In August 2018 the IRS issued Prop. Regs. Sec. 1.168(k)-2 to provide guidance that reflects changes made by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, to bonus depreciation in Sec. 168(k) (REG-104397-18). The proposed regulations answered many taxpayer and preparer questions about the amendments to the bonus depreciation rules, while simultaneously creating new questions.
Bonus depreciation in Sec. 168(k) was introduced by the Job Creation and Worker Assistance Act of 2002, P.L. 107-147, allowing an additional first-year depreciation deduction in the year qualified property was placed in service. Subsequent amendments have modified the bonus depreciation percentage and property that is considered to be qualified.
On Dec. 22, 2017, the TCJA amended Sec. 168(k) to increase the bonus depreciation percentage from 50% to 100% for qualified property and to modify the definition of property that is considered to be qualified. The new rules apply to property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2027 (or before Jan. 1, 2028, for longer production period property (LPPP)). Bonus depreciation is also allowable for specified plants planted or grafted after Sept. 27, 2017, and before Jan. 1, 2027.
The bonus depreciation percentage is 100% for qualified property placed in service, or specified plants planted or grafted, before Jan. 1, 2023 (or before Jan. 1, 2024, for LPPP). It is then phased down by 20 percentage points annually for qualified property placed in service, or specified plants planted or grafted, after Dec. 31, 2022 (or after Dec. 31, 2023, for LPPP).
Prior to the TCJA, qualified property eligible for bonus depreciation included certain Sec. 168 property with a recovery period of 20 years or less, certain computer software, water utility property, and qualified improvement property, the original use of which begins with the taxpayer. The TCJA expanded property eligible for bonus depreciation to include certain film, television, and live theatrical production property, and removed qualified improvement property (as discussed later). Perhaps most significantly, qualified property now includes certain used property.
The proposed regulations provide new rules and definitions for applying bonus depreciation to acquisitions of used property. Such property may not have been used previously by the taxpayer (or its predecessor) and cannot be acquired from a related party or in certain tax-free transactions. There is a special rule for members of a consolidated group.
Most importantly, the proposed regulations define previous use as having a "depreciable interest in the property at any time prior to such acquisition" (Regs. Sec. 1.168(k)-2(b)(3)(iii)(B)(1)). That rule applies whether or not the taxpayer actually claimed deductions for depreciation. As written, the definition is very broad, and the proposed regulations provide some helpful examples for applying this test.
For example, if a taxpayer initially acquires a depreciable interest in 50% of an asset and subsequently acquires an additional depreciable interest in the same property, the proposed regulations provide that the additional depreciable interest is not treated as being previously used by the taxpayer. However, if the taxpayer had sold its original 50% interest in the asset and subsequently acquired a different 50% interest in the asset, that new portion (up to the amount for which it had previously held an interest) is treated as being previously used by the taxpayer.
Another example provides that if a lessee acquires the property it is leasing, the additional basis acquired in the property (over the lessee's own improvements to the property) may be eligible for bonus depreciation.
The proposed regulations make it clear that assets acquired in Sec. 338 and Sec. 336(e) transactions may be eligible for bonus depreciation. The potential for bonus depreciation in such instances could be an important consideration in future merger-and-acquisition transactions and provides taxpayers an additional consideration during negotiations.
The proposed regulations also provide special rules for when to test whether property is acquired from a related party, including rules for consolidated groups. There are several very helpful examples.
While the proposed regulations clarify the used-property acquisition requirements, they create several new burdens and questions for taxpayers to consider. The rule appears to require tracking of every asset ever owned by the taxpayer or its predecessor from prior to the TCJA until bonus depreciation is phased out or the used-property rules are changed. This tracking will be burdensome to large and small taxpayers alike. It may raise questions such as:
- Is the benefit of 100% bonus depreciation on used property valuable enough to justify the tracking burden, or should the taxpayer elect out of bonus depreciation? (Keep in mind that used property is not a separate category for the election out. A taxpayer would have to elect out for both new and used property in each category for which the taxpayer purchased used property.)
- Is there a reasonable method of tracking that can reduce the burden? And how would it be applied to assets that could have been owned by the taxpayer in the past?
- What if the property is substantially or significantly altered or modified between the previous use and current reacquisition? Does some or all of that property qualify for bonus depreciation?
Application to certain partnership transactions
Currently, Regs. Sec. 1.168(k)-1 includes a rule that any increase in basis due to a Sec. 754 election does not satisfy the original-use requirement, and therefore any such adjustment does not qualify for bonus depreciation. As discussed above, the TCJA removed the original-use requirement and extended bonus depreciation to certain used property. Therefore, the IRS reconsidered the application of bonus depreciation in the context of partnership basis adjustments.
For purposes of the proposed regulations, the IRS takes the view that each partner owns and uses a proportionate share of the partnership's property. For a partnership adjustment to be eligible, an acquiring partner must not have used the transferor's portion of partnership property prior to the acquisition. Therefore, the proposed regulations only allow bonus depreciation for Sec. 743(b) adjustments, which generally are made if the partnership has a Sec. 754 election in place when there is a transfer of a partnership interest by sale, exchange, or the death of a partner. However, if a transfer is between related parties, then the Sec. 743(b) adjustment would not qualify for bonus depreciation. This is consistent with and similar to the rules for acquiring interests in portions of used property that were discussed above.
Taxpayers should be aware that bonus depreciation is required for such adjustments, unless they elect out. The IRS also considered other partnership adjustments, such as Sec. 734(b) adjustments, certain Sec. 704(c) allocations, and distributions of property as they relate to basis under Sec. 732. For various reasons, no other basis adjustments or allocations were determined to qualify for bonus depreciation.
