On March 27, 2020, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) to help expedite economic relief from the COVID-19 pandemic. The CARES Act corrected a glitch in the 2017 tax reform legislation, which prevented certain interior improvements made to nonresidential real property, known as qualified improvement property (QIP), from being eligible for accelerated depreciation.
The CARES Act reduces the depreciable life of QIP from 39 years to 15 years, which makes QIP eligible for 100% bonus depreciation. This change was retroactive to property acquired and placed in service after Sept. 27, 2017. Consequently, it will have a significant positive impact on most nonresidential and mixed-use historic tax credit (HTC) projects completed after Sept. 27, 2017. It’s worth noting that projects claiming HTCs will generally not be able to claim bonus depreciation on QIPs unless they’re willing to forgo claiming HTCs on such costs.
There are many complexities associated with applying this change retroactively. Here are our answers to the most pressing questions about the change.
Is the project eligible to take advantage of the shorter depreciable life for QIP?
Remember that residential projects aren’t eligible, but mixed-use projects can benefit from QIP if 20% or more of rent revenue is attributable to commercial leases.
How much of your qualified rehabilitation expenditures (QREs) are QIP?
Answering this question will require a detailed analysis of the underlying construction costs. Based on an analysis conducted by the Historic Tax Credit Coalition in 2016, QIP could be as much as 75% of a project’s QREs.
How do you prevent the change in the depreciable life of QIP from reducing your HTCs?
If your project has QIP, you’re generally required to claim 100% bonus depreciation on those costs. However, doing so will preclude you from claiming HTCs. The key to preventing a reduction of your HTCs is to elect out of bonus depreciation for QIP, and the election must be filed with the tax return for the year when the QIP was placed in service. Carefully review your options for making the election if you already filed the tax return for the year the QIP was placed in service and you didn’t include the election in that return.
What do you have to do to take advantage of accelerated depreciation for QIP?
If you haven’t yet filed your tax return for the year that your project is placed in service, you can depreciate QIP over 15 years when you file that tax return, if you elect out of bonus depreciation for QIP for that tax year.
If you’ve already filed your tax return for the year that the project was placed in service, the optimal approach will depend on a few factors, including the tax year that the QIPs were placed in service. In general, there are three potential options:
- File an amended return
- File a superseded return
- File Form 3115 (accounting method change)
On April 8, 2020, the Internal Revenue Service (IRS) issued Rev. Proc. 2020-23, which simplifies the process of amending a 2018 or 2019 partnership tax return to make changes if it’s filed before Sept. 30, 2020. In short, this guidance allows you to circumvent the new partnership audit rules that might modify the process for amending partnership tax returns, and delay and/or reduce the partners’ ability to receive a refund associated with the amendment. However, absent further guidance from the IRS, a partnership cannot amend its 2018 tax return to correct depreciation of QIP if the partnership has already filed its 2019 tax return.
Furthermore, on April 17, 2020, the IRS issued Rev. Proc. 2020-25, which simplified the process for filing Form 3115. Most importantly, taxpayers with QIP that are also QREs can now receive automatic approval of their Form 3115 without paying a sizable user fee.
How does the change in depreciable life of QIP impact projects that utilized a master-lease pass-through structure?
In a master-lease pass-through structure, the tax credit investor needs to amortize the HTCs into income over the shortest recovery period available for the property (i.e., “Section 50(d) income”). Since the CARES Act retroactively changed the recovery period for QIP from 39 years to 15 years for property acquired and placed in service after Sept. 27, 2017, the tax credit investor is required to retroactively revise the calculation of its Section 50(d) income for such QIP.
The acceleration of Section 50(d) income could increase the amount of tax distributions required to be made to the tax credit investor. However, that impact could be mitigated by the tax credit investor’s share of additional tax depreciation from the property owner’s change in depreciable life of QIP.
Since tax distributions are typically calculated on a stand-alone basis for each tax year, the tax year when retroactive additional depreciation is claimed could differ from the tax year when retroactive additional Section 50(d) income is recognized. To avoid a potential whipsaw, developers should communicate with the tax credit investor to understand how timing differences could impact tax distributions before deciding how to retroactively take advantage of accelerated depreciation on QIP. It’s also worth noting that the impact on investor tax distributions will likely be more adverse for projects where the master tenant has no ownership in the property owner.
Overall, the change in the QIP tax depreciation rules will be favorable for most developers, but the benefit can be maximized by communicating with your tax advisor. Questions? Give us a call. We can help.
