HVAC Units Installed Outside Of or On A Building Aren’t Qualified Leasehold Improvement Property

Posted on 03.18.13

HVAC Units Installed Outside Of or On A Building Aren’t Qualified Leasehold Improvement Property

Note: This article was originally published on March 18, 2013 and may have changed due to more recent changes to PATH for depreciation. 


In Chief Counsel Advice (CCA), IRS has concluded that heating, ventilation, and air-conditioning (HVAC) units installed outside of a building, or on its roof, are ineligible to be treated as qualified leasehold improvement property (QLIP) and thus can't be depreciated over 15 years, and aren't eligible for bonus depreciation. The units would have had to be installed to the interior portion of a building to be QLIP.


Background. Under the generally applicable modified accelerated cost recovery system (MACRS) rules, nonresidential real property is written off over 39 years using the straight-line method of depreciation. (Code Sec. 168(b)(3)(A), Code Sec. 168(c) ) However, under the exception in Code Sec. 168(e)(3)(E)(iv), QLIP is depreciated as 15-year property using the straight-line method.

QLIP is one of the types of property eligible for bonus depreciation under Code Sec. 168(k), and, in general, QLIP for 15-year writeoff purposes is defined the same way as it is for bonus depreciation purposes under Code Sec. 168(k)(3). However, under Code Sec. 168(e)(6), an improvement made by the person that was the lessor of the improvement when it was placed in service is QLIP only so long as the improvement is held by that person (a number of exceptions apply, such as for a mere change in business form).

Under Code Sec. 168(k)(3)(3), QLIP means any improvement to an interior portion of a building which is nonresidential real property if:

  1. The improvement is made under or pursuant to a lease by the lessee (or sublessee), or by the lessor, of that portion;
  2. That portion is to be occupied exclusively by the lessee (or any sublessee) of the portion; and
  3. The improvement is placed in service more than three years after the date the building was first placed in service.

QLIP does not include any improvement for which the expense is attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building.


RIA observation: The American Taxpayer Relief Act of 2012 (2012 Taxpayer Relief Act, P.L. 112-240) extended through 2013 the rule treating QLIP as 15-year property, and also extended the bonus 50% first-year depreciation deduction so that it applies for qualifying property acquired and placed in service before Jan. 1, 2014 (before Jan. 1, 2015 for certain long-production-period property and transportation property). See Weekly Alert 30 01/10/2013.

Reg. § 1.168(k)-1(c), explains the statutory QLIP requirements in more detail, but neither the regs, Code, or the legislative history explain a central QLIP requirement, namely that the improvement be made “to an interior portion” of a building.

Facts: Under a lease agreement with an independent third-party lessor, Lessee bears responsibility for improvements to the leased space. The leased premises are a large, stand-alone commercial building used for retail sales. Lessee has replaced several of the HVAC units: some are located on the roof of the building; and some are located on concrete slabs adjacent to the building. The replacement HVAC units serve the leased space which is exclusively occupied by Lessee.

Except for their location, ie., outside the leased premises, the HVAC unit replacements meet the QLIP requirements.

Quick writeoff denied. In the CCA, IRS says a plain reading of the Code is sufficient to determine what is meant by the term “interior portion” of a building. The use of the word “interior” in Code Sec. 168(e)(6), is clear and unambiguous. Based on the plain reading of the word “interior,” Code Sec. 168(e)(6) requires that a qualifying improvement be made to the inside or inner portion of the building.

The CCA adds that while the replacement HVAC units installed on the roof of the building and on concrete slabs adjacent to the building are structural components of the building, these improvements are to the exterior of the building and not to the interior portion of the building. Since the improvements are not to an interior portion of a building, they're not treated as QLIP.

RIA observation: The CCA's conclusion is a double hit to Lessee, because the replacement HVAC units won't qualify for bonus first-year depreciation or cost recovery as 15-year property. Instead, the units will have to written off over 39 years using straight line.

RIA observation: Qualified restaurant property is 15-year property under Code Sec. 168(e)(3)(E)(v), which was extended through 2013 by the 2012 Taxpayer Relief Act. Had the replacement HVAC units been installed outside or on the roof of such property, it might have qualified for a 15-year writeoff, because under Code Sec. 168(e)(7)(A), qualified restaurant property is any Code Sec. 1250 property which is a building or an improvement to a building, if more than 50% of the building's square footage is devoted to preparation of, and seating for on-premises consumption of, prepared meals. There is no requirement that the property be an improvement to the interior of a building. Note, however, that qualified restaurant property is not eligible for bonus depreciation unless it also qualifies as QLIP (see Weekly Alert 3 01/26/2012).

RIA observation: Qualified retail improvement property is 15-year property under Code Sec. 168(e)(3)(E)(ix), which also was extended through 2013 by the 2012 Taxpayer Relief Act. Had the replacement HVAC units been installed outside or on the roof of such property, it wouldn't have qualified for a 15-year writeoff under the CCA, since under Code Sec. 168(e)(8), qualified retail improvement property must, among other conditions, be an improvement to an interior portion of a building which is nonresidential real property.

References: For assets included in 15-year MACRS class property, see FTC 2d/FIN L-8208; United States Tax Reporter 1684.02; TaxDesk 266,208; TG 14103.

Source: Chief Counsel Advice / Internal Revenue Service