What Is IRS Qualified Improvement Property?

Qualified Improvement Property, or QIP, represents a specific category of internal upgrades made to commercial buildings. For business owners and real estate investors, understanding the nuances of QIP is important because of the tax benefits available, primarily through accelerated depreciation. These benefits can directly impact cash flow by allowing for larger deductions in the early years of an asset’s life.

Defining Qualified Improvement Property

To be classified as Qualified Improvement Property, an expenditure must meet three specific criteria. First, the improvement must be made to the interior of a building that is nonresidential real property, meaning it is used for commercial, retail, or industrial purposes. This explicitly excludes improvements made to residential rental properties. The definition covers work done by either the building owner or a tenant.

The second requirement is that the improvement must be placed in service after the date the building itself was first placed in service by any owner. This means QIP applies to modifications and upgrades to existing buildings, not costs associated with the original construction. The focus is on enhancing a structure that is already operational.

Finally, the definition of QIP has specific exclusions. The cost of improvements cannot be for the enlargement of the building, defined as increasing the building’s total volume. It also excludes expenditures for any elevator, escalator, or costs related to the internal structural framework of the building.

Common examples of qualifying improvements include:

• The installation of new interior drywall
• Acoustical ceilings
• Interior doors
• Updates to plumbing or electrical systems
• Fire protection and alarm systems

Conversely, projects like replacing a roof, installing new exterior windows, adding a new wing to a building, or making structural changes are not eligible.

Tax Treatment and Depreciation

The primary tax advantage of Qualified Improvement Property is its eligibility for accelerated depreciation. Under current tax law, QIP is assigned a 15-year recovery period under the General Depreciation System (GDS). This is an acceleration compared to the standard 39-year recovery period that applies to nonresidential real property.

A benefit of the 15-year life is eligibility for bonus depreciation, which allows businesses to immediately deduct a percentage of an asset’s purchase price. The bonus depreciation rate was 100% for property placed in service through 2022. This rate is scheduled to phase down to 80% for property placed in service in 2023, 60% in 2024, 40% in 2025, and 20% in 2026, before being eliminated.

The current treatment of QIP is the result of a legislative correction. The Tax Cuts and Jobs Act of 2017 (TCJA) intended to assign QIP a 15-year life, but a drafting error known as the “retail glitch” left it with a 39-year life, making it ineligible for bonus depreciation.

This error was retroactively corrected by the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020. The CARES Act assigned QIP its intended 15-year recovery period for property placed in service after December 31, 2017. If a taxpayer forgoes bonus depreciation, they must use the 15-year straight-line method; using another life could result in the IRS reclassifying the asset to a much longer recovery period.

Making a Depreciation Election

While taking bonus depreciation is the default treatment for QIP, taxpayers can elect out. This election is made for each class of property placed in service during the tax year. Since QIP is 15-year property, electing out of bonus depreciation for QIP means electing out for all other 15-year property placed in service that year.

A business might choose to elect out of bonus depreciation for several strategic reasons. For instance, a company with low or no taxable income in the current year might prefer to spread the depreciation deductions over the 15-year life of the asset. This can be more advantageous if the business anticipates being in a higher tax bracket in future years, making the deductions more valuable later or for managing net operating losses (NOLs).

A taxpayer must attach a statement to their timely filed federal income tax return for the year the qualified property is placed in service. This statement elects out of the bonus depreciation provisions under Internal Revenue Code Section 168. Once made for a specific property class in a given year, the election is irrevocable.

If a taxpayer elects out of bonus depreciation, the QIP is depreciated over its 15-year GDS recovery period using the straight-line method. In certain situations, such as for a real property trade or business that elects out of the business interest deduction limit under Section 163, the property must be depreciated using the Alternative Depreciation System (ADS). The ADS mandates a 20-year recovery period for QIP and makes it ineligible for bonus depreciation.

How to Claim QIP Depreciation

Depreciation for Qualified Improvement Property is claimed on IRS Form 4562, Depreciation and Amortization, filed with the business’s annual tax return. The specific reporting depends on whether the taxpayer is taking bonus depreciation or electing to depreciate the asset over its recovery period.

To claim bonus depreciation, the cost of the QIP is included in Part II of Form 4562 for the Special Depreciation Allowance. If a taxpayer elects out of bonus depreciation, the asset is reported in Part III, Section B. Here, the taxpayer provides details such as the cost basis, date placed in service, and recovery period to calculate the annual depreciation deduction.

For taxpayers who placed QIP in service in 2018 or later but filed returns based on the incorrect 39-year life due to the “retail glitch,” there are procedures to correct the error. One option is to file an amended tax return for the year the property was placed in service to claim the catch-up depreciation.

Alternatively, a taxpayer can file Form 3115, Application for Change in Accounting Method. This is typically required if two or more returns have been filed using the impermissible depreciation method. Filing Form 3115 allows the taxpayer to take the missed depreciation from prior years as a one-time Section 481 adjustment on the current year’s tax return.