On February 20, 2026, Treasury and the IRS released Notice 2026-16, providing interim guidance on the new 100% special depreciation allowance for qualified production property (QPP) under Internal Revenue Code §168(n).[1]  Enacted as part of the One Big Beautiful Bill Act (OBBBA),[2] §168(n) allows taxpayers to elect 100% depreciation for qualifying portions of certain domestic nonresidential real property used in manufacturing, production, or refining activities. The Notice provides welcome clarifications and rules to help taxpayers evaluate and ensure eligibility for potentially significant cash tax savings for qualifying capital projects for which construction begins after January 19, 2025, and before January 1, 2029. This alert summarizes key aspects of the guidance and highlights practical implications.

Key Highlights of Notice 2026-16

1. Lessor-lessee exception allows QPP treatment for leased property if the lessee is in the same consolidated group or under common control with the lessor.
2. Provides definitions for manufacturing, production, and refining to determine whether an activity qualifies as a qualified production activity (QPA).
3. Adopts a favorable definition of substantial transformation, requiring a fundamental change in the nature or function of inputs.
4. Clarifies the integral part requirement and introduces a 95% de minimis rule for full-building qualification.
5. Storage of raw materials may qualify as integral to a QPA; storage of finished goods does not.
6. Dual-use infrastructure (e.g., HVAC, sprinkler systems) may be allocated between eligible and ineligible property.
7. Improvements or additions to existing property may qualify as separate QPP if requirements are met.
8. Taxpayers may use any reasonable method to allocate basis between eligible and ineligible property, excluding employee headcount or time-based methods.
9. Contract manufacturing arrangements may qualify for QPP treatment.
10. The §168(n) election must be made on a timely filed return and must identify each property to which the election applies.  It also permits a taxpayer to elect a portion of the qualifying property (i.e., clarifies that an election may apply to less than the entire property).

Lessor-Lessee Exception

Section 168(n) generally disallows QPP treatment for property leased to a third party. However, Notice 2026-16 provides two key exceptions:

• If the lessee is in the same consolidated group as the lessor, the lessee’s use of the property in a QPA is attributed to the lessor.
• If the lessee and lessor are under common control (generally defined as more than 50% ownership), the lessee’s QPA use is also attributed to the lessor.

These exceptions allow common real estate structures — such as operating companies leasing from related entities — to qualify for QPP treatment, provided all other requirements are met.

Definitions of Manufacturing, Production, and Refining

The Notice defines a QPA as manufacturing, production, or refining of a qualified product. Summary of the key definitions include:

• Manufacturing: Materially changing the form or function of tangible personal property to create a new item held for sale or lease. Minor assembly, packaging, or labeling does not qualify.
• Production: Limited to agricultural and chemical production, including cultivating crops and processing chemical compounds.
• Refining: Purifying or upgrading raw or intermediate materials into more useful or higher-value products.

These definitions help delineate eligible activities and clarify that only substantial, transformative processes qualify.

Substantial Transformation

A QPA must result in a substantial transformation of inputs into a final, complete, and distinct product. The output must be fundamentally different from the original materials. Examples include converting wood pulp into paper or steel rods into bolts. Activities such as bundling or packaging finished goods do not meet this standard.

The inclusion of “subcomponents” in the definition supports qualification for complex assembly operations, such as automotive or engine manufacturing, where the final product is materially distinct from its parts.  This is a welcome clarification considering the substantial transformation test in Treas. Reg. §1.954-3(a)(4) excluded the assembly of automotives and engines.

Integral Part Requirement and 95% De Minimis Rule

To qualify as QPP, the property must be used as an integral part of a QPA. Only the physical space where the QPA occurs qualifies. If a QPA is conducted in only part of a building, only that portion qualifies.

However, the Notice provides a de minimis rule: if 95% or more of the building’s space is used in a QPA at the time it is placed in service, the entire building may be treated as QPP.

Storage of Raw Materials vs. Finished Goods

The Notice distinguishes between storage of raw materials and finished goods:

• Storage of raw materials or inputs used in a QPA may qualify as integral to the QPA if conducted in the same property or integrated facility.
• Storage of finished goods is not considered integral to a QPA and is treated as ineligible property.

