election is irrevocable. Section 168(k)(5) allows taxpayers to apply the special rules of Section 168(k)(5) to one or more of the specified plants planted, or grafted to a plant that has already been planted, by the taxpayer in the ordinary course of its farming business.
Section 168(k)(7), on the other hand, allows an election out of bonus depreciation for any class of property that is qualified property placed in service during the taxable year. The election under Section 168(k)(7) applies annually and on a class-by-class basis. In addition to the option to elect out, Section 168(k)(10) also allows taxpayers to make an election to deduct 50%, rather than 100%, bonus depreciation for all qualified property acquired by the taxpayer after Sept. 27, 2017, and placed in service by the taxpayer during its taxable year that includes Sept. 28, 2017.
CARES Act Technical Correction to Section 168
Section 2307 of the CARES Act added a new clause to Section 168(e)(3)(E) thereby resolving the technical misstep made in the TCJA. Specifically, the depreciation of QIP placed in service by the taxpayer after Dec. 31, 2017, has changed. Such property is depreciated under the GDS using the straight-line method of depreciation, a 15-year recovery period, and the half-year or mid-quarter convention, pursuant to Section 168(b)(3), (c), and (d); it is depreciated under the ADS using the straight-line method of depreciation, a 20-year recovery period, and the half-year or mid-quarter convention, as applicable, pursuant to Section 168(g)(2) and (3)(B).
With this change, the depreciable life of QIP placed in service by a taxpayer after Dec. 31, 2017, has been reduced to 15 years as opposed to defaulting to the 39-year life of nonresidential real property, and under ADS, such QIP has been given a 20-year recovery period. Furthermore, and assuming all requirements of Section 168(k) are met, QIP acquired by the taxpayer after Sept. 27, 2017, and placed in service by a taxpayer after Dec. 31, 2017, is eligible for 100% bonus depreciation under Section 168(k). Consequently, the CARES Act enables businesses, particularly those in the retail, restaurant, and hospitality industries, to immediately deduct QIP costs, retroactive to Dec. 22, 2017, the date the TCJA was enacted. It is important to note, the CARES Act also amended the definition of QIP in Section 168(e)(6) by providing that the improvement must be “made by the taxpayer.”
Rev. Proc. 2020-25 Guidance Related to Section 168
With the release of Rev. Proc. 2020-25, the IRS has provided taxpayers with alternative approaches for implementing the retroactive changes to bonus depreciation available for QIP placed in service by a taxpayer after Dec. 31, 2017, in the taxpayer’s 2018, 2019, or 2020 taxable year. Specifically, the revenue procedure permits a taxpayer to file an amended return, AAR, or a change in accounting method, to change the depreciation of QIP placed in service after Dec. 31, 2017.
The new automatic change procedure also waives the provisions Rev. Proc. 2015-13. Specifically, taxpayers may use the new procedures to change the depreciation method of QIP placed in service after 2017 even if the taxable year of change is the taxpayer’s final tax year or if another depreciation method change for the same asset has been made during the previous five taxable years. These temporary waivers are limited to the first or second tax year after the QIP was placed in service year or, if later, to accounting method changes made with a timely filed return between April 17, 2020, and Oct. 15, 2021.
The revenue procedure further permits a taxpayer to make a late election under Section 168(g)(7), (k)(5), (k)(7), or (k)(10), to revoke an election under 168(k)(5), (k)(7), or (k)(10), or to withdraw an election under 168(g)(7), for property placed in service by the taxpayer during its 2018, 2019, or 2020 taxable year. To reduce the administrative burden of filing amended returns or administrative adjustment requests (AARs) to make the aforementioned late elections or revoke and/or withdraw elections, Rev. Proc. 2020-25 allows taxpayers to treat such elective acts as a change in accounting method with an accompanying Section 481(a) adjustment for a limited period of time. The chart below summarizes the available procedures and implementation tools to effectuate each change.
The guidance modifies Rev. Proc. 2019-43 to add two new automatic method changes: DCN 244, to change the depreciation method of QIP placed in service after Dec. 31, 2017; and, DCN 245, to make a late election out of bonus depreciation or to revoke an election out of bonus depreciation.
It is important to note that notwithstanding the flexibility of Rev. Proc. 2020-25, there are certain limitations. For example, to the extent a taxpayer has QIP placed in service after Dec. 31, 2017, but made a late election, or withdrew an election, under Section 163(j)(7)(B) or (C) to be treated as a real property or farming trade or business in accordance with Rev. Proc. 2020-22, any changes to depreciation for such property must be made in accordance with Rev. Proc. 2020-22, rather than Rev. Proc. 2020-25, which limits adjustments to the amended return process.
In many ways, this revenue procedure allows taxpayers a “do-over” for bonus depreciation. There is great breadth regarding the available changes and how such changes are implemented. In light of the current economic uncertainty, taxpayers will appreciate the flexibility afforded in the revenue procedure.
It is nonetheless important to be mindful of the procedural nuances of Rev. Proc. 2020-25 when using an accounting method change approach. For example, the automatic accounting method change available to change a taxpayer’s depreciation method for QIP is available for both taxpayers which have adopted a method of accounting for QIP (i.e., used an impermissible method for at least two consecutive taxable years), and taxpayer, which have not yet adopted a method for QIP, having only applied the impermissible method for one year. Rev. Proc. 2020-25 labels the latter as “1-year QIP” and allows taxpayers to correct such method as if the taxpayer had adopted a method of accounting for such QIP. To streamline the filing process, Rev. Proc. 2020-25 not only provides reduced filing requirements on the Form 3115 for participating taxpayers, but also enables those filing changes under the revenue procedure to file both changes to QIP depreciation and elections in and out of bonus, to be made concurrently on the same Form 3115.
In evaluating whether to file late elections or revoke previously-filed elections, taxpayers will want to fully evaluate their past and current financial and tax positions. For example, a taxpayer that may have elected out of bonus depreciation previously, may now seek to revoke such election to take advantage of the retroactive change to QIP depreciation made by the CARES Act and to expand its NOL carryback capacity to take advantage of law changes under the CARES Act. On the other hand, a taxpayer now experiencing significant losses may seek to elect out of bonus now and seek a longer recovery for QIP. To that extent, it will be important for companies to evaluate whether an amended return or accounting method change provides the optimal result for such elective changes.
While the technical correction, procedural options, and ability to treat certain elective actions as changes in accounting methods offer taxpayers flexibility, it is important to be aware of the CARES Act change to the definition of QIP that the improvement must be “made by the taxpayer.” Although no substantive guidance has been issued addressing this provision, taxpayers should nonetheless be aware of this change as bonus depreciation is claimed. Because bonus depreciation is available for used property under Section 168(k)(2)(E)(ii), this change may affect the scope of property eligible for bonus depreciation. This change should also be considered in an asset acquisition context as it could affect asset valuations with respect to QIP that was installed by others. Because QIP is not a separate and distinct depreciable asset, a taxpayer may not claim bonus depreciation for QIP acquired from another taxpayer.
The choice to file either a change in accounting method or an amended return means a taxpayer must evaluate procedural requirements as well as business considerations in connection with automatic accounting method changes filed with a 2019 or 2020 return, or the benefit of amending returns. As with the TCJA and CARES Act guidance, a taxpayer should carefully model the various options and their interaction to determine the path that provides the most beneficial results.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Ellen McElroy is a partner and Michael Resnick is an associate in Evershed Sutherland (US) LLP’s Washington office.