When the CARES Act provided a technical correction for the so-called “retail glitch” in the Tax Cuts and Jobs Act, it also created a trap that could cause taxpayers to permanently lose future qualified improvement property (QIP) depreciation deductions.
The fix generally allows taxpayers to immediately deduct up to 100 percent of the cost of such improvements using bonus depreciation, rather than depreciate them over 39 years.
Not only can the deduction be taken for improvements made in future years, but the IRS also made it easy for taxpayers to go back and claim the deduction for improvements made in 2018 and 2019. By filing an amended return or a Form 3115, taxpayers can generate additional deductions and increase their cash-flow.
But what if a taxpayer doesn’t want to go back and claim the deduction available to them for the prior year? In such cases, can a taxpayer choose to simply keep depreciating QIP placed in service in 2018 and/or 2019 using the 39-year life with no bonus depreciation? Taxpayers may want to do so for a variety of reasons:
- To avoid the additional time and expense involved
- To avoid amending partner or shareholder returns in the case of a flow-through entity
- To avoid opening up a previously filed return to audit or causing an extension of the statute of limitations
- Perhaps any additional depreciation deductions generated would not provide an immediate benefit due to the application of another limitation in the tax law such as the passive loss rules
Common sense would say the IRS wouldn’t mind if a taxpayer opted to continue using a 39-year depreciable life with no bonus depreciation, because it is better for the IRS. Surprisingly, however, there are negative consequences to not adjusting the depreciable life and method of QIP placed in service in 2018 or 2019 to reflect the retroactive changes made in the CARES Act. In such a case, taxpayers risk permanently losing future depreciation deductions with respect to those QIP assets.
The ‘allowed or allowable’ dilemma
The IRS indicated that using a 39-year depreciable life for QIP placed in service in 2018 and beyond is now considered to be an impermissible depreciation method. In addition, bonus depreciation is mandatory with respect to qualified property unless a taxpayer elects out on the tax return for the year in which the property was placed in service.
IRS rules require generally that the basis of depreciable property be reduced by the greater of the depreciation ‘allowed or allowable.’ The basis of depreciable property eligible for bonus depreciation must also be reduced by the greater of the bonus amount ‘allowed or allowable’ before any other regular depreciation deductions are computed.
Because QIP placed in service in 2018 and 2019 was made retroactively eligible for bonus depreciation, unless an election out, taxpayers must reduce the tax basis of such QIP by the amount of “allowable”’ bonus depreciation, whether or not such bonus depreciation was actually claimed.
That means the basis of any QIP placed in service in 2018 and 2019 is required to be reduced by the amount of bonus depreciation that should have been taken, and future depreciation deductions can’t be claimed with respect to that basis reduction amount going forward.
Further, in the year of sale, a taxpayer using an impermissible depreciation method would still be required to reduce its tax basis by the amount of depreciation that would have been ‘allowable’ had a permissible method been used. This could create a ‘whip-saw’ situation, since taxpayers would be required to pick up additional gain as if the ‘allowable’ depreciation deductions were claimed but would have never actually received the benefit of those deductions.
That’s why the rules create a trap for the unwary.
Taxpayers that placed QIP in service in 2018 or 2019, did not elect out of bonus depreciation and do not file a 3115, amended return or AAR for such years to either claim bonus depreciation or elect out of bonus depreciation and claim additional depreciation deductions using a shorter depreciable life, will permanently lose the benefit of all future deductions with respect to such QIP.
Action required by taxpayers with QIP placed in service in 2018 or 2019
To avoid this trap, taxpayers with QIP placed in service in 2018 or 2019, who did not specifically elect out of bonus depreciation and/or used a 39-year life for that QIP should take one of the following actions:
- File a 3115, amended return or AAR for the affected years to claim bonus depreciation on all QIP placed in service during such years.
- File a 3115, amended return or AAR for the affected years to elect out of bonus depreciation for the 15-year asset class and claim additional depreciation deductions using a 15-year life, rather than a 39-year life.
Each taxpayer’s unique situation will dictate the best option. Some of the options are limited by time constraints as well. Contact Wipfli to learn more.
Brianna Komppa is a senior manager for taxes with Milwaukee-based Wipfli. She works with real estate developers, construction contractors and community banks. She not only provides basic tax compliance services for clients, such as return preparation and deferred tax calculations, but also is involved with tax planning, research, and transactional consulting services.