The Department of the Treasury and the Internal Revenue Service (IRS) recently issued Notice 2026-16 to provide crucial administrative guidance regarding the new temporary special depreciation allowance. The primary reason the IRS has issued this notice is to announce that the Treasury Department and the IRS "intend to issue proposed regulations (forthcoming proposed regulations) addressing the special depreciation allowance for qualified production property under § 168(n) of the Internal Revenue Code (Code)".

Because the enactment of the One, Big, Beautiful Bill Act (OBBBA) significantly altered depreciation timelines for certain property, tax professionals require immediate operational rules. Notice 2026-16 bridges the gap between the statutory enactment and the eventual publication of final Treasury Regulations by offering interim guidance upon which taxpayers may rely.

Statutory Provisions Added by the One Big Beautiful Bill Act

Section 70307 of Public Law 119-21, commonly known as the OBBBA, fundamentally modified the Modified Accelerated Cost Recovery System (MACRS) by adding subsection (n) to I.R.C. § 168. This new provision establishes a temporary, 100-percent special depreciation allowance for qualified production property (QPP).

Specifically, I.R.C. § 168(n)(1)(A) mandates that "for any qualified production property for which an election is made, the depreciation deduction provided by § 167(a) for the taxable year such property is placed in service includes an allowance equal to 100 percent of the adjusted basis of the qualified production property". Furthermore, I.R.C. § 168(n)(1)(B) dictates that the adjusted basis of the QPP must be "reduced by the amount of the deduction under § 168(n)(1)(A) before computing the amount otherwise allowable as a depreciation deduction for such taxable year and any subsequent taxable year".

Interim Guidance Under Notice 2026-16

Pending the formal promulgation of proposed and final regulations, Notice 2026-16, Sections 3 through 8, sets forth detailed interim rules governing definitions, property eligibility, leasing arrangements, election mechanics, and recapture triggers.

Defining Qualified Production Property

Under I.R.C. § 168(n)(2)(A), QPP is strictly defined as the portion of any nonresidential real property that meets several rigorous statutory tests. Notice 2026-16 clarifies that to qualify as QPP, the property must be MACRS property that is "used by the taxpayer, or will be used by the taxpayer once placed in service, as an integral part of a qualified production activity".

The timeline for QPP is strict: the construction of the property must begin after January 19, 2025, and before January 1, 2029. Additionally, the property must be placed in service "after July 4, 2025, and before January 1, 2031".

The Notice also identifies specific exclusions. I.R.C. § 168(n)(2)(C) explicitly dictates that QPP "does not include any portion of nonresidential real property that is 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". Practitioners must ensure that their clients allocate the unadjusted depreciable basis between eligible and ineligible property using a "reasonable method," such as square footage or cost segregation data.

Alternatively, the IRS offers a taxpayer-friendly "de minimis rule," which dictates that if "95 percent or more of the physical space of a property satisfies the integral part requirement at the time the property is placed in service, the taxpayer may elect to treat the entire property as satisfying the integral part requirement".

Statutory Timing Requirements for Qualified Production Property

To qualify for the 100-percent special depreciation allowance under I.R.C. § 168(n), taxpayers must strictly adhere to statutory timelines regarding the beginning of construction and the eventual placement of the property into service. Under Notice 2026-16, qualified production property (QPP) is defined, in part, as property "the construction of which begins after January 19, 2025, and before January 1, 2029". Furthermore, the statute mandates that the property must be "placed in service after July 4, 2025, and before January 1, 2031".

Guidance on Determining the Beginning of Construction

Tax professionals will find familiar mechanics for determining exactly when construction begins, as the IRS has opted to leverage existing regulatory frameworks rather than creating a new standard. Notice 2026-16 explicitly cross-references the bonus depreciation rules found in the Treasury Regulations. According to Section 4.05 of the Notice, "For purposes of determining whether property satisfies the beginning of construction requirement, a taxpayer applies rules consistent with § 1.168(k)-2(b)(5)(iv)(B), including the safe harbor provided in § 1.168(k)-2(b)(5)(iv)(B)(2)".

By relying on Treas. Reg. § 1.168(k)-2(b)(5)(iv)(B), practitioners can utilize the established physical work test and the 10-percent safe harbor to demonstrate that a client has commenced construction within the required statutory window.

