Deadlines for Increased Expensing Provisions
As noted in our Alert of October 4, 2010,the recently enacted Small Business Jobs Act of 2010 (the “Act”) expands two federal income tax provisions intended to encourage the purchase of business property, but these require property to be placed in service by the end of 2010 or, in certain cases, 2011:
- An increased dollar limitation on the amount of tangible personal property and off-the-shelf computer software that can be taken as a current tax deduction under Section 179 of the Internal Revenue Code (IRC) applies to qualified property placed in service in tax years beginning in 2010 or 2011. In addition, this deduction is expanded to cover certain types of real property.
- The Act also extends a provision for additional first year or bonus depreciation of 50% of the adjusted basis of qualifying property (which cannot be used property) which is purchased and placed in service during 2010. However, for certain transportation property and property with a recovery period of ten years or more, the date is extended through 2011.
Observation: These provisions enable a business to obtain larger tax deductions in the first year qualified property is placed in service. If applicable tax rates remain the same over an asset’s depreciable life, these provisions accelerate the tax benefits of depreciation deductions for the cost of business property. If tax rates increase, the present value of the benefits of the accelerated deductions may decrease, and vice versa.
The balance of this Alert provides more details on the benefits and requirements of these two provisions, for our clients and friends who may wish to take advantage of them.
Section 179 Expensing
An increased dollar limitation on the amount of tangible personal property and off-the-shelf computer software that can be taken as a current tax deduction under Section 179 of the IRC was in effect for property placed in service in a tax year beginning in 2009. The Act increases the amount of the available write-off and expands the type of property eligible for this benefit. The new benefits apply for qualified property placed in service in tax years beginning in 2010 and 2011. This should encourage many businesses to purchase qualified property this year or next.
The purchase of tangible personal property, computer software and real estate for use in the active conduct of a trade or business is generally treated as a capital expenditure and the cost thereof is deductible over several years under applicable depreciation rules. However, under Section 179, an election is available to treat the cost of eligible property placed in service during a year as a current expense. The maximum deduction which may be taken under this election for property placed in service during a year beginning in 2010 or 2011 is $500,000. This is double the maximum amount available in 2009.
Observation: The basis of property for which a Section 179 election is made is reduced by the amount of the Section 179 expense deduction. The remaining basis is depreciable under the normal rules, including eligibility for bonus depreciation.
The Act expands the types of property eligible for a Section 179 election deduction to “qualified real property” placed in service in 2010 or 2011. Qualified real property is depreciable real property that is (a) qualified leasehold improvement property (for example, electrical and plumbing systems and doors), (b) qualified restaurant property, or (c) qualified retail improvement property. However, no more than $250,000 of qualified real property is eligible for Section 179 expensing and such property is included in the overall $500,000 limitation. A separate election is required in order to make qualified real property eligible for a Section 179 deduction. The following types of property are not eligible for such a Section 179 deduction:
- Air conditioning or heating units
- Property used outside the United States
- Property used for lodging
- Property used by certain tax-exempt organizations
- Certain property used by governmental or foreign persons or entities
- Real property attributable to the enlargement of a building, any elevator or escalator, or any internal structural components of a building.
Observation: The annual dollar limitation is reduced by the amount by which the cost of Section 179 property placed in service during the year exceeds $2,000,000 (up from $800,000). Thus, if $2,500,000 worth of such property is placed in service in 2010 or 2011, no Section 179 deduction will be available. As a result, in some cases it will be advantageous to delay putting tangible personal property into service until the beginning of the next taxable year in order to maximize the available Section 179 deductions.
The amount of the allowable deduction cannot exceed the aggregate amount of the taxpayer’s taxable income which is derived from the active conduct of any trade or business. However, a carryover is available for the deduction disallowed because of this taxable income limitation.
Observation: The portion of such a carryover attributable to qualified real property cannot be carried over to a taxable year beginning after December 31, 2011.
Partnerships and S corporations can elect to expense the cost of Section 179 property up to the applicable limitation, and the deduction passes through to their partners and shareholders as a separately stated item. The partners and shareholders are also subject to the applicable limitation. For example, a profitable, two-person partnership can elect to expense $500,000 (in the year 2010) of Section 179 property and pass a $250,000 deduction out to each partner. Assuming one of the partners is not subject to other limitations (e.g., basis, at-risk, or passive loss rules) and has a $300,000 Section 179 deduction from another source, he or she will be limited to a $500,000 Section 179 deduction for the year 2010. The $50,000 excess amount will be lost as a deduction.
Observation: If a partnership or an S corporation has a loss for a taxable year, the Section 179 deduction cannot be passed out to its partners or shareholders.
Married persons filing a joint return are limited to a $500,000 aggregate Section 179 deduction. Married persons filing separate returns are treated as one taxpayer, so they must split the $500,000 limitation equally. Estates and trusts are not entitled to a Section 179 deduction.
The component members of a controlled group of corporations must apportion the $500,000 limitation among the members. For this purpose, where a corporation owns more than 50% of another corporation (instead of the usual 80%), the corporations will be considered component members of a controlled group.
