As accounting professionals navigate the transition between ASC 840 and ASC 842, Leases, and consider the changes implemented in the Tax Cut and Jobs Act (TCJA) of 2017 and the Coronavirus Aid, Relief and Economic Security Act (CARES Act) enacted in March 2020, questions regarding the definitions of lease-related terms and proper accounting application are in no short supply. A common question among entities who are installing leasehold improvements is “What is Qualified Leasehold Improvement Property?”
Qualified Improvement Property (QIP) is a term found in the Internal Revenue Code, Section 168, and encompasses any improvements made to the interior of a commercial real property. Improvements must be placed into service after the building’s date of service and explicitly exclude expansion of the building, elevators and escalators, and changes made to a building’s internal structural framework. QIP replaces several categories of improvements detailed in tax regulations prior to the TCJA, including Qualified Leasehold Improvement Property. Any property that is subject to the rules of QIP and is leased by a single tenant now falls under the rules for QIP for tax accounting purposes.
The new rules under the CARES Act modify the depreciable life of assets falling under this category from 39 years to 15 years, which makes QIP eligible for bonus depreciation and offers taxpayers significant tax-reduction opportunities.
This bonus depreciation may be retroactively applied for those entities who placed qualified improvement property into service in the 2018 and 2019 taxable years and may create losses, which could result in tax refunds.
The depreciation for nonresidential real property, residential real property, and qualified improvement property is calculated using the straight-line method under the rules of accounting for both tax and generally accepted accounting principles (GAAP). If an improvement qualifies under the rules of QIP, an entity must depreciate it over the 15-year prescribed recovery period for tax purposes. If the entity uses any other depreciable life, the IRS could consider that an alternative depreciation system was elected which would make the improvement subject to using a 39-year recovery period. This would also put any other properties eligible for the 15-year recovery period, and that were placed into service the same tax year, at risk for reclassification to longer periods.
For GAAP accounting, amortization of leasehold improvements is the same under both ASC 840 and ASC 842. If the improvements meet or exceed the entity’s capitalization threshold amount, the asset would be capitalized and amortized over the lesser of the useful life of the improvement based on management’s estimates or the remaining term of the lease.
The addition of significant leasehold improvements can affect the term of the lease if, when the option to extend or terminate the lease becomes exercisable, it makes the exercise of a renewal option reasonably certain to be executed. GAAP requires that, if a renewal option becomes reasonably certain to be exercised, the term of the lease should be reassessed. The assets would then be subject to amortization over the new remaining life of the lease term. Other factors which could affect the assurance of the exercise of a renewal option are penalties in the contract for termination and optional bargain buyouts after the next lease period. The addition of a leasehold improvement could make any penalty economically detrimental for the lessee to incur because of the increased value the improvement provides. It could also make the buyout at the end of the lease more attractive since the leased property is already customized for the entity’s business purposes.
Overall, the changes made to the classification and treatment of qualified leasehold improvement property in recent tax law have simplified application and provided financial benefits for both lessees and lessors in the form of bonus depreciation over a shorter recovery period and potential tax refunds.
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