In situations involving the acquisition of eligible used property—where the acquisition date acts as a proxy for the beginning of construction—similar cross-references apply. Notice 2026-16, Section 4.06(4) directs that "for purposes of determining whether used property is acquired after January 19, 2025, and before January 1, 2029, a taxpayer applies rules consistent with § 1.168(k)-2(b)(5)".

Guidance on When Construction Ends and Property is Placed in Service

Neither I.R.C. § 168(n) nor Notice 2026-16 provides guidance on when construction officially "ends," as the termination of construction is not the relevant legal benchmark for depreciation purposes. Instead, the critical endpoint for tax purposes is the date the property is placed in service.

To determine when property has achieved this status, Notice 2026-16, Section 3.07 stipulates that "the term placed in service has the same meaning as the term 'first placed in service' in § 1.167(a)-11(e)(1)". Consequently, CPAs and EAs must look to the long-standing definition under Treas. Reg. § 1.167(a)-11(e)(1), which generally establishes that property is first placed in service when it is placed in a condition or state of readiness and availability for a specifically assigned function.

Exceptions to the Placed-in-Service Deadline

While the general rule requires property to be placed in service before January 1, 2031, the IRS does provide an avenue for relief for taxpayers impacted by extraordinary events. Under I.R.C. § 168(n)(2)(H), the Secretary of the Treasury is granted the authority to extend the placed-in-service date if a taxpayer is prevented from placing the property in service "due to an act of God" as defined in the Comprehensive Environmental Response, Compensation, and Liability Act of 1980.

Pursuant to this authority, Notice 2026-16, Section 4.11 establishes a bright-line administrative rule: "An automatic one-year extension of the placed-in-service-date requirement is granted for any property that is located in a disaster area (as defined in § 165(i)(5)(B)) at any time during 2030". For property meeting this criteria, "the requirement to place property in service before January 1, 2031, is automatically extended to January 1, 2032". Taxpayers relying on this relief must ensure they "include a declaration to that effect on the election statement" attached to their return.

Treatment of Acquired Real Property and Subsequent Improvements

The situation in which a taxpayer purchases an existing building and subsequently hires a contractor to enact significant improvements does not inherently disqualify the property from the temporary 100-percent special depreciation allowance. Instead, I.R.C. § 168(n) and Notice 2026-16 dictate that tax professionals must bifurcate this scenario into a two-part analysis: the acquisition of the existing structure (the "used" property) and the capitalized improvements constructed thereafter.

Qualifying an Acquired Existing Building

As a general rule, to qualify as qualified production property (QPP), I.R.C. § 168(n)(2)(A)(iv) requires that the property be nonresidential real property "the original use of which commences with the taxpayer". Naturally, the purchase of an existing building raises an immediate original use issue.

However, the statute provides a critical safe harbor for acquired used property. Under I.R.C. § 168(n)(2)(B)(i) and Notice 2026-16, Section 4.06(1), a taxpayer that acquires used property after January 19, 2025, and before January 1, 2029, is strictly "treated as the original user of the property and the construction of the property is treated as having begun" within the requisite statutory window if three rigorous conditions are met.

First, Notice 2026-16, Section 4.06(1)(a) requires that the property "was not used in a QPA (determined without regard to whether such activity resulted in a substantial transformation of the property comprising a qualified product) by any person at any time during the period beginning on January 1, 2021, and ending on May 12, 2025". Second, the property must not have been "used by the taxpayer at any time prior to such acquisition". Third, the transaction must meet the related-party and cost-basis requirements of I.R.C. § 179(d)(2) and (3), ensuring the property "is not acquired from a related party or by a member of a controlled group from another member of the same group, and the taxpayer’s basis in the property is not determined by reference to its basis in the hands of the transferor".

If the acquisition of the existing building satisfies these stringent prior-use and purchase requirements, the building itself overcomes the original use hurdle and may qualify as QPP, provided it is then used as an integral part of a qualified production activity (QPA).

Treatment of Subsequent Improvements and Additions

When the taxpayer hires a contractor to make significant changes or improvements to the acquired building, those capitalized costs are not simply lumped into the building's initial basis for QPP evaluation. Instead, Notice 2026-16, Section 4.03(1)(b) establishes a strict unit-of-property rule: "If the taxpayer places in service an improvement or addition to an asset after the taxpayer placed the asset in service, the improvement or addition, including any of its structural components, is a separate unit of property".

