The Internal Revenue Service released Rev. Proc. 2020-25 to provide guidance on how taxpayers may change their depreciation for taxable years ending in 2018 through 2020 to take advantage of the CARES Act amendments related to qualified improvement property. Taxpayers should carefully consider which of the available options is most advantageous, and should use that option prior to October 15, 2021.
Under the Tax Cuts and Jobs Act of 2017 (TCJA), qualified improvement property (QIP) was unintentionally classified as nonresidential real property and therefore did not qualify for bonus depreciation. The Coronavirus Aid, Relief, and Economic Security (CARES) Act fixed that error (referred to as the “retail glitch”) by including QIP within the scope of property depreciable over 15 years and thereby making QIP eligible for bonus depreciation retroactive to 2017. The Internal Revenue Service (IRS) issued Rev. Proc. 2020-25 on April 17, 2020, to provide guidance on how taxpayers may change their depreciation for taxable years ending in 2018 through 2020 in order to take advantage of the fix to the retail glitch.
The guidance permits taxpayers to recognize the impact of the CARES Act changes by filing amended returns for those years consistent with Rev. Proc. 2020-23, filing administrative adjustment requests (AARs), or filing a Form 3115 to take the changes into effect through an IRC 481(a) adjustment. Regardless of which method is chosen, the adoption of the changes introduced by the CARES Act is to be treated as though the taxpayer were changing from an impermissible method of accounting to a permissible method of accounting.
Background: The Retail Glitch and the CARES Act Fix
QIP consists of improvements to an interior portion of a building. When the TCJA added the definition of QIP to section 168(e) of the Internal Revenue Code (IRC), Congress had intended to provide a 15-year recovery for such property, but language to this effect was inadvertently omitted from the statute. As a result of this glitch, the IRS took the position that such property is recoverable over 39 years, rather than the intended 15 years. If treated as 39-year property, QIP would not be eligible for the additional first year depreciation deduction (bonus depreciation) under section 168(k), because such property would not have a modified accelerated cost recovery system recovery period of 20 years or less. See IRC section 168(k)(2)(A)(i)(I).
Section 2307 of the CARES Act fixed the retail glitch by amending the definition of “15-year property” within IRC section 168(e) to include QIP. As a technical correction, Congress made this change retroactively effective to tax years beginning after December 31, 2017.
As a result, QIP subject to the general depreciation system provided for under IRC section 168(a) is depreciated according to the straight-line method of depreciation, a 15-year recovery period, and is subject to the half-year or mid-quarter convention. QIP subject to the alternative depreciation system under IRC 168(g) is also subject to the straight-line method of depreciation and the half-year or mid-quarter convention, but is subject to a 20-year rather than a 15-year recovery period.
In addition, QIP is now retroactively eligible for bonus depreciation. Specifically, QIP that was acquired by a taxpayer after September 27, 2017; placed in service by the taxpayer after December 31, 2017; and meets all the requirements under the currently enacted IRC section 168(k) and Treasury Regulation section 1.168(k)-2 is eligible for the additional first year depreciation deduction under IRC section 168(k), as amended by the TCJA.
Also, QIP (as defined in IRC section 168(k)(3) as it was in effect prior to amendment by the TCJA) that was acquired by a taxpayer before September 28, 2017; placed in service by the taxpayer after December 31, 2017; and meets all the requirements under IRC section 168(k) as it was written prior to amendment by the TCJA is now eligible for the additional first year depreciation deduction under IRC section 168(k) as it was in effect prior to amendment by the TCJA.
Rev. Proc. 2020-25: How to Benefit from the Fix
On April 17, 2020, the IRS issued Rev. Proc. 2020-25 to address how taxpayers may take advantage of the retail glitch fix for their taxable years ending in 2018 through 2020. Generally, Rev. Proc. 2020-25 applies to QIP placed in service by taxpayers after December 31, 2017, in the taxpayer’s 2018, 2019 or 2020 taxable year. However, the following types of QIP are excluded from the scope of Rev. Proc. 2020-25:
QIP placed in service after December 31, 2017, by a taxpayer that made a late election or withdrew an election under IRC section 163(j)(7)(B) (electing real property trade or business) or IRC section 163(j)(7)(C) (electing farming business) for the taxable year in which the QIP is placed in service, in accordance with Rev. Proc. 2020-22. Any changes to depreciation for such QIP or other depreciable property affected by the late or withdrawn election under IRC sections 163(j)(7)(B) or 163(j)(7)(C) are made in accordance with sections 4.02 and 4.03, or 5.02, of Rev. Proc. 2020-22, as applicable.
QIP for which the taxpayer deducted or deducts the cost or other basis of such property as an expense.
Rev. Proc. 2020-25 provides that taxpayers changing the depreciation of their QIP for their taxable years 2018 through 2020 can do so by filing for an automatic accounting method change (from an impermissible method of accounting to a permissible method) consistent with the automatic change procedures in Rev. Proc. 2015-13 or by filing an amended return (or, for an electing partnership, an AAR) to correct the depreciation method. For this purpose, an impermissible method of accounting for QIP is using a recovery period other than 15 years or failing to claim bonus depreciation in the year the property was placed in service.
