Some Implications of 100% Bonus Depreciation

Editor: Alan Wong, CPA

Depreciation

Given the often complex interaction of the many rules regarding modified accelerated cost recovery system (MACRS) depreciation, additional first-year (bonus) depreciation, Sec. 179 expensing, and state decoupling, optimization of the depreciation deduction has become more of an art than a science. This item highlights some of the implications and peculiarities of the newest addition to the mix: 100% bonus depreciation.

Background

On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, extended the bonus depreciation deduction to qualified property placed in service before 2013 (previously extended by the Small Business Jobs Act of 2010, P.L. 111-240, to qualified property placed in service before 2011) and created a new, 100% bonus depreciation deduction for qualified property acquired after September 8, 2010, and placed in service before January 1, 2012. Effective March 29, 2011, Rev. Proc. 2011-26 was issued to provide guidance on the application of these new provisions.

Too Much of a Good Thing?

As with previous iterations of bonus depreciation, taxpayers may elect to forgo the bonus on all qualified property in a given class that is placed into service in the same tax year (Sec. 168(k)(2)(D)(iii)). This may come as a relief to some taxpayers who, having placed a significant amount of assets into service, find that the prospect of a 100% deduction for these assets frustrates their plans (for example, to use expiring NOLs). Other taxpayers, however, might find it more advantageous to be able to just dial back the bonus deduction from 100% to 50% or even to 30%. Rev. Proc. 2011-26, Section 4.02, does provide a limited exception to Sec. 168(k)(2)(D)(iii), allowing a taxpayer to elect 50% bonus for all qualified property in a given class that is placed into service in the tax year that includes September 9, 2010. However, the stated purpose of this exception is simply to avoid disputes about the exact date an asset was placed into service during the initial year that 100% bonus became available; it is not a general step-down along the lines of Regs. Sec. 1.168(k)-1(e)(1)(ii)(B), which permitted an election to deduct 30%, rather than 50%, bonus at the discretion of the taxpayer. Barring future guidance, it is unclear whether a taxpayer will be able to elect a bonus depreciation percentage lower than 100% for qualified property placed into service in a tax year beginning after September 9, 2010.

Construction Exception

Rev. Proc. 2011-26 also updates the regulations concerning self-constructed property (Regs. Sec. 1.168(k)-1(b)(4)(iii)) to provide that if construction begins before September 9, 2010, 100% bonus depreciation is not available, even if the property is not placed into service until after September 8, 2010. Taxpayers should keep in mind that construction is not considered to begin until physical work of a significant nature begins, excluding preliminary activities such as planning or design, and that there is a safe harbor under which significant physical work is deemed not to begin until the taxpayer incurs or pays more than 10% of the total cost, excluding land and preliminary activities. Therefore, if the bulk of the work takes place after September 8, 2010, the project may still be eligible for the 100% bonus. In addition, Rev. Proc. 2011-26, Section 3.02(2)(b), offers a limited exception for components of a larger project begun before September 9, when the components themselves are not acquired or constructed until after September 8; the taxpayer may elect to treat just those components as eligible for the 100% bonus.

One Fell Swoop

The availability of the 100% bonus adds to the attractiveness of a somewhat counterintuitive procedure that allows two bonus depreciation deductions for the same expenditure. This happens when a taxpayer replaces an asset on which bonus depreciation was originally taken, in a like-kind exchange or after a casualty conversion, with an asset that is also qualified property for bonus depreciation. According to Regs. Sec. 1.168(k)-1(f)(5)(iii)(A), both the remaining carryover basis of the original asset and the excess basis of the replacement asset are eligible for the bonus deduction. This paradoxical result makes more sense when considered as equivalent to a disposal of the original asset at its adjusted basis, followed by the purchase of a new one with the proceeds plus additional cash. The practical effect is that after the exchange, both the carryover and excess bases can receive a 100% bonus deduction, eliminating the need to track and depreciate them separately in future years.

Business Auto Complications

Certainly the oddest aspect of 100% bonus depreciation is what it does to the depreciation of business automobiles. In order to understand the problem, it is helpful to first consider the Code section addressing the allowance for bonus depreciation, which says that the adjusted basis of qualified property must be reduced by the bonus depreciation allowance (50% or 100%, as applicable) before computing the amount otherwise allowable as a depreciation deduction for the initial and all subsequent tax years (Sec. 168(k)(1)). The regulations expand on this, defining the “remaining adjusted depreciable basis” as the unadjusted depreciable basis of qualified property reduced by the amount of bonus depreciation allowed or allowable. This remaining adjusted depreciable basis is then to be depreciated using either the applicable calculations (double-declining balance in the case of business autos) or the optional depreciation tables (Regs. Sec. 1.168(k)-1(d)(2)). Clearly, the authors of these provisions never envisioned the advent of the 100% bonus, which reduces the remaining adjusted depreciable basis to zero, leaving nothing to which one can apply either the declining balance calculations or the table percentages.

