QLI & QRI Extension - Great News for Taxpayers

Written by Steven D. Beaucaire, MST
Vice President, Tax - Bedford Capital Consulting

Great news! Qualified Leasehold Improvements (QLIs) and Qualified Restaurant Improvements (QRIs) are back. The Tax Relief and Health Care Act of 2006 retroactively extended the deadline for this special treatment from December 31, 2005 to December 31, 2007. This provision allows taxpayers to depreciate "qualifying" improvements using a 15-year straight line recovery period instead of the standard 39-year period, which can provide significant value by way of improved cash flow.

Impact of Allocating to 15-Year $100,000 allocated to 15- year SL vs. 39-Year SL 10-year NPV savings = $11,939 40-year NPV savings = $10,845 NPV Calculated using a 40% tax rate and 6% discount rate.

QLIs were originally introduced as part of the Job Creation and Worker Assistance Act of 2002. This Act established favorable depreciation provisions for qualifying improvements. Although the specific treatment (discussed below) has since been modified, the definition of qualified improvement has remained the same.

Generally, a QLI is any improvement to an interior portion of a building that is nonresidential real property, provided all of the following requirements are met.

1.The improvement is made under or pursuant to a lease by the lessee
(or any sublessee) or the lessor of that part of the building. Note
that a binding commitment between related persons is not treated
as a lease.
2.The part of the building is to be occupied exclusively by the lessee
(or any sublessee) of that part.
3.The improvement is placed in service more than 3 years after the
date the building was first placed in service. Note that this is
referring to when the building was first placed in service,
not when the current owner purchased the building.

However, a QLI does not include any improvement for which the expenditure is attributable to any of the following:

1.The enlargement of the building.
2.Any elevator or escalator.
3.Any structural component benefiting a common area.
4.The internal structural framework of the building.

When first introduced by the 2002 Act QLIs were handled the same way as costs that were eligible for bonus depreciation, with the remaining balance depreciated over 39-year. This applied to improvements placed in service between September 11, 2001 and December 31, 2004. The 2002 Act was modified by the American Jobs Creation Act of 2004, which also introduced QRIs for the first time (discussed below). The 2004 Act stated that QLIs placed in service between October 22, 2004 and December 31, 2005 should be depreciated using a 15-year straight line recovery period. Although this was not as beneficial as the previous allowance of using bonus depreciation, it was far better than the usual 39-year recovery period.

QRIs, as mentioned above, were first introduced by the American Jobs Creation Act of 2004. This Act established the same depreciation benefits and deadlines for QRIs as it did for QLIs. QRIs placed in service between October 22, 2004 and December 31, 2005 should be depreciated using a 15-year straight line recovery period. The difference was in the definition of qualified improvement.

A QRI, also referred to as qualified restaurant property, is any section 1250 property that is an improvement to a building and meets the following requirements:

1. The improvement is placed in service more than 3 years after
the date the building was first placed in service. Again, please
note that this is referring to when the building was first placed
in service, not when the current owner purchased the building, and
2. More than 50% of the building's square footage is devoted to
preparation of meals and seating for on-premise consumption of
prepared meals.

The four limitations listed above also apply to QRIs. A QRI does not include any improvement for which the expenditure is attributable to any of the following:

1. The enlargement of the building.
2. Any elevator or escalator.
3. Any structural framework of the building.
4. The internal structural framework of the building.

Bringing things up to date, the recently passed Tax Relief and Health Care Act of 2006 has retroactively extended the deadline set by the 2004 Act from December 31, 2005 to December 31, 2007. Therefore any QLIs and QRIs placed in service between October 22, 2004 and December 31, 2007 should be depreciated using a 15-year straight line recovery period.

More good news! Taxpayers who initially overlooked this opportunity, but otherwise would have qualified can still take advantage of the special treatment. By doing a look-back study taxpayers can get bonus depreciation for qualifying improvements after September 11, 2001 and before December 31, 2004. That is, as long as they did not specifically "elect out" of bonus depreciation on their tax return. A look-back study can also be done for qualifying improvements added after December 31, 2004 where the 15-year straight line recovery period should have been applied. Note that the "elect out" rules do not pertain in this situation.

The best way to identify QLIs and QRIs is with a cost segregation study. In addition to identifying the costs that are eligible for the special 15-year treatment a quality cost seg study will also identify all costs that can be allocated to 5 and/or 7-year recovery periods.