Rev. Proc. 2020-25 also generally allows a taxpayer to make a late election, or to revoke or withdraw an election, under IRC sections 168(g)(7) (allowing a taxpayer to elect depreciation under the alternative depreciation system), (k)(5) (relating to special rules for depreciation of certain plants bearing fruits or nuts), (k)(7) (providing an election out of first year bonus depreciation), or (k)(10) (allowing a taxpayer to elect to deduct 50% instead of 100% bonus depreciation) for the taxpayer’s 2018, 2019 or 2020 taxable years, by filing a Form 3115, an amended income tax return or an AAR.
Per Rev. Proc. 2020-25, the following options may be filed to effect a change in the depreciation method or the amount of depreciation claimed, to effect a late election, or to revoke or withdraw an election:
Amended Return. An amended federal income tax return or amended Form 1065, “U.S. Return of Partnership Income,” may be filed for the placed-in-service year of the property on or before October 15, 2021, except as provided in Rev. Proc. 2020-23, but not later than the applicable period of limitations on assessment for the tax year for which the amended return is being filed. As discussed in our prior article, by issuing Rev. Proc. 2020-23, the IRS provided relief for partnerships subject to the Centralized Partnership Audit Regime provided for in the Bipartisan Budget Act of 2015 by permitting those partnerships the option to file amended Forms 1065 and amended Schedules K-1, in lieu of an AAR, for taxable years beginning in 2018 and 2019, in order to allow those partnerships to recognize immediate benefits from the amendments introduced by the CARES Act. Per Rev. Proc. 2020-23, amended tax returns for taxable years beginning in 2018 and 2019 must be filed no later than September 30, 2020. Thus, for partnerships seeking to benefit from the amendments to the treatment of QIP for taxable years beginning in 2018 and 2019, amended returns must be filed by September 30, 2020, instead of October 15, 2021.
AAR. Partnerships may file an AAR as an alternative to filing an amended return or for years for which an amended return cannot be filed because the placed-in-service year of the property is a taxable year that is not within the scope of Rev. Proc. 2020-23 (which only permits extensions for filing amended returns for taxable years beginning in 2018 and 2019). Under the AAR procedures, however, an adjustment to a prior year’s taxable income (the reviewed year) that reduced taxable income would be “pushed out” to the reviewed year partners. Each reviewed year partner would then claim a refund equal to the decrease in the partner’s chapter 1 tax as though the AAR adjustment had been claimed on the partner’s original return for the reviewed year. This decrease in tax would be taken into account as a reduction in the partner’s tax liability for the year in which the AAR is filed (i.e., the reporting year), akin to a non-refundable credit. As discussed in our prior article, the AAR procedures raise issues in terms of delaying the recognition of benefits from the CARES Act amendments to at least 2021, and potentially resulting in a taxpayer having insufficient 2020 taxable income to utilize the resulting credit.
Form 3115. Taxpayers may generally file a Form 3115 with the taxpayer’s timely filed original federal income tax return or Form 1065 for the taxpayer’s first or second tax year succeeding the tax year in which the taxpayer placed the property in service, or that is filed on or after April 17, 2020, and on or before October 15, 2021. Accordingly, for a taxpayer’s taxable year 2018, a taxpayer has until October 15, 2021, to decide whether to amend the 2018 return or to instead file Form 3115 to effect a §481(a) adjustment in 2019.
Making a late election under any of IRC sections 168(g)(7), (k)(5), (k)(7) or (k)(10) or revoking an election under any of IRC sections 168(k)(5), (k)(7) or (k)(10) on or after April 17, 2020, and on or before October 15, 2021, will be treated as a change in method of accounting consistent with IRC sections 446(e) and 481 and their corresponding regulations. A taxpayer that wishes to make a late election or revoke an election must use the automatic change procedures in Rev. Proc. 2015-13 or its successor.
Where a taxpayer makes an IRC section 168(g)(7) election on its timely filed original federal income tax return or Form 1065 for the placed-in-service year of such depreciable property, and such return was filed on or before April 17, 2020, then, if the taxpayer decides to withdraw that election, the taxpayer will be treated as if the election was never made for all property included in the class of property and placed in service during the same taxable year. If instead the taxpayer withdraws such an IRC section 168(g)(7) election made for an item of nonresidential real property or residential rental property, the taxpayer will be treated as if the election was not made for that specific item of nonresidential real property or residential rental property.
Practice Point: By issuing Rev. Proc. 2020-25, the IRS created multiple opportunities for taxpayers to recognize the benefit of the amendments enacted by the CARES Act with respect to QIP. Taxpayers should carefully consider which of the options available to them—filing an amended return, filing an AAR or filing a Form 3115—is most advantageous, and should utilize that option prior to October 15, 2021.