Section 168(e)(6) and Qualified Improvement Property

The tax treatment for interior enhancements to nonresidential buildings is governed by specific regulations. Understanding these rules is part of effective tax planning for any business that invests in its physical space. The classification of these improvements dictates their recovery period and eligibility for accelerated depreciation methods.

Defining Qualified Improvement Property

Qualified Improvement Property, or QIP, is a classification under the Internal Revenue Code for any improvement made by a taxpayer to the inside of a commercial building that is already in service. This means the work must be done after the building has been opened for use. The definition is broad, covering many common upgrades like new drywall, interior lighting, plumbing, and flooring.

The tax code excludes certain expenditures from the QIP definition. Any expenditure for the enlargement of the building, such as an addition, is explicitly excluded. The installation of any new elevator or escalator also does not qualify. Furthermore, improvements that affect the internal structural framework of the building are not considered QIP.

This definition consolidated several previous categories of property, including qualified leasehold, restaurant, and retail improvements, which had separate rules before the Tax Cuts and Jobs Act (TCJA) of 2017. The creation of QIP was intended to simplify these provisions, but it initially led to unintended consequences.

The Depreciation Treatment Correction

A drafting error in the Tax Cuts and Jobs Act of 2017, often called the “retail glitch,” unintentionally assigned Qualified Improvement Property (QIP) a 39-year recovery period. This longer depreciation timeline meant these interior improvements were not eligible for bonus depreciation. This was a major incentive included in the TCJA for other asset classes.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, passed in 2020, provided a retroactive technical correction. The CARES Act amended the tax code to assign QIP a 15-year recovery period. This change was made effective as if it had been included in the original 2017 law, applying to property placed in service after December 31, 2017.

Property with a recovery period of 20 years or less is generally eligible for bonus depreciation. By reducing the recovery period to 15 years, the CARES Act made QIP eligible for this accelerated depreciation, allowing a business to deduct a large portion of the cost in the first year. While this allowed for a 100% bonus depreciation deduction through 2022, the rate is phasing down. For property placed in service in 2025, the bonus depreciation rate is 40%, decreasing to 20% in 2026 and eliminated in 2027 unless Congress intervenes.

Applying the Correction to Tax Filings

Taxpayers who placed QIP in service from 2018 to 2020 and depreciated it over 39 years must take action to claim the benefits of the retroactive CARES Act correction. The Internal Revenue Service provided guidance in Revenue Procedure 2020-25, which outlines two primary pathways for correcting the depreciation on prior-year filings.

One option is to file an amended tax return for the year the property was placed in service. For partnerships subject to the centralized partnership audit regime, this involves filing an Administrative Adjustment Request (AAR). This approach allows the taxpayer to recalculate the depreciation for the affected year and claim any available bonus depreciation.

Alternatively, a taxpayer can file Form 3115, Application for Change in Accounting Method. This allows for a change from an impermissible accounting method (depreciating QIP over 39 years) to a permissible one. This method allows the taxpayer to take the entire cumulative difference in depreciation, known as a Section 481(a) adjustment, in the year of the change. The IRS simplified the procedure, allowing taxpayers to attach Form 3115 to a timely filed return without a user fee or advance consent.