IRS Notice 2026-16 Summary
Interim Guidance on Special Depreciation for Qualified Production Property (QPP)
The IRS recently issued Notice 2026-16, providing interim guidance on the 100% special depreciation allowance for Qualified Production Property (QPP) under Internal Revenue Code §168(n). This provision was enacted as part of the One, Big, Beautiful Bill Act (OBBBA) and is intended to encourage domestic manufacturing and production investment.
The notice outlines how taxpayers can determine whether property qualifies, defines the activities that meet the requirements of a Qualified Production Activity (QPA), and establishes procedures for making the QPP election and addressing recapture rules.
Taxpayers may rely on the guidance in Notice 2026-16 until proposed regulations are issued. Key provisions of the notice are summarized below.
Defining Qualified Production Property (QPP)
Notice 2026-16 provides important clarification regarding what constitutes QPP and when property is considered an integral part of a QPA.
Property meets the integral part requirement if the QPA occurs within the physical space of the property or a portion of it. If 95% or more of the property’s physical space is used for a QPA, taxpayers may elect to treat the entire property as satisfying the integral-part requirement.
For purposes of determining QPP:
- Each building is treated as a single unit of property.
- Improvements or additions to a building are treated as separate units of property.
- Multiple buildings operating as an integrated facility on the same or contiguous land may be treated as a single unit of property.
Leasing and Related-Party Exceptions:
In general, property leased to another party cannot be treated as QPP by the lessor. However, the notice provides two important exceptions:
- Consolidated groups, and
- Commonly controlled passthrough entities
Under the passthrough exception, if a partnership, S corporation, or individual leases property to a commonly controlled person (defined as 50% or more common ownership), the lessor determines QPP eligibility based on the lessee’s activities.
Additional Property Definitions:
The definition of ineligible property generally follows the statute in excluding space used for offices, administrative services, lodging, parking, sales, research, software development or engineering actives, but includes an important addition for any portion of a property used to store finished products. The guidance does allow taxpayers to use any reasonable allocation method when determining the eligible and ineligible portions of a property’s basis.
Defining Qualified Production Activities (QPA)
A Qualified Production Activity is defined as a trade or business involving the manufacturing, production, or refining of a qualified product.
The core requirement is that the activity must result in a “substantial transformation” of property into a finished product.
Activities that do not themselves cause the transformation may still qualify if they are essential to completing the transformation.
An activity is considered essential if:
- It occurs within the same property or integrated facility as the substantial transformation
- It does not occur in an ineligible area (such as administrative offices)
- Without the activity, the substantial transformation could not occur or would materially change the product’s quality or quantity
The receiving and storage of raw materials used in the production process are also treated as essential activities. However, storage of finished products is explicitly excluded and is considered an ineligible use.
Certain other activities commonly associated with production operations may qualify if performed within the same eligible property as the substantial transformation, including:
- Oversight and direction of the production process
- Material selection and vendor management
- Management of production costs and capacity
- Development or direction of product designs, trade secrets, or other intellectual property used in production
Key Definitions Supporting QPA
The notice provides detailed definitions for several key terms used in determining QPA eligibility.
Substantial Transformation:
A substantial transformation occurs when inputs are converted into a final, complete, and distinct item of property that is fundamentally different from the original materials.
Examples include:
- Converting wood pulp into paper
- Processing fresh tuna into canned tuna
Activities that simply group, package, or bundle finished goods—such as assembling gift baskets—do not qualify.
Manufacturing:
Manufacturing involves materially changing the form or function of tangible personal property to create a new item held for sale, rent, or lease. The transformation must be significant enough that the inputs:
- Are distinguishable from the final product, and
- Cannot readily return to their original state
Minor assembly, labeling, or packaging alone does not qualify.
Production:
The notice limits the definition of production to:
- Agricultural production, or
- Chemical production
Refining:
Refining involves purifying a substance into a higher-value or more useful product.
Examples include:
- Petroleum processing
- Metal purification
- Vegetable oil processing
- Wet corn milling
Agricultural Production:
Agricultural production includes activities such as:
- Soil preparation
- Planting and harvesting crops
- Managing livestock
Chemical Production:
Chemical production refers to chemical processes that create products from raw materials, including:
- Basic chemicals
- Synthetic resins
- Fertilizers
- Pharmaceuticals
- Soaps
Qualified Product:
A qualified product generally includes tangible personal property but excludes food or beverages prepared in the same building as a retail establishment where they are sold.
Safe Harbor for 2025
The notice includes a safe harbor for property placed in service during 2025.
An activity will be treated as a QPA if:
- The taxpayer’s principal business activity code on its most recently filed return falls within the applicable NAICS sectors:
- 31–33 (Manufacturing), or
- 111–112 (Crop and Animal Production)
2. The activity results in or is essential to a substantial transformation of a qualified product
Election Procedures
To claim the 100% special depreciation allowance, taxpayers must elect to treat property as QPP.
The election must be made on the taxpayer’s timely filed original federal income tax return, including extensions, for the taxable year in which the property is placed in service.
Recapture and Change-in-Use Rules
The notice also establishes detailed recapture rules if property that received the special depreciation allowance later becomes disqualified.
If within 10 years of being placed in service, the property ceases to satisfy the integral part requirement and is used for another productive purpose; the property becomes a disqualified property.
Certain situations do not trigger recapture, including:
- Changing from one QPA to another QPA
- Temporary idle periods for maintenance, upgrades, or operational interruptions where production is expected to resume
For leased property within consolidated groups or commonly controlled entities, a change in use occurs if:
- The lessee stops conducting a QPA, or
- The control relationship between entities changes
Tax Consequences of a Change in Use:
When QPP becomes disqualified property, it is treated as though it were disposed of for tax purposes.
The taxpayer must recognize ordinary income equal to the excess of the property’s recomputed basis over its adjusted basis. Generally, the recomputed basis reflects the depreciation previously claimed.
After recapture:
- The property’s basis increases by the amount of recognized gain
- It is treated as a new asset placed in service on the first day of the year of change
Depreciation going forward is determined using the appropriate recovery period and method, such as 39-year straight-line depreciation with a mid-month convention for nonresidential real property.
Importantly, the disqualified property cannot claim additional special depreciation allowances, including:
- Bonus depreciation under §168(k)
- Expensing under §179
If only a portion of the property changes use, recapture is calculated by multiplying the original QPP basis by the percentage of the property that changed use.
