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IRS Issues Proposed Regulations on Bonus Depreciation

Under the Tax Cuts and Jobs Act, significant changes were made to bonus depreciation under Section 168(k) of the Internal Revenue Code. This section allows an additional first-year depreciation deduction for qualified property. Prior to the Tax Act, bonus depreciation was 50% of the cost of qualified property. The Tax Act amended the code to allow a 100% bonus depreciation deduction for qualified property acquired and placed in service after September 27, 2017, and placed in service before January 1, 2023. On August 3, 2018, the IRS issued proposed regulations on the new 100% bonus depreciation deduction.

Key points from the proposed regulations are:

  • Absent a statutory correction, qualified improvement property, which generally consists of interior improvements to nonresidential real estate, is no longer eligible for bonus depreciation after December 31, 2017. Nevertheless, qualified improvement property acquired and placed in service after September 27, 2017 and before January 1, 2018 is eligible for 100% bonus depreciation.
  • Used property is now eligible for bonus depreciation. However, the property could not have been used by the acquiring taxpayer. Property is treated as previously used by the taxpayer if the taxpayer had a depreciable interest in the property before acquisition, regardless of whether depreciation was claimed.  Lessees with a depreciable interest in improvements made to leased property who later acquire the leased property will only be allowed bonus depreciation on the acquisition cost net of the basis attributable to the improvements.
  • Section 743(b) basis adjustments from the sales of partnership interests (with valid Section 754 elections) are eligible for bonus depreciation if certain requirements are met. This applies even if the acquirer was already a partner in the partnership and is just purchasing another partner’s interest.

A detailed listing of the significant changes under the Tax Act as well as the clarification from the proposed regulations is presented below:

1. Definition of Qualified Property – Property Type

  1. The proposed regulations clarify that qualified property includes property with a MACRS recovery period of 20 years or less as well as certain computer software, water utility property, qualified film or television productions, qualified live theatrical productions, and specified plants. 
  2. The significant change from earlier law is the change of classification for qualified improvement property which was specifically included as a type of qualifying property under the old tax law and therefore was allowed the bonus depreciation deduction. However, the Tax Act removed this designation.
    1. Based on Congressional Committee Reports, it is believed that Congress intended qualified improvement property to have a 15-year life, and therefore be automatically eligible for bonus depreciation under the less-than-20-year qualification. As a result, the specific designation of qualified improvement property qualifying for bonus was removed. However, there was a statutory error because qualified improvement property was not assigned a recovery period and therefore defaults to 39 years. 
    2. Absent a statutory correction and confirmed by the proposed regulations, qualified improvement property is no longer eligible for bonus depreciation after December 31, 2017. 
    3. Because the effective date of the amendments to the definition of qualifying property is property placed in service after December 31, 2017, the proposed regulations confirm that qualified improvement property is eligible for bonus depreciation if acquired and placed in service after September 27, 2017 and before January 1, 2018. 
    4. Therefore, qualified improvement property which was previously eligible for 50% bonus depreciation will only be eligible for 100% bonus depreciation in this narrow timeframe. After December 31, 2017, bonus depreciation will no longer be available for qualified improvement property unless Congress makes a statutory correction.
  3. The proposed regulations confirm that property that is required to be depreciated under the Alternative Depreciation System (“ADS”) is not eligible for bonus depreciation. Examples of such property are tangible property used outside of the United States and tax-exempt use property. Furthermore, if a taxpayer elects to be a real property trade or business so that it is not subject to new interest expense limitations under the Tax Act, depreciation under ADS is required and therefore the nonresidential real property, residential rental property, and qualified improvement property held by the taxpayer would not be eligible for bonus depreciation. It should be noted that these categories would nevertheless not be eligible for bonus depreciation under the general qualifications absent a statutory correction.

2. Definition of Qualified Property – New and Used Property

  1. The bonus depreciation rules before the Tax Act required that qualified property be new property, the original use of which began with the taxpayer taking bonus depreciation deductions. The Tax Act now allows bonus depreciation for used property subject to certain requirements:
    1. The property was not used by the taxpayer or a predecessor at any time prior to the acquisition, the acquisition of the property meets certain related party and carryover basis requirements, and the acquisition of the property meets certain cost requirements.
    2. The proposed regulations clarify that property is treated as previously used by the taxpayer if the taxpayer had a depreciable interest in the property before acquisition, regardless of whether depreciation was claimed. 
    3. For lessees with a depreciable interest in improvements made to leased property, an acquisition of the leased property will cause bonus depreciation only to be available for the acquisition cost net of the basis attributable to the improvements.
    4. For a taxpayer that already has a depreciable interest in a portion of a property and subsequently acquires an additional interest, the proposed regulations state that the taxpayer will not be deemed to have previously used the additional interest. The rule is different, though, if a taxpayer acquires an additional interest after selling the original interest. The taxpayer will be treated as previously having a depreciable interest in the property up to the amount of the portion sold.
    5. Bonus depreciation is not allowed for members of a consolidated group when property is disposed of by one member of a consolidated group outside the group and subsequently acquired by another member of the same group. The proposed regulations treat a member of a consolidated group as previously having a depreciable interest in all property in which the consolidated group is treated as previously having a depreciable interest.

