Editor: Greg A. Fairbanks, J.D., LL.M.
In September 2019 the IRS issued Regs. Sec. 1.168(k)-2 (T.D. 9874, the final regulations) and Prop. Regs. Sec. 1.168(k)-2 (REG-106808-19, the 2019 proposed regulations), which provide guidance regarding the bonus depreciation deduction under Sec. 168(k), as modified by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Both the final regulations and the 2019 proposed regulations include significant, taxpayer-favorable changes from the proposed regulations issued in 2018 (REG-104397-18, the 2018 proposed regulations), including rules for self-constructed property, the determination of acquisition dates, predecessor ownership, certain partnership rules, and some industry-specific guidance.
The TCJA increased the additional first-year depreciation deduction in Sec. 168(k) from 50% to 100% for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023 (or before Jan. 1, 2024, for longer-production-period property). The 100% additional first-year depreciation deduction is also allowed for specified plants planted or grafted after Sept. 27, 2017, and before Jan. 1, 2023. The 100% additional first-year depreciation deduction is then phased down by 20% each year for five years.
The TCJA also expanded bonus depreciation to certain used property, which is beneficial for taxpayers that acquire property that is not original-use. This change, among others, led to the need for new rules to address bonus depreciation post-TCJA. The IRS issued Prop. Regs. Sec. 1.168(k)-2 on Aug. 8, 2018, to provide guidance for property acquired and placed in service after Sept. 27, 2017. The IRS received comments on the 2018 proposed regulations and addressed those comments in the preambles to the final and 2019 proposed regulations. Many of those comments resulted in favorable changes that are reflected in the two regulation packages that were released.
Perhaps one of the most significant changes in the final regulations is that the IRS reversed its position on property subject to a written binding contract that was constructed, manufactured, or produced for the taxpayer by another person, so that it is now considered to be self-constructed, instead of being subject to the default written binding contract rules for determining the acquisition date. Because of this favorable change, third-party constructed property under a written binding contract is deemed to have been acquired on the date when physical work of a significant nature begins, including by application of the 10% safe-harbor test. This may favorably affect projects that started around the Sept. 27, 2017, date and were completed and placed in service in 2018 or later. For third-party constructed property without a written binding contract, the 2019 proposed regulations now provide that the property is deemed to have been acquired when more than 10% of the total cost of the property is paid or incurred.
The 2019 proposed regulations also added a component rule election for larger self-constructed property, similar to the election in Rev. Proc. 2011-26. The component rule election is available for "components" of a larger self-constructed property for which manufacture, construction, or production began before Sept. 28, 2017, and that was placed in service before Jan. 1, 2020. Those components must have been acquired or self-constructed after Sept. 27, 2017, for the election to apply. When the component rule election is made, those components will be eligible for 100% bonus depreciation, even though the larger self-constructed property is not. The 2019 proposed regulations do not define exactly what a "component" is for purposes of this election. Taxpayers that intend to make the election will need to carefully consider the larger self-constructed property in determining components that may be eligible for the election.
The favorable election must be made by the due date, including extensions, of the federal income tax return for the tax year in which the taxpayer places in service the larger self-constructed property, which means that the IRS will need to provide further guidance for taxpayers that wish to make the election for a 2017 or a 2018 return that may already have been filed.
Acquisition date of property
The final regulations provide additional guidance for determining the date on which a written contract becomes binding, for purposes of determining a property's acquisition date. Property acquired under a contract that was signed prior to Sept. 27, 2017, but became binding later, qualifies for 100% bonus depreciation. Under the final regulations, the acquisition date of property that a taxpayer acquires pursuant to a written binding contract is the later of:
- The date on which the contract was entered into;
- The date on which the contract is enforceable under state law;
- If the contract has one or more cancellation periods, the date on which all cancellation periods end; or
- If the contract has one or more contingency clauses, the date on which all conditions subject to those clauses are satisfied.
The 2019 proposed regulations provide rules specifically to treat asset-acquisition transactions as binding only if the contract is enforceable under state law. Therefore, any negotiations regarding regulations or minor terms do not prevent the contract from being binding. For property not acquired under a binding contract, the acquisition date is deferred until the date that the taxpayer has paid or incurred more than 10% of the cost of the property. Land and other preliminary costs are excluded from the 10% test. This is similar to the safe harbor for self-constructed property in the final regulations.
The change to the acquisition date for written binding contracts is favorable for taxpayers because it may shift the acquisition date from before Sept. 27, 2017, to after that date. Taxpayers should assess how they have treated past assets to determine if any asset would be eligible under the final regulations for 100% bonus depreciation rather than the reduced bonus depreciation rate.