Because the improvements constitute a "separate unit of property," they must independently satisfy the statutory requirements for QPP. Since the taxpayer is initiating the construction of these improvements, the "original use" requirement is inherently met for the improvement costs, even if the underlying building failed the used-property safe harbor mentioned above.

Satisfying the Integral Part Requirement as an Integrated Facility

Because the improvements are treated as separate units of property, practitioners might wonder how an electrical upgrade or a newly constructed wing satisfies the requirement that it be used as an "integral part" of a QPA.

To resolve this, the IRS provides the "integrated facilities" rule. Notice 2026-16, Section 4.03(2) dictates that "in the case of multiple properties that operate as an integrated facility (as evidenced by their actual operation) and that are physically located or co-located on the same piece or contiguous pieces of land, all properties comprising the integrated facility may be treated as a single unit of property".

The Notice illustrates this exact contractor-improvement dynamic in Example 3. In the example, a taxpayer who previously placed a factory in service later capitalizes a $2,000,000 "Electrical System Upgrade". The IRS concludes that while the factory and the upgrade are "treated as separate units of property," they operate as an integrated facility. Consequently, "whether the Electrical System Upgrade satisfies the integral part requirement, either in whole or in part, is determined by reference to whether Factory B satisfies the integral part requirement".

Ultimately, 168(n) can absolutely apply to this situation. If the acquired building clears the I.R.C. § 168(n)(2)(B) used-property hurdles, its unadjusted depreciable basis is eligible for the 100-percent allowance. Separately, the significant improvements made by the contractor constitute a separate unit of property whose original use begins with the taxpayer, making those capitalized costs eligible for the special depreciation allowance, provided the facility as a whole operates as an integral part of a QPA.

Defining Qualified Production Activity

The core of the QPP allowance hinges on the property’s use in a Qualified Production Activity (QPA). I.R.C. § 168(n)(2)(D) defines QPA as "the manufacturing, production, or refining of a qualified product that results in a substantial transformation of the property comprising the qualified product". Notice 2026-16 formally defines this "substantial transformation" as the processing of raw materials 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 specifies that certain related activities, while not themselves causing a substantial transformation, will not disqualify the property if they are "essential to the completion of the QPA". For example, the receiving and storage of raw materials "are activities essential to the QPA if they are conducted in, or take place within, the same property, or within the same integrated facility... as the QPA". Conversely, "any other storage activity not described in section 5.01(2)(b)(i) of this notice, such as the storage of finished products, is not an activity essential to a QPA" and thus constitutes ineligible property.

Statutory Background and the Definition of Substantial Transformation

To qualify for the temporary 100-percent special depreciation allowance under the One, Big, Beautiful Bill Act (OBBBA), nonresidential real property must be used by the taxpayer as an integral part of a qualified production activity. I.R.C. § 168(n)(2)(D) mandates that a qualified production activity is defined as the "manufacturing, production, or refining of a qualified product that results in a substantial transformation of the property comprising the qualified product".

Notice 2026-16, Section 5.02(9)(a), establishes the administrative parameters for this pivotal requirement. The IRS dictates that "the term substantial transformation of the property comprising a qualified product means 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".

Illustrative Affirmative Examples

The IRS provides concrete, bright-line examples to assist tax practitioners in determining whether a client's operations meet this standard. According to Notice 2026-16, Section 5.02(9)(b), explicit "Examples of substantial transformation of the property comprising a qualified product include the conversion of wood pulp to paper, steel rods to screws and bolts, and freshly caught tuna fish to canned tuna".

Furthermore, the Notice offers a comprehensive, multi-step illustration involving the production of jarred tomato sauce to demonstrate when the actual substantial transformation takes place during a continuous manufacturing process. In this example, while the initial stages of inspecting, sorting, and chopping raw ingredients constitute a manufacturing process, the substantial transformation does not legally occur until the subsequent "sauce processing and sauce jarring stage". The IRS concludes that it is only during this final stage that the "constituent inputs (the prepared ingredients) [are] further manufactured into a final, complete, and distinct item of property (jarred sauce) that is fundamentally different from the original constituent inputs (the sauce ingredients)".

