History

Since its inception in 2001, many taxpayers have used the Qualified Leasehold Improvements (QLI) designation as an effective tax planning strategy to help accelerate depreciation and recover the cost of certain improvements over a shorter period of time. For improvements that qualify, the recovery period is reduced from 39 years to 15 years. The improvement is also eligible for Bonus Depreciation and Section 179 expensing in the year placed in service. As beneficial as the QLI designation has been to many taxpayers, its application has been limited as a result of two significant requirements:

1. The nonresidential real property, for which the improvement is made must be placed in service at least three years prior to the improvement
2. The improvement must be made pursuant to a lease between non-related parties

For improvements that do not qualify as QLI, the recovery period remains 39 years and the improvement is ineligible for additional accelerated depreciation in the year placed in service.

With the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 came the modification to three existing "Qualified Properties" and the addition of an entirely new Qualified Property for tax years beginning Jan. 1, 2016 and onward. These changes now provide taxpayers with an additional incentive in making certain improvements to nonresidential real property, where previously the improvements may not have qualified for one of the three “Qualified Property” designations. Most notably is the addition of the Qualified Improvement Property (QIP) designation.

QIP has similar requirements as QLI as to the type of improvement being made; however this new designation does not require that the nonresidential real property for which the improvement is made be placed in service at least three years prior to the improvement, nor that the improvement be made pursuant to a lease between non-related parties. Although the recovery period for QIP’s remains at 39 years, QIP’s are eligible for Bonus Depreciation in the year placed in service. This is significant, as Bonus Depreciation is set to 50 percent through the end of 2017, and scheduled to phase-out to 40 percent in 2018 and 30 percent in 2019.

Qualified Property Designations:

• Qualified Leasehold Improvements (QLI) - Effective since Sept. 11, 2001, any improvement to an interior portion of a building that is nonresidential real property, where the building was placed in service at least three years prior to the improvement, and such improvement is made pursuant to a lease between non-related parties. QLI specifically excludes expenditures for:

1. The enlargement of a building
2. Elevators or escalators, or
3. The internal structural framework of a building

• Qualified Retail Improvement Property (QRIP) - Effective since Jan. 1, 2009, any improvement to an interior portion of a building that is nonresidential real property, where the building was placed in service at least three years prior to the improvement, and such portion is open to the general public and is used in the retail trade or business of selling tangible personal property to the general public. QRIP specifically excludes expenditures for:

1. The enlargement of a building
2. Elevators or escalators, or
3. The internal structural framework of a building

• Qualified Restaurant Property (QRP) - Effective since Oct. 23, 2004, a building (new construction or existing structure) or improvement to a building (interior or exterior) where more than 50 percent of the building’s square footage is devoted to preparation of and seating for on-premises consumption of prepared meals.
• Qualified Improvement Property (QIP) - New designation effective Jan. 1, 2016, any improvement to an interior portion of a building that is nonresidential real property, where the improvement is placed in service after the date such building was first placed in. QIP specifically excludes expenditures for:

1. The enlargement of a building
2. Elevators or escalators, or
3. The internal structural framework of a building

The 2015 PATH Act permanently restored Section 179 expensing. The Section 179 limit for tax years beginning Jan. 1, 2016 is $500,000 and will be adjusted for inflation going forward. The 2015 PATH Act also extended Bonus Depreciation through 2019 with the following phase-outs:

• 50 percent Bonus Depreciation through the end of 2017
• 40 percent in 2018
• 30 percent in 2019

Qualified Property Treatment Following 2015 PATH Act (tax years beginning Jan. 1, 2016 and onward):

• QLI - The 2015 PATH Act made permanent the recovery period of 15 years straight-life for QLI. QLI's are eligible for both Section 179 and Bonus Depreciation.
• QRIP - The 2015 PATH Act made permanent the recovery period of 15 years straight-life for QRIP. QRIP's are eligible for both Section 179 and Bonus Depreciation.
• QRP - The 2015 PATH Act made permanent the recovery period of 15 years straight-life for QRP. QRP's are eligible for Section 179. QRP's are only eligible for Bonus Depreciation if they also meet the criteria of either QLI or QIP.
• QIP - The 2015 PATH Act created this new designation with a recovery period of 39 years straight-life. QIP's are eligible for Bonus Depreciation. QIP's are only eligible for Section 179 if the improvement also meets the criteria of either QLI, QRIP, or QRP.

Example

The following example will help to demonstrate the effectiveness of the new QIP designation: On Jan. 3, 2016, Corporation X made a non-structural interior improvement of $100,000 to its corporate headquarters located in Los Angeles, CA. The improvement did not enlarge the building and was not an expenditure relating to an elevator or escalator system. The building was newly constructed in 2014, and Corporation X leases the space from a related party.

Before PATH Act: $2,461 of tax depreciation allowed on Corporation X’s 2016 income tax return. The

improvement will be depreciated over 39 years at approximately $2,500 per year through 2055.

Analysis: Although the improvement itself meets the core requirements for a qualified improvement, since the improvement was made pursuant to a lease between related parties and the building was not placed in service for at least three years prior to the improvement, this improvement does not qualify as a QLI. As such, the recovery period remains 39 years, and no accelerated depreciation is allowed in the year placed in service.

After PATH Act: $51,231 of tax depreciation allowed on Corporation X’s 2016 income tax return. 50-percent Bonus Depreciation is allowed in the year placed in service with the remaining basis depreciated over 39 years at approximately $1,250 per year through 2055.

Analysis: The improvement does not meet the requirements of QLI, and therefore is not permitted a reduced recovery period from 39 years to 15 years. However, this improvement does qualify as a QIP and is eligible for 50-percent Bonus Depreciation in the year placed in service. This improvement qualifies as a QIP, as there are no unrelated party or three-year placed-in-service rules for QIP’s.

Summary

The 2015 PATH Act has created many tax planning opportunities going forward by making permanent Section 179 expensing and by extending Bonus Depreciation through 2019. Also, with the addition of the QIP designation, the 2015 PATH Act has broadened the base on what improvements are eligible for Bonus Depreciation. This has significantly increased the likelihood of accelerated depreciation on what would otherwise have a recovery period of 39 years. Unlike QLI's and QRIP's that require the property be placed in service for at least three years for the improvement to qualify for accelerated depreciation, QIP's have no such requirement for Bonus Depreciation. Furthermore, QIP's have no restriction on related party leases, like the restriction placed on QLI's. Lastly, with the addition of QIP's, QRP's that also meet the criteria of QIP are now eligible for Bonus Depreciation.

If you have any questions about the changes outlined in the PATH Act and how they can be used as effective tax planning strategies going forward, please contact me or your GHJ advisor at 310-873-1600.

IRC §168(e)(6).

IRC §168(e)(8).

IRC §168(e)(7).

IRC §168(k)(3).