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IRS Explains New 100% Depreciation for Real Property Used in Qualified Production

IRS Explains New 100% Depreciation for Real Property Used in Qualified Production

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New Bonus Depreciation Rules for Production Property Explained

Since the late 1980s, depreciation rules for real property used in a trade or business have been unfavorable, requiring the straight-line method over extended recovery periods of up to 40 years. Then, in the early 2000s, Congress added some nonresidential real property components, such as qualified leasehold improvements, to the list of property qualified for bonus depreciation. Now, H.R. 1, the One Big Beautiful Bill Act (OBBBA), has expanded the definition of qualified property to include “qualified production property”, now eligible for the special depreciation allowance.  

The IRS has released Notice 2026-16 providing interim guidance on electing bonus depreciation for these manufacturing activities. The statute and the Notice define qualified production property as nonresidential real property used as an integral part of a qualified production activity. A “qualified production activity” is a manufacturing, chemical production, agricultural production, or refining activity that results in the substantial transformation of an input into a new or distinct product.

The property must meet the following criteria:

  • Located in the U.S. or a U.S. possession
  • Original use begins with the taxpayer
  • Construction begins after January 19, 2025 and before January 1, 2029
  • Placed in service after July 4, 2025 and before January 1, 2031

Key Items Covered in IRS Notice

The notice provides the following interim guidance on specific issues relating to the election to take bonus depreciation for qualified production property.

Other Property Qualifications

Under the Notice, leased property can qualify for bonus depreciation if the lessee is part of the same consolidated group of the lessor or in a commonly controlled passthrough entity. Property also qualifies if it was already held by the taxpayer but was not previously used for a qualified production activity.

Buildings with dual usage may qualify. The Notice has a 95% de minimis rule that allows bonus depreciation for the entire building if 95% of it is used in a qualified activity. Businesses also may allocate building areas and components between eligible and noneligible property for dual use properties.

Storage areas have their own rules. The storage of raw materials or other inputs which will be used or consumed during a qualified production activity is considered an essential activity, so those areas of the property are eligible. Storage of finished products, however, is not considered essential and does not qualify.

Also, contract manufacturing activities may qualify under the Notice.

Note that bonus depreciation is not allowed for any portion of nonresidential real property used for “offices, administrative services, lodging, parking, sales activities, research activities, software development or engineering activities, or other functions unrelated to the manufacturing, production, or refining of tangible personal property.”

Qualified Production Activities

The first rule here is that only agricultural and chemical production qualify.  The key requirement is that an activity result in the “substantial transformation” of an input into a new or distinct product.

Substantial transformation is defined as “the further manufacturing, production, or refining of the constituent elements, raw materials, inputs, or subcomponents into a final, complete, and distinct item of property in the hands of the taxpayer that is fundamentally different from the original constituent elements, materials, inputs, or subcomponents.” The Notice offers the following examples:

  • conversion of wood pulp to paper
  • conversion of steel rods to screws and bolts
  • processing of freshly caught tuna fish to create canned tuna

Activities that would not qualify

  • grouping and packaging of multiple finished goods for sale as a single item, such as gift baskets, subscription boxes, and bundled electronics

How and When to Make Election

Taxpayers may elect to use bonus depreciation by making an election onthe due date, including extensions, of the taxpayer’s original federal income tax return for the taxable year when the eligible property is placed in service. The election must identify each property included in the election. 

Depreciation Recapture Rules

To prevent businesses from claiming the full first-year depreciation and then abandoning their qualified production activities, the new law includes a 10-year recapture rule. If the property ceases to qualify before 10 years after the property was placed in service, it will be treated as having been disposed of, with gain recognized at ordinary income rates.

Observations

The 100% depreciation for qualified production activities is designed as an incentive for businesses to engage in domestic manufacturing, production, and refining. The benefit requires a 10-year commitment, so decisions on current or planned domestic operations should be made carefully based on the detailed guidance in the IRS Notice and forthcoming regulations.

Taxpayers may rely on the Notice until proposed regulations are issued.

The IRS also requests comments on the interim guidance, including asking taxpayers to identify specific issues on which additional guidance is needed. The public comments received will likely help shape the forthcoming proposed regulations for qualified production activities.

For companies considering new or expanded production activities, Frazier & Deeter can help ensure compliance while maximizing available benefits.

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