Normally, this would not matter because the asset in question will already have been fully depreciated in the placed-in-service year by the application of the 100% bonus. However, consider what happens in the case of business autos, the depreciation of which is subject to yearly dollar caps (Sec. 280F(a)). The maximum annual depreciation deduction for a business auto is the lesser of the otherwise allowable depreciation amount or the applicable cap. Although the cap for the first year of service is increased by $8,000 when the auto qualifies for bonus depreciation (Sec. 168(k)(2)(F)(i)), it is likely that the cost of any new auto purchased today will still be greater than the amount of the enhanced cap ($11,060 for 2011, according to Rev. Proc. 2011-21). Therefore, there will be unrecovered basis in an amount equal to the difference between the car’s cost and the first-year cap but no way to depreciate this unrecovered basis in subsequent recovery years, since the remaining adjusted depreciable basis after the 100% bonus depreciation is zero (as noted above, the remaining adjusted depreciable basis is calculated before the application of any other depreciation provisions, including the Sec. 280F limitations). Instead, the unrecovered basis is deducted beginning in the first tax year succeeding the recovery period (Sec. 280F(a)(1)(B)). For a car costing $25,000 (assuming 100% business use and no Sec. 179 expense taken), $11,060 depreciation would be deducted in the initial year, but the unrecovered basis of $13,940 could be expensed only beginning in the seventh year, subject to the Sec. 280F cap each year. Years 2–6 would receive no depreciation deduction.

Anticipating the problem, Rev. Proc. 2011-26, Section 3.03(5)(c)(ii), provides a safe-harbor method of accounting for business automobiles that qualify for 100% bonus depreciation. Under the safe harbor, depreciation for the first placed-in-service year remains the lesser of 100% bonus or the first-year limitation amount. For subsequent recovery years, there are two separate methods: under the first, the taxpayer applies the applicable table rates to the remaining adjusted depreciable basis of the asset as if a 50% bonus had been claimed instead of 100%; that is, they are applied to 50% of the unadjusted depreciable basis rather than to zero. This produces reasonable depreciation deductions for years 2–6 and a correspondingly smaller amount of unrecovered basis to be expensed beginning in the seventh year. A taxpayer uses this method for subsequent years if there is any unrecovered basis specifically from the first placed-in-service year, calculated as the excess of the allowable depreciation for the first year as if a 50% bonus were in effect over the first-year limitation amount. For a $25,000 car, the first year of depreciation with 50% bonus under the half-year convention would be (25,000 × 50%) + (12,500 × 20%) = $15,000; the first-year limitation is $11,060, so the unrecovered basis from the first year is $3,940. Depreciation for the second recovery year is therefore (25,000 × 50%) × 32% = $4,000 (which is lower than the second-year limitation amount of $4,900 and therefore fully deductible).

If there is no unrecovered basis from the first year, a taxpayer cannot use the optional depreciation tables for subsequent years. Instead, the taxpayer depreciates the asset in those years in accordance with Rev. Proc. 87-87, Sections 6.03, 6.04, 6.05, and 6.06 (double-declining- balance method for automobiles), applied to the adjusted depreciable basis as defined in Regs. Sec. 1.168(b)-1(a)(4)—that is, the adjusted basis after depreciation deductions. For a car costing $15,000, there is no unrecovered basis from the first year, as (15,000 × 50%) + (7,500 × 20%) = $9,000, which is less than the first-year limitation of $11,060. Therefore, depreciation for the second recovery year is calculated as [(15,000 – 11,060) ÷ 5] × 2 = $1,576 (which is lower than the second-year limitation of $4,900).

A Herd of SUVs

Heavy SUVs (over 6,000 pounds) are not subject to the luxury automobile dollar caps of Sec. 280F because they do not meet the definition of a passenger automobile (Sec. 280F(d)(5)). This has made them very popular for business use, despite their lack of fuel efficiency. In the past, this loophole was partially closed by Sec. 179(b)(6), which allows no more than $25,000 of the cost of a heavy SUV to be expensed under Sec. 179. However, 100% bonus depreciation allows taxpayers to expense these vehicles, if used 100% for business, entirely in the initial year of service.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.