Claiming Bonus Depreciation on Self-Constructed Long Production Period Assets

Editor: Anthony S. Bakale, CPA, M. Tax.

Depreciation

The Small Business Jobs Act of 2010, P.L. 111-240, extended 50% bonus depreciation for assets placed in service before January 1, 2011. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (TRA 2010), created 100% bonus depreciation for assets placed in service after September 8, 2010, and before January 1, 2012, and extended 50% bonus depreciation for assets placed in service after December 31, 2011, and before January 1, 2013.

Both acts contain binding contract exceptions. The first exception is that bonus depreciation of either 50% or 100% cannot be claimed for assets acquired after December 31, 2007, and placed in service before (or after) the applicable dates if the asset was acquired under a written binding contract entered into prior to January 1, 2008. Under TRA 2010, a taxpayer cannot claim 100% bonus depreciation for assets acquired after September 8, 2010, and placed in service before January 1, 2012, if the taxpayer acquired the asset under a written binding contract entered into before September 9, 2010. In the case of certain assets (longer production period property, transportation property, and certain aircraft), 50% bonus depreciation is available if the asset is acquired under a binding contract entered into after December 31, 2007, and before January 1, 2013, and the asset is placed in service prior to January 1, 2014. A similar binding contract rule applies to these assets with respect to 100% bonus depreciation with appropriate date modifications.

Although the binding contract rules seem simple enough to apply with respect to acquired property, the waters become a bit muddied when the taxpayer’s qualified property is self-constructed. Self-constructed property can be broken down into two general categories. The first category is enumerated in Sec. 168(k)(2)(B) (“Certain property having longer production periods”). The other category would include everything else (or property that does not have a longer production period) that is otherwise qualified property. This item addresses self-constructed property having a longer production period, since the general rules are applicable to the latter category. In March 2011 the IRS issued Rev. Proc. 2011-26, in part to clarify how the binding contract rules apply to self-constructed longer production period assets and to provide an election to “componentize” the costs associated with such projects to account for the different phases of bonus depreciation available to the taxpayer for such projects.

Self-Constructed Assets

First, a little background is needed on self-constructed longer production period assets. In order to qualify for bonus depreciation, these assets must meet the general qualification rules for Sec. 168(k). Under Sec. 168(k)(2), qualified property means Sec. 168 property that has a recovery period of 20 years or less, computer software that is depreciable under Sec. 167(a), water utility property, or qualified leasehold improvement property, the original use of which commences with the taxpayer after December 31, 2007, subject to the binding contract rules described above and placed in service prior to January 1, 2014. In addition, the property must meet the following additional requirements:

• The property has a recovery period of at least 10 years or is transportation property;
• It is subject to the uniform capitalization rules under Sec. 263A; and
• It must have an estimated production period exceeding one year and an estimated cost exceeding $1 million as set forth in Sec. 263A(f)(1)(B)(iii).

Applying the Rules

Assuming the self-constructed longer production period assets meet these requirements, the taxpayer must then determine how the binding contract rules and placed-in-service rules apply to its particular project. First, under Sec. 168(k)(2)(E)(i), self-constructed property meets the requirement of being acquired after December 31, 2007, and before January 1, 2013, if the taxpayer begins production of the property during this period. Regs. Sec. 1.168(k)-1(b)(4)(iii)(C)(1) further provides that if costs are incurred or components are acquired after December 31, 2007, and relate to a “larger self-constructed project” that began before December 31, 2007, such costs incurred or components acquired will not qualify for the 50% bonus depreciation. Sec. 168(k)(5) (the 100% bonus depreciation provision) states that for purposes of the 100% bonus depreciation, “rules similar” to the acquisition and placed-in-service general rules will apply to qualifying assets for purposes of claiming 100% bonus depreciation, with appropriate adjustments for the applicable dates (i.e., after September 8, 2010, and before January 1, 2012). But here is where it gets interesting.

Rev. Proc. 2011-26, Section 2.04, indicates that the IRS will allow a limited exception for “certain components” as set forth in Section 3.02(2)(b) of the revenue procedure. Under the general rule above, if the taxpayer incurs the costs after the effective date (December 31, 2007) for a larger self-constructed project that the taxpayer began prior to the effective date, the additional costs would not qualify for bonus depreciation. It may seem that this rule would also be applicable to self-constructed assets for 100% bonus depreciation rules, so that for a larger self-constructed project started before September 8, 2010, costs incurred after that date would not qualify for 100% bonus depreciation. However, under its authority to interpret legislation, the IRS has granted itself some latitude in the application of these rules due to the use of the word “similar” (as opposed to “same”) within the statutory language. Section 3.02(2)(b) provides that solely for purposes of Sec. 168(k)(5) (100% bonus depreciation), the IRS will allow a limited exception for larger self-constructed property where the production began after December 31, 2007, and before September 9, 2010. Under this exception, for otherwise qualified property, costs incurred after September 8, 2010, and before January 1, 2012 (before January 1, 2013, in the case of qualified property described in Sec. 168(k)(2)(B) or (C)), will qualify for 100% bonus depreciation. The taxpayer must elect on a component-by-component basis to have this provision apply.

To further illustrate how these rules apply, Rev. Proc. 2011-26 provides several examples.

