On February 20, 2026, the Internal Revenue Service (IRS) issued Notice 2026-16 (the Notice), providing interim guidance on the new 100% special depreciation allowance for Qualified Production Property (QPP) under Section 168(n), enacted as part of P.L. 119-21, widely known as the “One Big Beautiful Bill Act.” While much attention has focused on the definition of qualified production activities, the Notice contains critical leasing rules that will significantly affect real estate, manufacturing and private equity structures.
This update highlights the guidance in Section 4.02(3) of Notice 20261-6, addressing when property used by a lessee may or may not be treated as QPP, including two important exceptions that provide planning opportunities for consolidated groups and commonly controlled operating structures.
Key Takeaways
- General rule: Property used by a lessee does not qualify as QPP for the lessor.
- Consolidated groups benefit from a full look-through rule for intercompany leases.
- Commonly controlled passthrough and individual lessors may also look through to lessee activities if 50% ownership thresholds are met.
- The guidance favors integrated operating structures and limits benefits for passive real estate investors.
Taxpayers considering new construction, expansions, or restructurings involving production facilities should evaluate these rules early to ensure eligibility for the Section 168(n) special depreciation allowance.
QPP and the Integral Part Requirement
To qualify as QPP, nonresidential real property must be used by the taxpayer as an integral part of a qualified production activity (QPA), such as manufacturing, chemical production, agricultural production or refining that results in a substantial transformation of tangible personal property. Merely owning property in which production occurs is not sufficient; the statute and the Notice emphasize use by the taxpayer claiming the depreciation benefit. This integral part requirement is central to the IRS’s approach to leased property.
General Rule: Lessee Use Does Not Count for the Lessor
Under the general rule in Section 4.02(3)(a) of Notice 2026-16, property used by a lessee engaged in a QPA is not treated as used by the lessor as an integral part of a QPA. As a result, the lessor does not satisfy the integral part requirement and cannot treat the property as QPP.
Practical Impact
- Traditional arm’s-length leasing arrangements (for example, a real estate company leasing a factory to an unrelated manufacturer) will not qualify for the Section 168(n) 100% depreciation allowance at the lessor level.
- The IRS is signaling that Section 168(n) is intended to benefit operating taxpayers, not passive real estate owners whose tenants conduct qualifying production activities.
Absent an exception, lessee production activity cannot be attributed to the lessor.
Exception #1: Intercompany Leases Within Consolidated Groups
Notice 2026-16 provides a significant exception for consolidated groups.
If:
- A member of a consolidated group (S) owns property and leases it to another group member (B), and
- The lease is an intercompany lease under the consolidated return regulations,
then:
- S is not treated as a lessor for purposes of the lessee-use prohibition, and
- The consolidated group is treated as a single taxpayer for purposes of the integral part requirement.
Under this rule, the determination of whether the property is an integral part of a QPA is made by reference to the operating activities of the lessee member (B) conducted in or within the leased property.
For corporate groups filing consolidated returns, this exception preserves QPP eligibility in common structures where:
- One entity owns real estate, and
- Another group member operates the manufacturing or production business.
This approach is consistent with the single-entity concept underlying the consolidated return regime and avoids penalizing groups for internal legal separations of real estate and operations.
Exception #2: Commonly Controlled Pass-through and Individual Lessors
Notice 2026-16 also introduces a nonconsolidated look-through rule for certain commonly controlled leasing arrangements involving pass-through entities or individuals.
This exception applies where the lessor is (each referred to in the Notice as a lessor pass-through entity or lessor individual):
- A partnership,
- An S corporation, or
- An individual.
The property must be leased to a commonly controlled person, defined using a 50% ownership threshold, measured for a majority of the taxable year in which the property is placed in service (including the last day of the year). Ownership is determined using direct ownership and attribution rules under Section 267(b) and 707(b).
The Notice recognizes two qualifying ownership structures:
- Common Owner Structure: The same person or group of people owns at least 50% of both:
- The lessor pass through entity, and
- The lessee operating entity.
- Vertical Ownership Structure: The lessor pass-through entity or lessor individual owns at least 50% of the lessee operating entity.
If the common control test is satisfied:
- The lessor is not treated as a lessor for purposes of the lessee-use rule, and
- The integral part requirement is tested by reference to the lessee’s trade or business activities conducted in the leased property.
This exception is relevant for:
- Property company/operating company structures,
- Closely held and family-owned businesses,
- Private equity portfolio companies using partnerships or S corporations.
Where ownership thresholds are met, production activities conducted by the operating entity can support QPP treatment at the real estate owner level.
Other Items
Ownership and Attribution Analysis Is Critical
The 50% ownership tests rely heavily on Section 267(b) and Section 707(b) attribution rules, which can produce unexpected results. Taxpayers should carefully analyze indirect ownership, family attribution and related-party relationships before relying on the exception.
Timing Matters
Ownership must exist for a majority of the taxable year in which the property is placed in service, including year-end. Changes in ownership around the placed-in-service date may jeopardize eligibility.
Mixed-use and Excluded Space Still Applies
Even where the lessee-use exception applies, property used for offices, administrative services, parking, research and development (R&D) or other excluded functions remains outside the QPP definition and may require basis allocation.
Recapture Risk Remains
If property ceases to be used as an integral part of a QPA within 10 years of being placed in service, Section 168(n) recapture rules may apply, converting prior depreciation into ordinary income.
Your Guide Forward
Cherry Bekaert’s Tax Credits & Incentives Advisory team can assist clients by evaluating QPP eligibility under Section 168(n), structuring leasing and ownership arrangements, modeling depreciation benefits and recapture exposure, and navigating consolidated group and pass-through ownership rules.
If you have questions about how Notice 2026-16 applies to your organization, please contact our tax advisors.
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