Understanding the tax implications of property improvements is crucial for small business owners and real estate investors. One significant area to consider is Qualified Improvement Property (QIP) and its eligibility for bonus depreciation. Additionally, it’s essential to understand the rules surrounding leasehold improvements, especially when dealing with related parties.
What Is Qualified Improvement Property (QIP)?
QIP refers to any improvement made by the taxpayer to the interior portion of a nonresidential building after the building was first placed in service. However, it excludes expenditures related to:
- Enlarging the building
- Installing elevators or escalators
- Modifying the internal structural framework
It’s important to note that improvements to residential rental properties do not qualify as QIP. Additionally, if you acquire a building, you cannot treat existing enhancements made by the previous owner as QIP for your tax purposes.
Depreciation Life of Leasehold Improvements
Leasehold improvements are structural modifications or enhancements made to rental space to meet the needs of a tenant. The depreciation life of these improvements depends on their classification:
- Qualified Leasehold Improvements (QLI): Before 2018, QLI had a 15-year recovery period. However, the Tax Cuts and Jobs Act (TCJA) of 2017 eliminated the QLI category, consolidating it into QIP.
- Qualified Improvement Property (QIP): Under the TCJA, QIP was intended to have a 15-year recovery period, making it eligible for bonus depreciation. Due to a drafting error, QIP was initially assigned a 39-year recovery period. The CARES Act of 2020 corrected this, retroactively assigning a 15-year recovery period to QIP placed in service after December 31, 2017, and making it eligible for bonus depreciation.
Bonus Depreciation for QIP
Bonus depreciation allows businesses to deduct a significant portion of the cost of eligible property in the year it’s placed in service. For QIP:
- Eligibility: QIP placed in service after December 31, 2017, is eligible for bonus depreciation.
- Phase-Out Schedule: The 100% bonus depreciation rate began to phase out starting in 2023, decreasing by 20% each year:
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027 and beyond: 0%
This phase-out schedule means that the bonus depreciation benefit for QIP diminishes over time.
Leasehold Improvements and Related Parties
When leasehold improvements involve related parties (e.g., a business owner leasing property to their own company), specific rules apply:
- Ownership and Depreciation: The party that pays for the improvements typically capitalizes and depreciates them over the appropriate recovery period. It’s crucial to establish clear ownership and responsibility for the improvements in the lease agreement.
- Related-Party Leases: The TCJA’s consolidation of QLI into QIP removed the previous requirement that improvements be made under a lease between unrelated parties. Therefore, QIP can include improvements made under related-party leases, provided other qualifying criteria are met.
Key Takeaways
- Classification Matters: Properly classify improvements as QIP to benefit from favorable depreciation rules.
- Stay Informed: Tax laws evolve; staying updated ensures compliance and maximizes tax benefits.
- Consult Professionals: Given the complexities, consulting with tax professionals is advisable to navigate the specifics of QIP, bonus depreciation, and related-party leasehold improvements.
By understanding and applying these rules, small business owners and real estate investors can make informed decisions that optimize their tax positions.