IRS Provides Clarity on Bonus Depreciation for Qualified Production Property

The IRS recently issued Notice 2026-16, providing interim guidance to address the new Section 168(n) depreciation allowance and announcing that it plans to propose regulations consistent with the notice. 

The One Big Beautiful Bill Act (OBBBA) enacted Section 168(n), which allows taxpayers to elect to immediately deduct 100% of the unadjusted depreciable basis of qualified production property (QPP) placed in service during the year. Notice 2026-16 answered many questions left open in the OBBBA, such as how to treat buildings used to perform qualified production activity (QPA).

Notice 2026-16 provides definitions, explains various aspects of the election, and notes that taxpayers can rely on its guidance until the IRS proposes regulations. The notice provides clarity on many issues raised by the statute enacted last year, and allowing taxpayers to rely on it until the IRS proposes regulations is welcome news.

Qualified Production Property

The notice defines QPP as the portion of any nonresidential real property that satisfies the following requirements:

• The property is depreciable under the modified acceleration cost recovery system (non-ADS);
• Construction of the property begins after January 19, 2025, and before January 1, 2029; 
• The property is placed in service in the U.S. or any territory thereof after July 4, 2025, and before January 1, 2031;
• The property’s original use begins with the taxpayer;
• The property is used (or will be used once placed in service) as an integral part of a QPA; 
• The property is not ineligible property; and
• The taxpayer designates the property as QPP in an election statement.

Used property acquired by a taxpayer might also qualify as QPP. In that situation, the original use and beginning-of-construction requirements are satisfied if:

• The taxpayer acquires the property after January 19, 2025, and before January 1, 2029;
• No one used the property in a QPA between January 1, 2021, and May 12, 2025;
• The taxpayer did not use the property at any time before acquisition; and
• The property was not acquired from specific related parties or in specified types of transactions in which basis carries over.

The notice references existing rules for regular or bonus depreciation under Section 168(k) for the following concepts: when construction begins, when property is placed in service, whether original use begins with the taxpayer, when property is acquired, and the used property acquisition requirements.

Integral Part Requirement

To qualify as QPP, the property (or a portion thereof) must be used as an integral part of a QPA. Property satisfies this requirement if a QPA takes place within its physical space. If a QPA takes place only within a portion of the property’s physical space, only the portion satisfies the requirement. 

Unit of Property

Notice 2026-16 states that each unit of property must satisfy the integral part requirement. Drawing from the general depreciation rules, a unit of property is each building, including its structural components, or, in the case of an improvement or addition to an asset after it has been placed in service, the improvement or addition, including any of its structural components. 

The notice introduces a taxpayer-favorable unit-of-property rule that provides that if a taxpayer operates multiple properties as an integrated facility and the properties are on the same piece or bordering pieces of land, the unit of property will be all properties making up the integrated facility. For example, without that integrated facilities rule, if a taxpayer were to use a building solely for storing raw materials that will be used in a QPA, when regarded as a unit of property on its own, the building would not qualify as meeting the integral part requirement. When grouped as part of an integrated facility, however, the building would qualify as meeting the requirement because its activities are combined with the activities of other buildings where a QPA takes place. A property comprising only ineligible property cannot be part of an integrated facility.

The notice provides a de minimis rule whereby if at least 95% of a property’s physical space meets the integral part requirement, a taxpayer can elect to treat 100% of the property as meeting the requirement.

Leasing Situations

Section 168(n)(2)(A) provides that for leased property, when applying the integral part requirement, a lessor cannot regard a lessee’s QPA as its own use of the property. That broad rule has raised numerous concerns from taxpayers that lease property within their consolidated or otherwise related groups. Under some circumstances, the notice grants exceptions for leasing activities within consolidated groups and among commonly controlled pass-through entities that allow lessors to reference the related lessee’s QPA when applying the integral part requirement.

