CARES Act: Qualified Improvement Property and Section 163(j) Revisions

Background

On March 27, 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law.  Two significant changes from this legislation impacting taxpayers include:

  • The recovery period of qualified improvement property was retroactively changed to 15 years making it eligible for accelerated bonus deprecation.
  • The business interest expense limitation under Section 163(j) was modified to provide taxpayers previously limited by the original Tax Cuts and Jobs Act (TCJA) additional relief under new provisions.

Since the enactment of the CARES Act, numerous Revenue Procedures have been issued further clarifying these revisions and providing instructions on how taxpayers may institute these changes on qualifying tax returns.

What is Qualified Improvement Property?

Qualified improvement property (QIP) is defined as any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date the building was first placed in service. Qualified improvement property specifically excludes expenditures attributable to the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. Originally this property was assigned a recovery period of 39 years under the TCJA.

What’s new?

The CARES Act retroactively changed the recovery period of QIP to 15 years beginning September 27, 2017. This means that any QIP placed in service after this date is eligible for bonus depreciation under Section 168(k) and may qualify for 100% expensing. It is worth noting that for any QIP depreciated under the Alternative Depreciation System (ADS), the recovery period is changed from 40 to 20 years and does not qualify for accelerated bonus depreciation. Additionally, the CARES Act modified the definition of QIP so that only improvements “made by the taxpayer” qualified. As a result, it is inferred that improvements to a non-residential building acquired by the taxpayer, and originally placed in service by another taxpayer, will not meet the definition.

As a result of these revisions, Rev. Proc. 2020-25 was issued allowing taxpayers to change their depreciation deductions for 2018, 2019, or 2020 tax years as it relates to any QIP placed in service after December 31, 2017. Furthermore, taxpayers are allowed to make late elections, or revoke previously made elections, under various provisions of Section 168 specifically as it relates to bonus depreciation and the election to depreciate assets under ADS. A taxpayer may have three potential choices to change their depreciation deductions or elections: (1) an amended return, (2) an administrative adjustment request (AAR), or (3) a change in accounting method adjustment.

Taxpayers must file an amended return by October 15, 2021, for the tax years the QIP was placed in service or the Section 168 election was made.  Under Rev. Proc. 2020-23, even BBA partnerships subject to the centralized audit regime may file amended returns and K-1s. However, it should be noted these amended returns are due before September 30, 2020. Additionally, BBA partnerships are allowed to correct depreciation or change certain elections under Section 168 for 2018, 2019, and 2020 tax years by filing an AAR by October 15, 2021. Be advised that amended returns or AARs must be filed for any succeeding tax years affected by the change in depreciation or change in election.

One of the more important changes of Rev. Proc. 2020-25 is that it allows taxpayers, for a limited time, to treat changes to depreciation and depreciation elections as an accounting method change correctable with a Section 481(a) adjustment. This provides the ability for taxpayers to modify their depreciation calculation and potentially expense any remaining QIP in a single tax year by filing Form 3115 and thus removing the administrative burden of filing amended returns or AARs.

Note that Form 3115 cannot be used to revoke all elections, such as the Section 168(g)(7) election to use ADS.  This must be done through an amended return or AAR.  Because of this complexity, it is important to consult with a tax professional to determine what options are available to you.

What is Section 163(j) Interest Limitation?

Originally enacted as part of the TCJA, Section 163(j) limits the deductibility of business interest expense for certain specified taxpayers. As originally enacted, this limitation was equal to the sum of (1) business interest income, (2) 30% of adjusted taxable income (ATI), and (3) floor plan financing interest. Additional provisions carved out certain excepted trades or businesses that could make an irrevocable election under Section 163(j)(7)(B) to not limit their business interest.  Under this election, these businesses are required to change the depreciation of all real property assets to ADS, which generally requires longer recovery periods and makes assets ineligible for bonus depreciation under Section 168(k).

 What’s new?

The CARES Act amended Section 163(j), increasing the deductibility of business interest for 2019 and 2020 to prevent penalizing taxpayers from incurring debt during economic uncertainty. For most taxpayers, the limitation increased from 30% of ATI to 50% of ATI for tax years 2019 and 2020.  Furthermore, it gave taxpayers the ability to elect to use their 2019 ATI in the calculation of their 2020 business interest limitation.  Most taxpayers expect to have more taxable income in 2019 than 2020 so making this election would allow them to use a higher ATI number and take a larger deduction in 2020.

Special provisions exist for taxpayers filing as partnerships. For these entities, business interest is still limited at 30% of ATI for 2019 with the calculation changing to 50% of ATI beginning in the 2020 tax year. However, any business interest limit incurred by a partnership in 2019 and passed through to its partners as excess business interest expense, will also be 50% deductible by those partners in 2020.

These changes alter how many taxpayers make decisions as it relates to the business expense limitation, specifically those that meet the definition of excepted trades or businesses. In response to this, Rev. Proc. 2020-22 allows taxpayers to withdraw, or make a late election, under Section 163(j)(7)(B). This is applicable to 2018, 2019, and 2020 tax years and can be done through an amended return or an AAR for partnerships subject to the centralized audit regime. Both must be filed for the tax year in which the election was made and are due by October 15, 2021. As mentioned above, BBA partnerships filing amended returns under Rev. Proc. 2020-23 must do so before September 30, 2020.

Next Steps

The changes made to QIP and Section 163(j) under the CARES Act provide many new tax benefits which can be taken advantage of through proper tax planning.

If you have incurred costs for interior improvements to nonresidential real property placed in service in 2018, 2019, and 2020, there is potential to expense 100% of the entire cost through bonus depreciation. Alternatively. if you have elected to depreciate your assets using ADS, there is still potential to expedite deductions by converting the depreciable life of QIP from 40 years to 20 years.  Additionally, any taxpayer that previously chose to depreciate property under ADS through a Section 168 election, or an election out of Section 163(j) as an excepted trade or business, can now revoke those elections and revert their depreciation method back to the general depreciation system (GDS) making assets eligible for bonus depreciation.

Finally, if you have been subject to Section 163(j) and have had business interest deductions limited, there may be options that can be taken advantage of in 2019 or 2020 for additional expensing.  With the increased threshold for deductions, prior decisions as it relates to these provisions should be reassessed to determine if they are still the most favorable under the new law changes.

While the revisions enacted under the CARES Act can provide tax savings, the methods to institute these changes are especially complex with many having varying deadlines. We recommend consulting with a tax professional, like those at Elliott Davis, to see what options are available to you and develop a plan to maximize the benefits through a value-based tax strategy.

We can help

Please reach out to your Elliott Davis Tax Advisor for additional information. As always, we will continue to monitor and communicate any future legislative updates.

For more helpful tax updates and business continuity resources to navigate COVID-19, visit the Elliott Davis COVID-19 Resource Center.