Small business owners historically have been frustrated they’re unable to recover nonresidential commercial real estate costs through depreciation in a reasonable amount of time.

Nonresidential real property had been relegated to a 39-year straight line recovery life with no opportunity for accelerated deductions. This unfavorable depreciation period and disappointing annual deduction led real estate investors to spend time and resources to optimize current year deductions. Congress recognized these inefficiencies and attempted to provide some relief with the introduction of qualified improvement property (QIP).

QIP is a fixed asset category first established in the Protecting Americans from Tax Hikes (PATH) Act of 2015. Under Section 168(k)(3), improvements to  nonresidential real estate now qualify for accelerated depreciation (bonus depreciation), except for improvements that enlarge the building, involve elevators or escalators or change the internal structural framework of the building. Although assets remain subject to a 39-year life, the act afforded them bonus depreciation eligibility starting with the 2016 tax year.

Bonus depreciation is a specific type of accelerated cost recovery available in the first year new assets are placed in service. While it traditionally has been restricted to assets with class lives of 20 years or less, PATH made an exception for QIP. QIP assets placed in service before
Sept. 27, 2017, are eligible for bonus depreciation on 50 percent of their unadjusted basis, while qualifying assets acquired and placed in service between that date and Dec. 31, 2022, are eligible for 100 percent bonus. No elections or forms are required to claim the benefits of QIP. Its characteristics simply apply to individually qualifying assets. These broad limitations have allowed for significantly quicker cost recovery on small business assets.

To fully understand the benefits of QIP, it’s important to first recognize the limitations of the previous system. Although the 39-year life wasn’t ideal, the real benefit of QIP stems from the ease with which assets qualify for bonus depreciation.

Prior to the introduction of QIP, qualified leasehold improvements offered a 15-year life. But the building had to be at least three years old and the construction needed to be completed pursuant to a lease. Moreover, it could not be a lease involving related parties, and all qualifying improvements had to be made to leased space only and not common areas. Qualified retail improvements and qualified restaurant property also offered a 15-year life, but only for equipment meeting specific operational standards in specific industries. For instance, a restaurant had to use at least 50 percent of its square footage for preparation of meals and on-site consumption of prepared meals.

QIP has replaced all of these categories with simple regulations and a comparatively broad standard for commercial real estate owners or lessors to follow. QIP can also come in handy for taxpayers required to use the alternative depreciation system (ADS) rather than the general depreciation system (GDS). This group can include certain farm property, tangible property used mainly outside the United States, listed property used 50 percent or less in a qualified business and the properties of businesses electing out of the new business interest limitation rules.

One legislative wrinkle to keep an eye on involves the specific text of the Tax Cuts and Jobs Act of 2017 (TCJA) enacted in December. While the previously mentioned bonus depreciation benefits are assured, the initial version of the law left some unintentional ambiguity as to whether or not QIP will be reduced from a 39- to 15-year life starting in 2018. The congressional committee responsible for drafting the bill has signaled its intention to correct this section to clearly provide a 15-year life with a technical corrections bill, but it has not yet passed. There are also some moderate risks associated with taxpayer interpretation of the phrases “structural components” and “common area” as they apply to QIP eligibility. However, Reg. sections 1.48-1(e)(2) and 1.168(k)-1(c)(3)(ii) provide some helpful guidance on these terms.

Overall, the introduction of QIP has simplified fixed asset depreciation decisions. Whereas the 2014 tangible property regulations introduced numerous frameworks and operational guidelines related to the depreciable lives of new construction, QIP has eliminated much of this analysis and facilitated an easy 100 percent bonus depreciation option.

While the current bonus depreciation rules and related property classifications are scheduled to expire at the end of 2022, these interim years should provide significant benefits for taxpayers undertaking new nonresidential construction projects.