Interim rules address special depreciation for Section 168(n) QPP

Proposed guidance

The guidance provided in Notice 2026-16 generally aligns with the statutory requirements of Section 168(n) and addresses several key aspects, including:

• Definition of QPP, including rules for determining eligible and ineligible property
• Definition of QPA and other relevant terms
• Basis allocation rules
• Procedures for making a QPP election
• The 10-year depreciation recapture rule

In addition, the notice generally provides that special rules for a) property placed in service and disposed of in the same taxable year, b) redetermination of basis and c) like-kind exchanges and involuntary conversions are consistent with rules under the bonus depreciation rules in Treas. Reg. §1.168(k)-2.

Qualified production property

Section 4 of the notice generally provides that QPP is nonresidential real property that is MACRS property placed in service in the U.S. or any U.S. territory and satisfies the following four requirements:

1. Integral part requirement: Property satisfies this requirement if a QPA is conducted in, or takes place within, the physical space of such property. If a QPA is conducted in only a portion of the property, only such portion satisfies this requirement.
2. Original use requirement: The original use of the property commences with the taxpayer.
3. Beginning of construction requirement: Construction must begin after Jan. 19, 2025, and before Jan. 1, 2029.
4. Placed-in-service-date requirement – The property is placed in service after July 4, 2025, and before Jan. 1, 2031. A special rule provides an automatic one-year extension for any property located in a disaster area at any time during 2030.

Much of the interim guidance that is relevant for evaluating these requirements incorporates rules from existing regulations. For example:

• Rules for determining a unit of property are based on the MACRS disposition rules in Treas. Reg. §1.168(i)-8(c)(4), which generally provide that each building, including its structural components, is a single unit of property, and that an improvement or addition to an asset after it is placed in service is treated as a separate unit of property.
• Taxpayers determine whether the original use requirement and the beginning of construction requirement are satisfied by applying rules consistent with the bonus depreciation rules in Treas. Reg. §§1.168(k)-2(b)(3) and (b)(5), which includes the 10% safe harbor to determine when construction of self-constructed property begins.

A special rule applies for determining whether the original use and the beginning of construction requirements are satisfied for certain acquired property. Under this rule, the property must be acquired by a taxpayer after Jan. 19, 2025, and before Jan. 1, 2029.

Additionally, the property must not have been used by the taxpayer at any time prior to the acquisition and may not have been used in a QPA by any person during the period beginning Jan. 1, 2021, and ending on May 12, 2025. Taxpayers should apply rules consistent with Treas. Reg. §§1.168(k)-2 and 1.1502-68 to evaluate whether property satisfies the acquisition date test and prior use test for this special rule.

Determining eligible property

In general, each unit of property must separately satisfy the integral part requirement. However, the notice provides both a de minimis rule and a special rule for integrated facilities for purposes of evaluating this requirement.

• De minimis rule: If 95% or more of the physical space of a property satisfies the integral part requirement when the property is placed in service, taxpayers may elect to treat the entire property as meeting the requirement.
• Integrated facilities rule: Multiple properties that operate as an integrated facility and are physically located or co-located on the same piece or contiguous pieces of land may be treated as a single unit of property for purposes of the integral part requirement. Aligning with the statute, the notice provides that any portion of property used for offices, administrative services, lodging, parking, research, software development, engineering or sales functions is ineligible for the special QPP deduction. In addition, subject to certain exceptions for consolidated groups and commonly controlled pass-through entities (e.g., partnerships or S corporations), leased property does not meet the integral part requirement, even if the lessee performs a QPA.

Qualified production activities

Notice 2026-16 provides much-anticipated guidance regarding activities that are QPAs. A QPA is the manufacturing, production, or refining of a qualified product that results in a substantial transformation of the property comprising the qualified product. 

Substantial transformation of a qualified product

In general, substantial transformation of the property comprising a qualified product occurs upon the further manufacturing, production, or refining of the constituent elements, raw materials, inputs or subcomponents into a final, complete and distinct item of property that is fundamentally different from the original inputs. The notice provides examples of this substantial transformation requirement, such as the conversion of wood pulp to paper and steel rods to screws and bolts. In contrast, activities that do not result in a substantial transformation include grouping and packaging multiple finished goods (e.g., gift baskets). 

As provided in the statute, a qualified product is tangible personal property but excludes food or beverage prepared in the same building as a retail establishment in which the property is sold (e.g., a restaurant). The notice further provides that tangible personal property has the same meaning as it does for purposes of the investment tax credit in Treas. Reg. §1.48-1(c), under which tangible personal property includes any tangible property except land, buildings, or other inherently permanent structures, as well as all property (other than structural components) contained in or attached to a building (e.g., production machinery).

Manufacturing, production & refining

The notice defines manufacturing, production, and refining under Section 168(n) and provides non-exhaustive examples of such activities. For qualifying property placed in service during 2025, a safe harbor allows taxpayers to evaluate these activities by reference to certain principal business activity codes uses on their most recently filed federal tax return.

• Manufacturing: Results in a material change in the form or function of tangible personal property, including parts and components, to create a new item of tangible personal property. A material change in the form or function occurs if, upon completion of the process, the inputs have been transformed such that they are distinguishable from, and cannot be readily returned to, their original state.
• Production: Either agricultural production or chemical production, defined as:
  • Agricultural production: The process of cultivating the ground, including raising and harvesting crops and breeding livestock for sale, rent or lease. This does not include raising animals that are not livestock.
  • Chemical production: A chemical process that formulates a product from organic and inorganic raw materials, including preparing raw materials for reaction, combining materials to form a new substance and purifying the final product. This may include manufacturing synthetic resins and plastics, manufacturing soaps or detergents and manufacturing pharmaceutical products.
• Refining: To purify a substance into a useful and higher-value product. For example, removing free fatty acids from animal fats, purifying nonferrous metals by electrolytic methods, processing vegetable oils to remove impurities and processing liquid natural gas.