Ineligible Property

QPP cannot be ineligible property, which is any property (or portion thereof) that is not eligible property. The notice specifies that any portion of property used for functions unrelated to a QPA, such as offices, administrative services, lodging, parking, sales, research, software development, and engineering, is ineligible property. Even property that has manufacturing, production, or refining activity will be ineligible if not used as an integral part of a QPA. For example, property used to store finished products and other specified items, as well as property where only related activities take place, are ineligible property.

Taxpayers can use any reasonable method to allocate a QPP’s unadjusted depreciable basis between eligible and ineligible property, provided the method is applied consistently and reflects the facts and circumstances. The notice identifies as potentially reasonable methods the use of: 

• Square footage; 
• Cost segregation data; 
• Architectural or engineering plans; 
• Process diagrams; or 
• Construction invoices. 

The notice specifies that employee headcount and employee time spent on QPAs are not reasonable methods. For infrastructure (e.g., a central HVAC system) that serves both eligible and ineligible property, the use of architectural or engineering plans, blueprints, process diagrams, or product specifications might be reasonable if the resulting allocation reflects actual or planned use of the dual-use infrastructure.

Qualified Production Activity

Section 168(n) defines a QPA as the manufacturing, production, or refining of a qualified product that results in a substantial transformation of the product. 

Manufacturing, Production, and Refining

The OBBBA referred to manufacturing and refining broadly, clarifying production only by specifying that it is limited to agricultural and chemical production. Notice 2026-16 provides significant detail on those topics.

The notice explains that manufacturing means to materially change the form or function of property, including its parts and components, to create a new item of property that is held for rent, lease, or sale. A material change occurs when the parts and components are transformed to the point where they are distinguishable from, and cannot readily be returned to, their original states. A change in form or function that is solely the result of packaging, repackaging, labeling, minor assembly, or a combination thereof is not a material change.

The notice states that refining is purifying a substance into a useful and higher-value product. It provides numerous examples, such as processing petroleum, liquid hydrocarbons, and other products from crude oil by using fractionation; straight distillation of crude oil and/or cracking; or recovering nonferrous metals (except copper and aluminum) from scrap. 

The notice defines agricultural production as the process of cultivating the ground, typically in fields or large acreage, including preparing the soil; planting seeds; raising, cultivating, irrigating, and harvesting crops for sale, rent, or lease; and breeding, rearing, feeding, and managing livestock for sale, rent, or lease. Agricultural production does not include raising animals that are not livestock and activities such as food marketing that benefit persons engaged in agriculture but are not agricultural production.

Chemical production involves formulating a product from organic and inorganic raw materials, including preparing raw materials for reaction; combining materials in a reactor to form a new substance; isolating the final product from byproducts, intermediates, and other substances; and purifying the final product. As it does with refining, the notice provides specific examples, such as manufacturing pharmaceutical products for internal and external consumption in such forms as capsules, ointments, powders, and solutions.

Notice 2026-16 also provides a safe harbor for some property placed in service between July 5, 2025, and December 31, 2025. Under the safe harbor, a taxpayer’s manufacturing, production, and refining activity might be considered a QPA if the principal business activity code used on the taxpayer’s most recent tax return is any of the codes listed under sectors 31, 32, or 33 or subsectors 111 or 112 of the North American Industry Classification System (NAICS).

Essential Activities

A manufacturing, production, or refining activity that does not result in a substantial transformation of the qualified product might be included in a QPA if it is essential to the QPA’s completion. An activity is essential if:

• It occurs within the same property where the substantial transformation of the property occurs;
• It does not occur within ineligible property; and 
• Without the activity, the property’s substantial transformation cannot occur, would result in a different quality end product than the intended qualified product, or would result in a different quantity of the qualified product than intended.

In an example involving a factory used to process various ingredients into jarred tomato sauce, the notice identifies the area where the sauce ingredients are inspected, sorted, and prepared for further processing as an essential activity. Although the material change during that stage does not constitute a substantial transformation, it meets the requirements of an essential activity because without it, the quality and/or quantity of the sauce would differ from the intended product.