3. Applicability of Bonus Depreciation to Partnerships

  1. Prior temporary regulations relating to bonus depreciation provided that basis adjustments in qualified property due to Section 754 elections were generally not eligible for bonus depreciation because the new property/original use requirements were not met. Since used property is now eligible, the proposed regulations examine the applicability to various types of basis adjustments.
    1. The proposed regulations clarify that the following types of property and basis adjustments are not eligible for bonus depreciation:
      1. Remedial allocations under Section 704(c).
      2. Property contributed to a partnership with a zero adjusted tax basis.
      3. Property distributed by a partnership to a partner.
      4. Section 734(b) basis adjustments made to the basis of partnership property because of distributions to partners.
    2. The proposed regulations clarify that Section 743(b) basis adjustments from certain transfers of partnership interests (resulting from a sale or exchange) may be eligible for bonus depreciation. 
      1. The proposed regulations take an aggregate view and provide that each partner is treated as having owned and used their proportionate share of partnership property. 
      2. If a partner acquiring an interest has not used the portion of the partnership property to which the section 743(b) basis adjustment relates at any time prior to the acquisition, notwithstanding the fact that the partnership itself has used the property, the partner may be allowed bonus depreciation on the 743(b) basis adjustment.
      3. This applies even if the acquirer was already a partner in the partnership and is just purchasing another partner’s interest.
      4. Certain rules apply such as the relationship between the transferor partner and the transferee partner must not be a prohibited relationship.
      5. A partnership’s election out of bonus depreciation will not impact a partner’s ability to claim bonus depreciation on a 743(b) basis adjustment.
      6. The proposed regulations state that bonus depreciation would not apply to 743(b) adjustments resulting from the death of a partner.

4. Date of Acquisition

  1. The proposed regulations state that qualified property must be acquired by the taxpayer after September 27, 2017, or acquired by the taxpayer pursuant to a written binding contract entered into by the taxpayer after September 27, 2017.
  2. If there is an acquisition pursuant to a written binding contract and the contract states the date on which the contract was entered into and a closing date, delivery date, or other similar date, the date on which the contract was entered into is the date the taxpayer acquired the property.
  3. The proposed regulations provide that a letter of intent for an acquisition is not a binding contract.
  4. A contract is defined as binding only if it is enforceable under state law against the taxpayer or a predecessor, and does not limit damages to a specified amount (for example, by use of a liquidated damages provision). However, it should be noted the proposed regulations state that, for this purpose, a contractual provision that limits damages to an amount equal to at least 5% of the total contract price will not be treated as limiting damages to a specified amount.
  5. For self-constructed property, the proposed regulations state that the acquisition timing requirements are treated as met if the taxpayer begins manufacturing, constructing, or producing the property after September 27, 2017.
  6. Property that is acquired before September 28, 2017, but placed in service after September 27, 2017 follows the old law phase-down of bonus depreciation which was in effect before the Tax Act. These percentages were 50% for 2017 and 40% for 2018. For example, if property was acquired pursuant to a written binding contract on September 1, 2017, but not placed into service until January 5, 2018, the applicable bonus depreciation percentage would be 40%.

5. Other Key Points

  1. The proposed regulations provide that bonus depreciation is allowed for both regular tax and alternative minimum tax (“AMT”) purposes.
  2. Bonus depreciation is not affected by a taxable year of less than 12 months for either regular or AMT purposes.
  3. For like-kind exchange transactions, the proposed regulations provide that only the excess basis, if any, of the replacement property is eligible for the bonus depreciation deduction if the replacement property is qualified property and meets the used property acquisition requirements. The proposed regulations retain the old rules that both exchange basis and excess basis of replacement property is eligible for bonus depreciation if the replacement property is new/original use property.
  4. For corporate M&A transactions, the proposed regulations provide that property deemed to have been acquired by a target corporation as a result of a Section 338 election, relating to qualified stock purchases, or a Section 336(e) election, relating to qualified stock dispositions, will be considered acquired by purchase.
  5. For certain syndication transactions where a lessor acquires and sells a leased property within a three-month time span and the lessee of the property remains the same during both ownership time periods (under original lessor and subsequent lessor), the proposed regulations state that the subsequent lessor is afforded the right to claim bonus depreciation and the original purchaser is not.

Michael Torhan is a Senior Tax Manager in the Real Estate Services Group providing tax compliance and consulting services for businesses in a variety of industries including the real estate, hospitality, and financial services sectors.

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