Taxpayers must allocate basis accordingly or rely on the 95% de minimis rule if applicable.

Dual-Use Infrastructure

Infrastructure that serves both eligible and ineligible property — such as HVAC, electrical, or sprinkler systems — may be allocated between QPP and non-QPP using any reasonable method. Acceptable methods include:

• Architectural or engineering plans
• Process diagrams or blueprints
• Cost segregation studies

Allocations must reflect actual or planned usage. This flexibility allows taxpayers to maximize QPP treatment for shared systems.

Improvements and Additions

Each building is treated as a separate unit of property (UOP). Improvements or additions placed in service after the original building are treated as separate UOPs and may independently qualify for QPP if they meet the requirements.

For purposes of the integral part requirement, multiple properties that operate as an integrated facility — evidenced by actual operations and physical proximity — may be treated as a single UOP. However, properties comprised solely of ineligible property cannot be included in an integrated facility.

Basis Allocation Rules

Taxpayers may use any reasonable method to allocate unadjusted depreciable basis between eligible and ineligible property. Acceptable methods may include:

• Square footage
• Cost segregation data
• Architectural or engineering plans
• Construction invoices

Multiple allocation methods may be used if a single method does not properly reflect the facts and circumstances. However, employee headcount and time-based methods are explicitly excluded as reasonable methods.

Contract Manufacturing

The Notice confirms that contract manufacturing arrangements do not disqualify a property from QPP treatment. A taxpayer may qualify if it conducts a QPA at the property, even if the taxpayer does not own the product or performs the activity under contract for another party.

Election Mechanics

The §168(n) election must be made on a timely filed original return. The election must:

• Identify each property (or portion thereof) designated as QPP
• Specify the amount of basis subject to the 100% depreciation deduction

The election is irrevocable without IRS consent, which the IRS will only provide in extraordinary circumstances. Taxpayers should carefully evaluate the long-term implications, including the 10-year recapture rule, under which property that ceases to qualify will be treated as having been disposed of at that time, with gain recognized under §1245, the basis increased by that gain, and the recomputed basis being treated as a new separate asset on the first day of the year of change (i.e., likely depreciated over a new 39-year recovery period).

Final Takeaways and Next Steps

Notice 2026-16 — which previews forthcoming proposed regulations — provides welcome clarity on the application of §168(n) and meaningful flexibility in structuring and documenting QPP eligibility.  Additionally, Notice 2026-16 provides favorable guidance on taxpayer issues, such as common control lessor-lessee structures, what constitutes substantial transformation of a product, and what activity is considered integral to QPA. Taxpayers may rely on the Notice for property for which construction began after January 19, 2025 (or acquired after that date) and placed in service before the proposed regulations are issued, provided they apply the guidance in its entirety and consistently to all applicable QPP beginning with the first taxable year of reliance.

With the guidance provided in Notice 2026-16, tax departments have additional clarity in what projects may qualify for the favorable cost recovery provision, as the ROI on an after tax basis can be significant.  As a result, tax teams should work within their organizations to help evaluate their domestic capital project portfolios, cost allocation methodologies, and documentation practices to evaluate eligibility, ensure compliance, and maximize the potential benefits of the 100% depreciation allowance.

[1] For additional information and insights on §168(n), see Rayth Myers et al., “Navigating the New Powerful Tax Incentive for U.S. Production Facilities Under Section 168,” Alvarez & Marsal Tax Alert, December 16, 2025.

[2] To explore additional insights on the OBBBA and its tax provisions beyond §168(n), see Kevin M. Jacobs et al., “The OBBBA Passed . . . Now What?,” Alvarez & Marsal Tax Alert, July 8, 2025.

Contacts

For more information on Notice 2026-16 or assistance evaluating the §168(n) election, please contact:

• Rayth Myers – Managing Director, National Tax Office
• Kevin M. Jacobs – Managing Director, National Tax Office
• Lucy Siegel – Director, National Tax Office
• Jenny Goldinstein – Senior Director, Global Tax Incentives
• Stephen McKinney – Senior Director, A&M Tax