Essential activities and related activities

Manufacturing, production, or refining activities that do not independently satisfy the substantial transformation requirement may constitute as a QPA if they are essential to the completion of a QPA. In addition, the notice provides a “related-activities” rule for employees that perform certain activities within an otherwise eligible property, such that the property will not become ineligible solely by reason of the activity.

• “Essential activities” include manufacturing, production, or refining activities that:
  • Occur within the same property or integrated facility in which the substantial transformation occurs
  • Do not occur within ineligible property (e.g., administration offices)
  • Are necessary such that, without them, the substantial transformation either could not occur, would result in an end qualified product of a different quality than intended, or would result in a different quantity of qualified product than intended.
• “Related activities” occur within the same property or integrated facility in which the substantial transformation occurs and must not occur within ineligible property. Examples include:
  • Oversight and direction of QPAs
  • Material selection and vendor selection, or control of raw materials substantially transformed into a qualified product
  • Management of costs or capacities attributable to QPAs (e.g., cost-reduction initiatives)
  • Development of product design and design specifications, including intellectual property used in conducting a QPA

The notice further clarifies that the storage of raw materials used in a QPA may be an essential activity, whereas storage of finished products is not. In addition, taxpayers engaged in contract manufacturing may perform QPAs, provided the activities otherwise qualify.

Allocation of unadjusted depreciable basis

The notice provides that a taxpayer may use any reasonable method to allocate a property’s unadjusted depreciable basis (as defined in Treas. Reg. §1.168(b)-1) between eligible property and ineligible property. Examples of reasonable methods include square footage, cost segregation studies, engineering plans and construction invoices. Taxpayers may use more than one reasonable allocation method, provided each allocation method is applied consistently.

Taxpayers also may use any reasonable allocation method to allocate the portion of basis attributable to dual-use infrastructure (e.g., central air conditioning system) that serves both eligible and ineligible property. Examples of reasonable methods include engineering plans, blueprints and process diagrams, provided the resulting allocation takes into account the actual or planned usage of the dual-use infrastructure. 

Once a taxpayer has determined the unadjusted depreciable basis properly allocable to eligible property, a taxpayer must designate the amount of such basis to be treated as QPP. This dollar-amount designation is made on a property-by-property basis. Amounts designated as QPP are treated as a separate class of property, and the taxpayer is treated as having made the applicable election(s) out of other special depreciation allowances (e.g., bonus depreciation under Section 168(k)) with respect to such property.

Manner of making a QPP election

Taxpayers make a QPP election for each person owning eligible property by attaching a statement to the timely filed (including extension) original federal tax return for the taxable year in which the eligible property is placed in service. The election statement must provide the taxpayer’s name, identification number and certain property-specific information, including:

• The property address and a description of the property and eligible property (if the property includes ineligible property)
• The total unadjusted depreciable basis of the property and the amount allocable to eligible property
• The portion of basis designated as QPP (which may be some, or all, of the property that is eligible to be QPP)
• A declaration that the taxpayer is applying the 95% de minimis rule, if applicable

Once made, the QPP may be revoked only with the Treasury Secretary’s consent by filing a private letter ruling request. Consent will be granted only in extraordinary circumstances and will not be provided where revocation would permit the use of hindsight.

10-year depreciation recapture

In general, taxpayers are required to recapture the portion of the special QPP deduction allocable to the portion of QPP that undergoes a QPP change in use in the taxable year in which the change occurs. Subject to certain special rules for consolidated groups and common controlled pass-through entities, a QPP change in use occurs if, at any time within the 10-calendar-year period beginning on the date the QPP is placed in service:

• The QPP ceases to satisfy the integral part requirement, and
• The QPP is used by the taxpayer in another productive use such that the property no longer qualifies as QPP.

A QPP change in use generally does not occur when QPP changes from being used in one QPA to another QPA. In addition, temporarily idle QPP does not undergo a QPP change in use, provided it is taken out of service only for a finite period and there is an expectation it will resume use in a QPA in the near future.

Any portion of QPP that undergoes a QPP change in use constitutes disqualified property. Taxpayers determine the recomputed basis of disqualified property by multiplying the eligible property’s unadjusted depreciable basis designated as QPP by the percentage of the eligible property that underwent the change in use. That percentage may be determined using any reasonable method, provided the method is applied consistently to any subsequent partial changes in use with respect to the same eligible property.

Once a QPP change in use occurs, the excess of the recomputed basis over the adjusted basis of the disqualified property is treated as ordinary income in the year of change, in accordance with Section 1245(a)(1). The taxpayer then increases its basis in the disqualified property by the amount of ordinary income recognized.

The taxpayer is allowed a depreciation deduction for the disqualified property as though it was placed in service as a new separate asset on the first day of the taxable year in which the QPP change in use occurs, taking into account the applicable convention. Disqualified property is generally not eligible for special allowances, including a Section 179 deduction or bonus depreciation under Section 168(k). 

Next steps

Notice 2026-16 provides helpful insight into the government’s interpretation of several key aspects of the special QPP deduction under Section 168(n) ahead of forthcoming proposed regulations. Taxpayers with property that may qualify for the deduction should review the notice carefully to understand how the government is currently interpreting this new provision.

Because reliance on the notice is optional and requires application of all its rules, taxpayers should evaluate whether reliance on the notice is appropriate based on their specific facts and circumstances, particularly with respect to definitions that incorporate rules from other provisions. Taxpayers should be aware that proposed regulations with rules consistent with the notice may be issued before the taxable year in which QPP is ultimately placed in service.