Section 168(n) Qualified Production Property: Claim the 100% Factory Building Deduction

A production building that would normally be depreciated over 39 years may now qualify for an immediate federal deduction. New Internal Revenue Code Section 168(n), enacted by Public Law 119-21, creates an elective special depreciation allowance of up to 100% of the adjusted basis of qualified production property. Treasury and the IRS followed with Notice 2026-16, which provides interim definitions, allocation methods, election procedures, and recapture rules taxpayers may rely on while regulations are forthcoming.

The headline is powerful, but the deduction is not automatic and a factory campus is not one indivisible tax asset. Offices, sales areas, research space, software development, parking, and finished-goods storage may be excluded. A lessor may fail even when its tenant manufactures. A later change in use can trigger ordinary income without a sale. The planning opportunity therefore begins with facility design and tax ownership, not with Form 4562 after construction is complete.

What Section 168(n) Changes

Ordinary nonresidential real property is generally recovered under MACRS over 39 years using straight-line depreciation. Section 168(n) does not shorten that recovery period. Instead, it permits the taxpayer to designate all or a specific dollar amount of eligible basis as qualified production property, or QPP, and deduct the designated adjusted basis in the year the building is placed in service.

This is a timing provision, not a tax credit or permanent exclusion. The deduction reduces current taxable income and basis. Its value depends on the taxpayer's rate, taxable income, loss limitations, financing, state conformity, expected holding period, and future use. Machinery and other short-lived components may separately qualify for 100% bonus depreciation under Section 168(k); land is not depreciable. The project model must prevent overlap and place each dollar of basis in the correct regime.

Which Buildings and Activities Qualify

Notice 2026-16 generally requires QPP to be nonresidential MACRS real property used by the taxpayer as an integral part of a qualified production activity in the United States or a U.S. territory. Original use must begin with the taxpayer, subject to a narrow rule for certain acquired buildings not used in a qualifying activity during the statutory lookback period. Property required to use the alternative depreciation system is excluded.

A qualified production activity must substantially transform tangible personal property through manufacturing, agricultural production, chemical production, or refining. Packaging, repackaging, labeling, or minor assembly by itself is not substantial transformation. The eligible physical space can include certain essential raw-material receiving, storage, preparation, testing, and oversight areas when the Notice's conditions are met.

Common excluded areas include:

• offices and administrative-service space;
• lodging, parking, sales, and retail functions;
• research, software-development, and engineering areas;
• finished-goods storage; and
• other space unrelated to the qualifying production activity.

If at least 95% of the physical space satisfies the integral-part requirement when placed in service, the taxpayer may elect the Notice's de minimis rule and treat the entire property as satisfying that requirement. Below that threshold, the eligible portion must be identified and supported.

The Three Deadline Gates

1. Begin construction on time. Construction generally must begin after January 19, 2025, and before January 1, 2029. Preserve contracts, construction draws, invoices, engineering records, and the factual analysis supporting the start date.
2. Place the facility in service on time. The property generally must be ready and available for its qualifying use after July 4, 2025, and before January 1, 2031. Completion alone does not establish placed-in-service status if operations cannot begin.
3. Make the election on the original return. Attach the Notice 2026-16 statement by the due date, including extensions, of the original federal income tax return for the year the property is placed in service.

The election statement identifies the owner, location, property description, total unadjusted depreciable basis, eligible basis, and the dollar amount designated as QPP. If no dollar amount is specified, the Notice treats the entire eligible basis as designated. Revocation generally requires a private letter ruling and extraordinary circumstances, so the election should follow a written forecast rather than a reflexive maximum-deduction choice.

How Cost Segregation Determines Eligible Basis

Notice 2026-16 expressly permits reasonable basis-allocation methods using square footage, cost-segregation data, architectural or engineering plans, process diagrams, and construction invoices. More than one method may be appropriate when a single allocation would distort mixed-use or dual-use infrastructure. Employee headcount or employee time is not a reasonable basis-allocation method under the Notice.

A defensible study should produce at least four buckets: land; machinery and shorter-lived components potentially governed by other depreciation rules; eligible Section 168(n) building basis; and ineligible 39-year building basis. For shared systems such as HVAC, power distribution, and sprinklers, the file should connect engineering use to the allocation. The tax fixed-asset ledger, construction ledger, floor plan, and election statement should reconcile to one controlled schedule.

Election, Ownership, and Recapture Decisions

The taxpayer owning the eligible property makes the election property by property. A conventional third-party landlord generally cannot qualify merely because a manufacturing tenant uses the building. Notice 2026-16 provides exceptions for qualifying intercompany leases within a consolidated group and for certain commonly controlled pass-through entities or individuals, but the ownership and control tests must be documented rather than assumed.

Tax ownership should be tested alongside liability protection, lender covenants, state taxes, partnership economics, and exit planning. If the operating company and real-estate owner are different entities, the tax team should determine whether the Notice's common-control exception applies and who will own the deduction, basis reduction, and recapture exposure.

Recapture is the sharpest long-term risk. If QPP stops being used as an integral part of a qualifying production activity and moves to another productive use within the ten-calendar-year period beginning on the placed-in-service date, the affected portion is generally treated as disposed of under Section 1245. The prior deduction can be recognized as ordinary income even though the building was not sold. Temporary idling with an expectation of near-term qualifying use may not trigger a change, but conversions, leasing changes, restructurings, and production relocations belong on the annual tax-control checklist.

Common Mistakes

• Calling the entire campus a factory. Eligibility follows physical use and supported basis, not the project name.
• Confusing equipment bonus with QPP. Section 168(k) and Section 168(n) cover different property and require coordinated basis schedules.
• Ignoring the lessor rule. A tenant's production activity generally does not become the landlord's activity.
• Using headcount to allocate basis. The Notice expressly rejects employee headcount and time as reasonable allocation methods.
• Treating packaging as manufacturing. Packaging, labeling, and minor assembly alone do not establish substantial transformation.
• Missing ADS status. Property required to use ADS cannot qualify, including property affected by certain elections or tax-exempt use rules.
• Waiting until return preparation. Facility design, contracts, placed-in-service evidence, and entity ownership may be impossible to reconstruct cleanly after year-end.
• Automatically designating 100%. Partial designation may better match taxable income, state conformity, financing, and recapture risk.
• Forgetting the ten-year operating covenant. A change in use can create ordinary income without a sale.

The Bottom Line

Section 168(n) can make the tax cost of a qualifying production building behave more like immediately deductible equipment, but only for the basis, use, owner, and period the statute and Notice protect. The right process is to test the production activity, lock the construction and placed-in-service evidence, engineer a supportable basis allocation, model a partial or full designation, and monitor the ten-year use commitment. Manufacturers planning projects before the January 1, 2029 construction cutoff should complete that analysis before design, ownership, and financing decisions become expensive to change.