Example 1—Acquired property and self-constructed property not eligible for the 100% additional first-year depreciation deduction: In June 2008, X begins constructing an electric generation power plant for its own use. In February 2009, prior to the plant’s completion, X and Y (an unrelated party) enter into a written binding contract under which X transfers the rights to own and use this power plant to Y for $2 million. On March 1, 2009, Y begins construction to complete the plant. Between March 2009 and August 2010, Y incurs another $10 million to complete construction. This $10 million includes amounts for components that Y acquired under written binding contracts entered into after March 1, 2009, and for self-constructed components, the construction, manufacturing, or production of which began after March 1, 2009. Y completes construction of the power plant in August 2010. On October 1, 2010, Y places the plant in service. The plant is included in asset class 49.13 of Rev. Proc. 87-56 and has a recovery period of 20 years under Sec. 168(c).

In this example, Y must first determine if the project qualifies for bonus depreciation under the general rules. Because Y acquired (and began) the project after December 31, 2007, it was not part of a larger self-constructed project that Y began before December 31, 2007, and the property otherwise met the definition of qualified property under Sec. 168(k)(2), the property qualifies under the general rule for bonus depreciation.

Next, Y must determine if the project or any of its components qualify for the special 100% bonus depreciation. Although the original use (placed-in-service date) of the project began with Y after September 8, 2010, and before January 1, 2013, the project as a whole does not meet the acquisition rule under Sec. 168(k)(5) because the property was acquired under a binding contract entered into prior to September 9, 2010, and the self-constructed portion of the project began before September 9, 2010.

Y must then determine if any of the project’s component costs qualify for 100% bonus depreciation under the special exception set forth in Rev. Proc. 2011-26, Section 3.02(2)(b). Under this exception, if a taxpayer began a larger self-constructed project before September 9, 2010, but incurred costs for project components after September 8, 2010, the component costs incurred after September 9, 2010, will qualify for 100% bonus depreciation, assuming the placed-in-service rule is met (prior to January 1, 2013). In this example, Y did not incur any costs associated with the project after September 8, 2010, so under the special exception none of the project costs qualify for 100% bonus depreciation. In summary, all the costs that Y incurred for the project qualify for 50% bonus depreciation.

Example 2—Acquired property and self-constructed property partially eligible for the 100% additional first-year depreciation deduction: In August 2009, X begins constructing an electric generation power plant for its own use. On September 1, 2010, prior to the plant’s completion, X and Y (an unrelated party) enter into a written binding contract, and X transfers the rights to own and use this plant to Y for $5 million. On September 15, 2010, Y begins construction to complete the plant. Between September 15, 2010, and November 2011, Y incurs another $10 million to complete construction. This $10 million includes amounts for components that Y acquired after September 15, 2010, and for self-constructed components, the construction, manufacturing, or production of which began after September 15, 2010. Y acquires all components to complete construction of the plant under written binding contracts entered into after September 1, 2010. Y completes construction of the plant in November 2011. On December 15, 2011, Y places the power plant in service. The plant is included in asset class 49.13 of Rev. Proc. 87-56 and has a recovery period of 20 years under Sec. 168(c).

In this example, Y must first determine if the project qualifies for bonus depreciation under the general rules. Because Y acquired (and began) the project after December 31, 2007, it was not part of a larger self-constructed project that Y began before December 31, 2007, and the property otherwise meets the definition of qualified property under Sec. 168(k)(2), the property qualifies under the general rule for bonus depreciation.

Next, Y must determine if the project or any of the project’s components qualify for the special 100% bonus depreciation. Although the original use (placed-in-service date) of the project began with Y after September 8, 2010, and before January 1, 2013, the project as a whole does not meet the acquisition rule under Sec. 168(k)(5) because the property was acquired under a binding contract entered into prior to September 9, 2010; the self-constructed portion of the project, although it began after September 8, 2010, does not qualify under the general rule because it was part of a larger project that began on September 1, 2010 (the date the partially completed plant was acquired).

Y must then determine if any of the project’s component costs qualify for 100% bonus depreciation under the special exception set forth in Rev. Proc. 2011-26, Section 3.02(2)(b). In this example, Y incurred all additional costs associated with the project after September 8, 2010, so under the special exception the costs associated with the self-constructed portion and related component costs would qualify for the 100% bonus depreciation because these costs were incurred after September 8, 2010. In summary, Y can claim 50% bonus depreciation on $5 million of costs, and the remaining $10 million of costs will qualify for 100% bonus depreciation if Y makes the component election. If the election is not made, the full $15 million of costs will qualify only for the 50% bonus depreciation.

The taxpayer can make the component election for one or more components that are described in Section 3.02(2)(b) of Rev. Proc. 2011-26. The taxpayer must make the election by the date (including extensions) of the federal tax return for the taxpayer’s tax year in which it places the larger self-constructed project in service. The election is made by attaching a statement to the return indicating that the taxpayer is making the election under Rev. Proc. 2011-26, Section 3.02(2)(b), and whether the taxpayer is making the election for some or all of the components of the self-constructed project.

Conclusion

Although the binding contract rules seem clear on the surface, when a taxpayer’s asset for which it wants to claim bonus depreciation is a self-constructed longer production period asset, the rules can become quite complicated. The IRS has provided additional guidance for this category of asset in Rev. Proc. 2011-26, and taxpayers and their advisers should review the revenue procedures to determine how the general rules and created exceptions may apply to their particular situations.

EditorNotes

Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.

For additional information about these items, contact Mr. Bakale at (216) 579-1040 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly International.