Activities Failing to Meet the Standard

Notice 2026-16 also clearly delineates what operations fail to rise to the level of a substantial transformation. Section 5.02(9)(c) of the Notice clarifies that "An example of an activity that does not result in a substantial transformation of the property comprising a qualified product is the grouping and packaging of multiple finished goods for sale as a single item, such as gift baskets, subscription boxes, and bundled electronics".

Additionally, the Notice establishes that if a taxpayer's trade or business activity taking place within a property consists solely of related administrative or oversight functions—such as material selection, vendor selection, management of manufacturing costs, or the development of product designs—that specific activity "does not result in substantial transformation of the property comprising a qualified product". Consequently, the trade or business activity conducted within that specific portion of the property "will not be a QPA".

Applicability Restricted Exclusively to Section 168(n)

Although I.R.C. § 168(n)(7) formally grants the Secretary of the Treasury the authority to prescribe regulations defining substantial transformation that are "consistent with guidance provided under § 954(d)", the IRS explicitly restricts the usage of the definitions contained within this interim guidance.

Notice 2026-16, Section 5.02(9)(d), strongly cautions practitioners against extrapolating these rules to other areas of tax law. The IRS states that the definition of substantial transformation, along with the illustrative examples provided in the Notice, "are limited to determinations under § 168(n), and do not apply with respect to determinations of whether property has been substantially transformed for any other purpose, including for purposes of any other provision of the Code or the regulations thereunder".

Election Procedures

To claim the allowance, taxpayers must affirmatively elect into the regime. Under I.R.C. § 168(n)(6)(A), the election must "specify the nonresidential real property subject to the election and the portion of such property designated as qualified production property". Notice 2026-16, Section 7.02 requires that this election be made by attaching a statement entitled “STATEMENT PURSUANT TO SECTION 7 OF NOTICE 2026-16” to the timely filed original Federal income tax return for the taxable year the property is placed in service. Once made, this election "may not be revoked except with the consent of the Secretary (and the Secretary may provide such consent only in extraordinary circumstances)".

Recapture Under Section 1245

Tax professionals must heavily caution clients regarding the recapture provisions. I.R.C. § 168(n)(5)(A) implements a 10-year look-forward period for changes in use. Notice 2026-16 states that a QPP change in use occurs if, within the 10-calendar-year period beginning on the date the property is placed in service, the property "ceases to satisfy the integral part requirement, and (ii) is used by the taxpayer in another productive use that results in the property that was previously QPP constituting disqualified property".

If a change in use occurs, I.R.C. § 1245 applies by "treating the property as having been disposed of when first used in a productive use that is not a qualified production activity, and (2) treating as ordinary income the excess of the property’s recomputed basis, as defined in § 1245(a)(2), over its adjusted basis".

Statutory Framework for Recapture

For tax professionals advising clients on the temporary 100-percent special depreciation allowance for qualified production property (QPP), the risk of recapture is a paramount planning consideration. The One, Big, Beautiful Bill Act (OBBBA) instituted a strict 10-year monitoring period for property benefiting from this allowance.

Specifically, I.R.C. § 168(n)(5)(A) provides that if, "at any time during the 10-year period beginning on the date that qualified production property is placed in service by the taxpayer, the property ceases to be used as an integral part of a qualified production activity and is used in another productive use," ordinary income recapture is triggered. When this occurs, the statute directs that I.R.C. § 1245 is applied by "treating the property as having been disposed of when first used in a productive use that is not a qualified production activity, and (2) treating as ordinary income the excess of the property’s recomputed basis, as defined in § 1245(a)(2), over its adjusted basis".

Defining a QPP Change in Use

To administer this statutory mandate, Notice 2026-16 establishes the concept of a "QPP change in use." According to Section 8.01(1)(a) of the Notice, a QPP change in use occurs if, within the 10-calendar-year period beginning on the date the property is placed in service, the QPP "(i) ceases to satisfy the integral part requirement, and (ii) is used by the taxpayer in another productive use that results in the property that was previously QPP constituting disqualified property".

The IRS explicitly clarifies that a change in use is not triggered merely by switching between eligible operations. The Notice dictates that a QPP change in use "has not occurred when a taxpayer ceases to use QPP as an integral part of one QPA and begins to use it as an integral part of another QPA, provided the QPP was not used in another productive use not described in section 5.01 of this notice in the interim".

