Common depreciation missteps and misconceptions: Qualified leasehold improvements
In previous articles, I’ve explored some of the most common misconceptions in depreciation law. For the most part, the content has focused on prospective issues. I think it’s important to also cover qualified leasehold improvements, or QLI.
As many professionals know, QLI was superseded by qualified improvement property (QIP) under the new tax law. However, to understand the new changes, it is important to understand how QLI worked prior to Jan. 1, 2018.
Prior to the new 2017 Tax Cuts and Jobs Act, taxpayers often took advantage of QLI. This treatment allowed qualified real property to be eligible for 15-year depreciation with additionally qualifying assets subject to bonus depreciation.
Qualifying assets were defined as nonstructural improvements to the interior of a building that met certain lease requirements, including that the improvements were subject to a lease between unrelated entities, to leased space and to the interior of a building older than three years.
Under these requirements, certain improvements did not qualify, including any improvements to a property in which the landlord and tenant were related parties. Using QLI for related-party leases was a common mistake we used to see. Similarly, improvements made to a property within three years of the property’s completion were not eligible for QLI, though my colleagues and I at McGuire Sponsel saw this error too many times. Finally, we would often see HVAC systems, roofs and other structural or exterior improvements included in QLI, another improper designation.
The good news is that under the Tax Cuts and Jobs Act, QLI is superseded by QIP.
QIP still requires that assets be in the interior of a building and be nonstructural in nature. However, under the new regulations, QIP does not require a lease between unrelated entities. Even better, the definition of QIP simply states that qualifying improvements must be done “after the building is originally placed in service,” eliminating the three-year requirement.
There is still a great a deal of confusion over the handling of QIP, much of which must be clarified by Congress. For instance, under the new tax law, QIP was supposed to be provided a 15-year life, similar to previous rules for QLI. This 15-year life would have made these assets eligible for bonus depreciation. Unfortunately, due to errors made in the rush to draft the new tax law, QIP is considered 39-year property, eligible for 179 treatment but not bonus depreciation. A technical correction to the tax law is expected, but legislators have been slow to push this forward.
What will not change under a technical correction is the requirement that both QLI and QIP must be within the interior of a building. This means that HVAC systems on the roof, roof work, façade work and other exterior improvements do not qualify. Additionally, both definitions require that structural improvements, escalators and elevators are excluded. And both require that assets be separated out prior to treatment as either QLI or QIP.
With all the confusion surrounding this and other depreciation questions under the new law, it is important to engage qualified advisors.