The Basics
- The “integral part” test is a manufacturer’s gateway to claiming 100% expensing on Qualified Production Property (QPP) under IRC § 168(n), requiring the property to be used as an integral part of a Qualified Production Activity (QPA).
- Substantial transformation is the linchpin concept, meaning raw materials or inputs must be changed in form, character, or use into a distinct final product that cannot be readily reverted.
- Notice 2026-16 provides critical taxpayer-favorable rules, including a 95% de minimis safe harbor and a 2025 NAICS-based safe harbor for manufacturers and agricultural producers.
Functionality Over Classification: Navigating the IRC § 168(n) Eligibility Rules
Our prior article introduced the new IRC § 168(n) deduction and the framework set out in IRS Notice 2026-16 for claiming 100% immediate expensing on Qualified Production Property (QPP). This follow-up zeroes in on the single most consequential eligibility hurdle: the integral part test.
Unlike traditional bonus depreciation under § 168(k), which applies to tangible personal property regardless of how it is used, § 168(n) extends 100% expensing to nonresidential real property — but only where the building itself is functionally tied to a qualifying production process. In other words, the deduction is not granted because of what the building is; it is granted because of what happens inside it. That’s where an integral part test is critical.
What is the Integral Part Test?
The integral part test requires that a building, or a defined portion of it, be used as an integral part of a Qualified Production Activity (QPA) — manufacturing, production, or refining — that results in a substantial transformation of tangible personal property into a distinct final product. Notice 2026-16, released Feb. 20, 2026, takes a practical approach: Property satisfies the requirement if a QPA takes place within its physical space. If a QPA occurs in only a portion of the building, only that portion qualifies as QPP.
Practically, integral-part space includes:
Production Floor Space: Areas where raw materials are actively transformed (assembly lines, stamping bays, refining units, mixing rooms).
Direct Production Support Areas: Space physically housing equipment or processes essential to the transformation activity.
Inventory and Staging Areas: Raw material and work-in-progress (WIP) storage physical spaces directly integrated into the production workflow.
Integrated Infrastructure: Utility rooms, in-line staging, and process-specific HVAC zones when essential to the production activity.
Excluded space (consistent with the statutory ineligibility list) includes offices, administrative areas, research and software development, parking, sales floors, lodging, and finished-goods storage.
The Heart of the Test: Substantial Transformation
Substantial transformation is the central concept on which the entire Integral Part Test turns. Without it, no amount of physical space qualifies as QPP.
Notice 2026-16 defines substantial transformation as a process that causes inputs to undergo “a significant change in form, character, or use,” such that they cannot readily be converted back into the original components. The IRS frames this as turning raw materials or subcomponents into a final, complete, and distinct item of property that is fundamentally different from what went in.
Qualifying Activities: The substantial transformation standard is read broadly — any process that changes an input’s form, character, or use into a distinct final product can qualify. Notice 2026-16 provides illustrative, though not exhaustive examples, such as converting:
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- Wood pulp into paper
- Steel rods into bolts
- Fresh tuna into canned tuna
- Sheet metal into stamped or molded parts
Non-Qualifying Activities include packaging, labeling, minor assembly, bundling/kitting, storage of finished goods, general distribution, and routine processing that falls short of substantial transformation.
Narrow Definition of “Production”: While “manufacturing” and “refining” are interpreted expansively, the term “production” in § 168(n) is limited to agricultural and chemical production.
The 95% De Minimis Rule: A Powerful Safe Harbor
Recognizing that few facilities are 100% production space, Notice 2026-16 adopts a 95% de minimis test. If at least 95% of the building’s physical space is used as an integral part of a QPA when placed in service, the taxpayer may elect to treat the entire property as QPP — including space that would otherwise be ineligible.
If the 95% threshold is not met, taxpayers may still qualify the production portion of the facility using any reasonable allocation method — including a cost segregation study, which Notice 2026-16 identifies as an accepted allocation methodology.
The 2025 NAICS-Based Safe Harbor
For property placed in service between July 4, 2025, and Dec. 31, 2025, Notice 2026-16 provides a transitional safe harbor.
The activity is treated as a QPA if both of the following conditions are met:
1. The taxpayer’s principal business activity code on its most recently filed return (filed before Feb. 19, 2026) falls within NAICS Sectors 31–33 (manufacturing) or NAICS Subsectors 111–112 (agriculture).
2. The activity results in — or is essential to — substantial transformation. The safe harbor simplifies the industry question but does not eliminate the substantial transformation requirement.
Risk Considerations: The 10-Year Recapture Trap
Even a clean Integral Part Test today does not lock in the benefit. Section 168(n) imposes a 10-year recapture period: if the property ceases to be used in a QPA within 10 years after being placed in service, § 1245 depreciation recapture applies — and the 100% deduction can be clawed back.
Section 1245 recaptures previously claimed depreciation by taxing the associated gain as ordinary income rather than at capital gains rates, effectively reversing the benefit if qualifying use ends within the window. This makes long-term use planning an essential part of any § 168(n) strategy — particularly for manufacturers considering facility sales, repurposing, or operational restructuring.
Your Takeaway
The integral part test is not a label test; it is a functional test focused on what actually happens inside the building. Taxpayers who can document substantial transformation and properly map their facility space are well positioned to claim this deduction. With Notice 2026-16 in interim status and proposed regulations forthcoming, taxpayers evaluating facility investments should assess eligibility carefully and document their positions in the near term.
Rehmann’s Specialty Tax Services team is actively helping manufacturers and other producers evaluate § 168(n) eligibility under Notice 2026-16. To ensure your facility investment is built on a solid tax foundation, click here to connect with our specialists.
Frequently Asked Questions
Q: Does the entire building need to be used for manufacturing to qualify?
A: No. If at least 95% of the physical space is used as an integral part of a QPA, the entire building can be treated as QPP. Below that threshold, only the qualifying portion are eligible.
Q: How do we prove substantial transformation occurred?
A: Documentation is critical. Maintain process flow diagrams, before/after photographs of inputs and outputs, engineering descriptions, and NAICS classification support. A cost segregation study performed by qualified engineers is the gold-standard substantiation tool.
Q: What happens if we sell or repurpose the facility within 10 years?
A: Section 168(n) imposes a 10-year recapture period. If the property ceases to be used in a QPA within that window, § 1245 recapture applies and the 100% deduction can be clawed back. This makes long-term use planning essential.