To be qualified for bonus depreciation, a used asset must not have been previously used by the taxpayer or a predecessor at any time before the acquisition. The IRS provided in the final regulations that a predecessor includes:
- A transferor of an asset to a transferee in a transaction to which Sec. 381(a) applies;
- A transferor of an asset to a transferee in a transaction in which the transferee's basis in the asset is determined, in whole or in part, by reference to the basis of the asset in the hands of the transferor;
- A partnership that is considered as continuing under Sec. 708(b)(2);
- The decedent in the case of an asset acquired by an estate; or
- A transferor of an asset in a trust.
A safe harbor was added that provides a five-calendar-year lookback period to determine whether a taxpayer had a prior depreciable interest. A substantial-renovation test was also included in the final regulations, which provides that if property was used by a taxpayer or predecessor before a substantial renovation and the property is later reacquired, the taxpayer will not be treated as having had a depreciable interest in the property. The property qualifies as substantially renovated only if 20% or less of the total cost of the property is used parts. These two rules expand the ability of taxpayers to treat used property as eligible for bonus depreciation, while reducing the potential tracking burden that would have been required under the 2018 proposed regulations.
Taxpayers received additional guidance specific to partnerships and partnership adjustments eligible for bonus depreciation. The 2019 proposed regulations provide that for determining its prior depreciable interest in partnership property, a partner is considered to have had a depreciable interest in the portion of property equal to that partner's share of depreciation deductions related to the property in that current calendar year and five years prior, similar to the five-year lookback rule provided in the final regulations. However, it is unclear whether that depreciation should be on a tax basis or take into account Sec. 704(b) book basis allocations.
The change made by the TCJA to include certain used property in Sec. 168(k) opened the opportunity for Sec. 743(b) adjustments to generally be eligible for bonus depreciation. However, that did not include any portion of the basis adjustment that is related to a Sec. 704(c) built-in gain that is recovered using the remedial method. The final regulations provide an exception to the proposed rule for partnerships that are not publicly traded partnerships. Thus, if a partnership qualifies to apply the exception, the final regulations provide that the entire Sec. 743(b) basis increase is eligible for the additional first-year depreciation.
Taxpayers that have assets used in regulated utilities or that have had floor plan financing interest also received specific guidance in the 2019 proposed regulations. Generally, taxpayers in those industries cannot take bonus depreciation on their assets as a result of special rules in Sec. 163(j). However, if a taxpayer is a lessor of property to either of those trades or businesses, then the lessor is allowed to claim the bonus depreciation as long as the lessor is not in one of those businesses.
Taxpayers that have floor plan financing will also be allowed to test annually whether the floor plan financing is "taken into account" in determining whether bonus depreciation is allowed for that tax year. In making it an annual test, the proposed regulations do not permanently prohibit the bonus depreciation deduction for assets placed in service in future tax years, but rather may allow or disallow bonus depreciation on a year-by-year basis. "Taken into account" for this purpose is determined by computing the Sec. 163(j) limitation by only including business interest income and 30% of adjusted taxable income and comparing that to the total business interest expense. If the limitation is in excess of the expenses, then the floor plan financing is deemed to not be taken into account. However, the IRS does not believe a deduction under Sec. 163(j) is optional, so if a taxpayer has interest expense in excess of the limitation (without regard to the floor plan financing component), then it is deemed to be taken into account, and bonus depreciation is denied for the tax year.
Taxpayers are required to apply the final regulations for tax years ending on or after Sept. 24, 2019. However, taxpayers may optionally apply the final regulations, in their entirety, to property acquired and placed in service after Sept. 27, 2017. The final regulations are generally taxpayer-favorable, so taxpayers should assess their prior years' depreciation to determine what the additional benefit may be.
The 2019 proposed regulations will be effective upon becoming final regulations, which will not be until 2020. Taxpayers may choose to rely on the proposed regulations and adopt them early, in their entirety, to property acquired and placed in service after Sept. 27, 2017. The 2019 proposed regulations are generally taxpayer-favorable, but certain taxpayers may find some of the guidance to be adverse and not wish to adopt the rules early.
Taxpayers should carefully assess the impact of both sets of regulations to determine what changes, if any, to make for prior tax years, and the changes that may be required for the final regulations right now. If a taxpayer determines it wants to take advantage of the additional benefit, it will likely need to either file a Form 3115, Application for Change in Accounting Method, to change its accounting method or amend its prior years' returns to apply the new rules, pending further guidance from the IRS.
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 email@example.com.
Contributors are members of or associated with Grant Thornton LLP.