The proposed regulations continue the special allocation rule that requires the parties to allocate such bonus depreciation pro rata by months between the transferor and transferee in transfers described in Sec. 168(i)(7), which are generally nontaxable contributions and distributions. However, the proposed regulations provide a narrow rule that if the property is transferred in a Sec. 721 transaction by partner A to partnership ABC in the same tax year when one of the other partners (either B or C) previously had a depreciable interest in the property (e.g., a Rev. Rul. 99-5, Situation 1, transaction), then bonus depreciation is allocated solely to the transferor and not to the partnership.
Qualified improvement property
The proposed regulations clarify that qualified leasehold improvement property (QLIP), qualified retail improvement property (QRIP), and qualified improvement property (QIP), including qualified restaurant property that is qualified improvement property (QRP), continue to be eligible for bonus depreciation if the property was placed in service prior to Jan. 1, 2018.
For property placed in service after Dec. 31, 2017, the TCJA eliminated the 15-year modified accelerated cost recovery system property classification for QLIP, QRP, and QRIP. Furthermore, the TCJA eliminated QIP as a specific category of qualified property for bonus depreciation but did not assign it a special recovery period.
The Joint Explanatory Statement included in the conference committee report for the TCJA states that as a replacement for QLIP, QRP, and QRIP, QIP was intended to have a 15-year recovery period, which would have made it eligible property for bonus depreciation (H.R. Conf. Rep't 115-466, Conference Report to Accompany H.R. 1, 115th Cong., 1st Sess., p. 367 (Dec. 15, 2017)). However, the statute failed to provide the 15-year recovery period. The proposed regulations do not follow the legislative history, nor does the preamble to the proposed regulations refer to the legislative history. Therefore, it appears that a technical correction is necessary to fix the statute and grant a 15-year recovery period to QIP, which would make it eligible for bonus depreciation. Until a technical correction is passed, taxpayers need to decide whether to follow the statute and proposed regulations as written or to take a position consistent with the legislative history. Either choice may require amended tax returns when the issue is resolved. Return preparers need to discuss the options carefully with their clients.
A new question arises if a technical correction is passed: Can QIP be acquired as used property, and if so, how far back does that apply (i.e., to all improvements placed in service after the original building was placed in service, or just improvements placed in service after Dec. 31, 2015, the date on which QIP was first added to the statute)? For taxpayers making estimated tax payments or distributions, QIP remains an area of uncertainty that requires consultation and planning.
The proposed regulations generally keep the same rules for self-constructed property as the existing regulations, with one notable exception. For purposes of bonus depreciation, the term "self-constructed property" does not include any assets manufactured, constructed, or produced for the taxpayer by another person (unless such property is also LPPP). Such property must instead follow the general rules for determining when it was acquired for purposes of bonus depreciation. That date will be when a written binding contract was entered into, which is generally a contract that is enforceable under state law, does not limit damages, and states the amount and design specifications of the property to be provided. This was a big change that many taxpayers were not expecting.
This change means that taxpayers with binding construction contracts generally may not apply the 10% safe harbor for determining when the construction began. This may adversely affect projects that started around Sept. 27, 2017, and were completed and placed in service in 2018 or later. It may also require analysis to determine if separately acquired components might qualify for more or less bonus depreciation than the property as a whole.
For self-constructed property, rules provide that components acquired or self-constructed prior to Sept. 27, 2017, will not taint the entire project's acquisition date. However, the components will be subject to a different bonus depreciation rate when finally placed in service. For this reason, acquisition dates of construction projects and separate components should be carefully analyzed and documented when claiming bonus depreciation.
Taken as a whole, the self-constructed property rule changes may leave taxpayers questioning whether a construction contract was binding when originally entered into. By removing the 10% safe harbor for constructed property provided by another person to the taxpayer, the IRS may have caused less clarity and increased confusion and questions surrounding the proper application of the acquisition date rules. Additionally, many taxpayers are questioning what happens if a contract is not binding on the date it was signed but becomes binding later.
The proposed regulations clarify the elections available to all taxpayers regarding bonus depreciation. However, the regulations do not clarify the new elections allowable under Sec. 163(j) relating to interest expense limitations that may impact the property that is qualified for bonus depreciation.
An election out of bonus depreciation that is generally made on a class-by-class basis continues to be available. For purposes of this election, an asset class is as defined in Sec. 168(e). There is no alternative minimum tax adjustment, regardless of whether the taxpayer elects out of bonus depreciation.
For a taxpayer's first year ending after Sept. 27, 2017, there is a special election to apply 50% bonus depreciation in lieu of 100% bonus depreciation to all qualified property. This election is not made on a class-by-class basis and must be applied to all classes of qualified property. However, both elections can be made, with the effect being that all qualified property will apply 50% bonus depreciation, except for classes for which an election out is made, in which case that class would not apply bonus depreciation. This allows some flexibility for taxpayers in tax planning during the transition year.
Because Sec. 743(b) adjustments may now be eligible for bonus depreciation, the proposed regulations add a new election out of bonus depreciation for Sec. 743(b) adjustments. The election out of bonus depreciation for a partner's Sec. 743(b) adjustments is made independently from the election out of bonus depreciation for the partnership's tax basis in the property.
The proposed regulations have provided guidance and answers for many questions that taxpayers and providers were asking after the enactment of the TCJA. However, some of the proposed rules create new questions that are unanswered. Taxpayers will need to consider their options when planning for tax filings until further guidance is issued or final rules are provided.
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.