Notice 2026-16 addresses one of the most common questions regarding new Section 168(n): whether storage space can qualify as QPP. The notice explains that essential activities include receiving and storing raw materials to be used and consumed during a QPA if they are conducted within the same property or integrated facility as the QPA. Any other storage activity — for example, the storage of finished products — is not an essential activity and cannot qualify as QPP.

Related Activities

Similarly, an activity that does not result in a substantial transformation of the qualified product will not cause a taxpayer to fail to have a QPA if individuals performing or supervising the manufacturing, production, or refining activities also perform activities related to the QPA. To meet that requirement:

• The related activity must occur within the same property where the substantial transformation of the property occurs; and
• The related activity cannot occur within ineligible property.

Examples of related activities include material and vendor selection, cost-reduction or -efficiency initiatives, and the development of product design. If a taxpayer’s activity within the property includes only related activities and not a QPA, the property will not be regarded as having a QPA.

Qualified Product

A qualified product is tangible personal property other than food or beverages prepared in the same building as a retail establishment where the property is sold. The notice clarifies that a retail establishment means a retail sales facility as defined in the UNICAP rules, which generally is a facility where a taxpayer sells merchandise exclusively to retail customers. A taxpayer does not need to own the qualified product when determining whether its activities are a QPA, meaning that contract manufacturers that merely perform tolling services for other parties might qualify as having a QPA.

Substantial Transformation

In the OBBBA, Congress directed the IRS to provide rules regarding what constitutes a substantial transformation of property consistent with guidance under Section 954(d). Notice 2026-16 defines the substantial transformation of a qualified product as further manufacturing, production, or refining of the constituent elements, raw materials, inputs, or subcomponents into a final, complete, and distinct item of property that in the taxpayer’s hands is fundamentally different from the original constituent elements, materials, inputs, or subcomponents. The notice cites the examples of substantial transformation from the Section 954 regulations; namely, the conversion of wood pulp to paper, steel rods to screws and bolts, and freshly caught tuna fish to canned tuna. It notes that the grouping and packaging of multiple finished goods for sale as a single item, such as gift baskets, subscription boxes, and bundled electronics, does not constitute substantial transformation. The IRS has requested comments on other examples of activities that do or do not result in the substantial transformation of property.

Election Procedure

A taxpayer elects to treat property as QPP by attaching a statement to its timely filed (including extensions) original federal income tax return for the tax year in which the property is placed in service. The statement must include:

• A description of the QPP and, if the eligible property is less than the entire property, the eligible property;
• The property’s basis and, if the eligible property is less than the entire property, the basis of the eligible property;
• The dollar amount of the basis of eligible property the taxpayer is designating as QPP (it does not need to be the entire basis);
• If the taxpayer is applying the de minimis rule, a declaration to that effect identifying the property to which the taxpayer is applying the rule; and
• If the taxpayer is using the one-year automatic extension of the placed-in-service requirement, a declaration to that effect, including details of the disaster and the property in the disaster area.

Recapture

If there is a change in use within 10 years of the QPP being placed in service by the taxpayer, recapture under Section 1245 applies. A change in use occurs when the property ceases to be used as an integral part of a QPA and instead is used by the taxpayer in another productive use that results in the property becoming disqualified property. Recapture will not apply if a taxpayer stops using the QPP as an integral part of one QPA and begins using it as an integral part of another QPA with no disqualifying activity in the interim. If only a portion of the QPP has a change in use, recapture will apply only to that portion. The notice also provides change-in-use rules for leasing scenarios involving consolidated groups and commonly controlled pass-through entities. 

There is no change in use when QPP is temporarily idle, which is when a taxpayer takes it out of service for a finite period with the expectation of resuming a QPA in the near future; for example, while upgrading a production line or performing facility-wide maintenance.

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