Safe Harbor for Temporarily Idle Property

Practitioners will be relieved to note that a temporary cessation of production activities does not automatically trigger Section 1245 recapture. Notice 2026-16, Section 8.01(1)(d) provides a taxpayer-friendly safe harbor, stating that a "property that has been placed in service but is temporarily idle does not cease to satisfy the integral part requirement and does not have a QPP change in use".

The IRS defines property as temporarily idle "when the taxpayer takes it out of service for a finite period with the expectation of resuming a QPA in the near future". The Notice illustrates this standard by citing property that is taken out of service "while upgrading a production line or performing facility-wide maintenance".

Recapture Triggers for Leased Property

For taxpayers utilizing leasing structures, Notice 2026-16 provides highly specific triggers that result in a QPP change in use for the lessor.

In the context of intercompany leases within a consolidated group, Section 8.01(1)(b) dictates that if the lessee member "ceases to have a QPA that is conducted in, or takes place within, the QPP, or if S [the lessor member] or B [the lessee member] leaves the consolidated group, then S has a QPP change in use".

Similarly, strict rules apply to leases between a lessor pass-through entity (or lessor individual) and a commonly controlled person. Section 8.01(1)(c) provides that if the commonly controlled person leasing the QPP "ceases to have a QPA that is conducted in, or takes place within, the QPP, or if the commonly controlled person is no longer described in section 4.02(3)(c) of this notice for any taxable year, the lessor pass-through entity or lessor individual, as applicable, has a QPP change in use".

Mechanics of Partial Changes in Use

Because QPP can consist of massive manufacturing facilities, a change in use may only impact a fraction of the overall property. Notice 2026-16, Section 8.01(1)(a) establishes that if "only a portion of QPP undergoes a QPP change in use, this section 8 applies only to the portion that underwent a change in use, provided that the other portion(s) of the QPP continue to meet the requirements of section 4.01 of this notice".

To calculate the resulting recapture, the tax professional must determine the recomputed basis of the specific portion of the property that was disqualified. Under Section 8.05(1), the recomputed basis of the disqualified property is "determined by multiplying the eligible property’s unadjusted depreciable basis designated as QPP by the percentage of the eligible property that underwent a change in use". Taxpayers may determine this percentage "using any reasonable method that takes into account the data and criteria described in section 4.08 of this notice," such as square footage or cost segregation data, provided the method is applied consistently for any subsequent partial changes in use.

Application of Section 1245 and Depreciation of Disqualified Property

Once a QPP change in use occurs, the affected portion becomes "disqualified property". Under Section 8.02 of the Notice, disqualified property is "subject to § 1245(a)(1) and is treated as having been disposed of by the taxpayer as of the first time the property had a QPP change in use". The taxpayer must recognize ordinary income in the year of change equal to the excess of the recomputed basis over the adjusted basis of the disqualified property.

Simultaneously, under Section 8.03, the taxpayer’s "basis in disqualified property is increased by the amount of gain recognized," with the adjustment treated as having occurred on the first day of the year of change. Moving forward, the depreciation allowance for the disqualified property is determined "as though the disqualified property was placed in service by the taxpayer as a new separate asset on the first day of the year of change, taking into account the applicable convention". Notably, the disqualified property is strictly ineligible in the year of change for the Section 179 deduction, the Section 168(k) additional first-year depreciation deduction, or any other special depreciation allowances.

Expectations for Future Guidance

Notice 2026-16 serves as a structural bridge to future regulatory codification. The IRS explicitly states that the Treasury Department and the IRS expect the forthcoming proposed regulations to be "consistent with the interim guidance provided in sections 3 through 8 of this notice". Furthermore, the IRS anticipates that the forthcoming proposed regulations will formally apply to property for which construction begins after January 19, 2025, and is placed in service in a taxable year beginning on or after the date the "final § 168(n) regulations are published in the Federal Register".

Until those regulations are published in the Federal Register, tax professionals and their clients "may rely on the guidance provided in sections 3 through 8 of this notice, provided that the taxpayer follows the guidance provided in sections 3 through 8 of this notice in its entirety for all QPP placed in service in such taxable years".

Prepared with assistance from NotebookLM.