Observation: Noncorporate lessors are not eligible to elect to expense the cost of Section 179 property, unless the property subject to the lease has been manufactured or produced by the lessor or certain activity tests are satisfied.
If a taxpayer’s Section 179 property is not used predominantly in a trade or business at any time before the end of the property’s applicable depreciation recovery period, the taxpayer must recapture any benefit derived from the current expense deduction. This recapture is accomplished by including in taxable income the excess of the amount expensed over the depreciation deductions that would have been allowable through the year in which the property ceased to be used predominantly in a trade or business.
Fifty Percent Bonus Depreciation
The Act also extends a provision for additional first year or bonus depreciation of 50% of the adjusted basis of qualifying property (which cannot be used property) purchased and placed in service during 2010. For certain transportation property, including aircraft, and property with a recovery period of ten years or more, the date is extended through 2011. Property eligible for bonus depreciation (“qualified property”) includes:
- Property with a recovery period of 20 years or less, such as machinery and equipment and furniture and fixtures.
- “Qualified leasehold improvement property,” which is an improvement to the interior portion of nonresidential real property made by a lessee (or sublessee) or lessor of such portion, where the portion is occupied exclusively by the lessee (or sublessee), and the improvement is placed in service more than three years after the date the building was first placed in service. The term does not include the enlargement of a building, an elevator or escalator, any structural improvement benefiting a common area, or the internal structural framework of a building.
- Computer software which is not amortizable over 15 years as a “Section 197 intangible.”
- Water utility property.
Qualified property also includes: (1) property with a class life of 20 years or more and either (a) an estimated production period exceeding two years or (b) an estimated production period exceeding one year and a cost exceeding $1 million; (2) transportation property; and (3) certain aircraft.
Observation: Qualified property does not include any property financed with tax-exempt bonds.
Deadline: Since most property eligible for this 50% bonus depreciation must be placed in service by December 31, 2010, quick action may be advantageous.
The following example illustrates benefits of the new provisions:
Assume a business owner leasing a portion of a building makes improvements to the interior portion of the building and acquires new machinery and equipment, all of which is placed in service during 2010. The leasehold improvements (not eligible for Section 179 expensing) cost $400,000 and the machinery and equipment cost $300,000. The first year tax benefit is $175,974, computed as follows:
Expensing allowance (Section 179 expense):
Machinery and equipment $300,000
Leasehold improvements: 50% x $400,000 200,000
Normal depreciation on the balance of expenditures:
Leasehold improvements: 1.391% times $200,000 2,782
Total depreciation deduction $502,782
Federal tax savings (at 35%) $175,974
The requirement that the adjusted basis of qualified property be reduced by the amount of the bonus depreciation for purposes of computing regular depreciation partially offsets the benefit of the bonus depreciation in the first year. Assume property with a cost of $100,000 is placed in service and would be eligible for 20% depreciation the first year, or $20,000. With bonus depreciation the first year’s depreciation is $60,000 ($50,000 plus 20% of $50,000). Thus, the bonus depreciation generates another $40,000 (40%) of depreciation deductions in the first year.
Observation: Another benefit for qualified property relates to the alternative minimum tax (AMT) computation. The bonus depreciation deduction and the Section 179 expensing amount are also deductible for purposes of AMT (i.e., they are not considered adjustments or preferences). In addition, the depreciation deductions available for the remaining basis of qualified property over its life are also fully deductible for purposes of AMT.
Caution: It is possible to elect out of first year bonus depreciation in order to take more depreciation deductions in later years. However, if such an election is made, the depreciation deductions will become subject to the normal rules for alternative minimum tax adjustments.
Other points to remember about these provisions:
- The Act’s impact on state and local taxes depends on whether the state conforms to federal tax law or has decoupled from it. Depending on each state’s law, additional state tax benefits may be available.
- A cost segregation study for a real estate project may help to identify costs eligible for the new benefits.
- It is possible to elect out of bonus depreciation, Section 179 expensing, or Section 179 expensing for qualified real property – but note, e.g., the caution mentioned further above.
- The Section 179 deduction is treated as a depreciation deduction for purposes of the limitation on deductions for luxury automobiles and other listed property (e.g., computers and cellular phones).
- The Section 179 deduction for a sports utility vehicle is limited to $25,000. A sports utility vehicle is a 4-wheeled vehicle with a gross vehicle weight over 6,000 pounds but not over 18,000 pounds.
- For passenger automobiles placed in service in 2010 and used 100% for business, the maximum otherwise allowable first year depreciation deduction is increased to $11,060 (from $10,960). However, this increase does not apply if an election out of bonus depreciation is made.
- The Act did not extend a provision allowing a corporation to monetize AMT credits and research and development credits, in lieu of 50% bonus depreciation and accelerated depreciation, if such credits arose in taxable years beginning before January 1, 2006. This provision applied to qualified property placed in service from April 1, 2008 through December 31, 2009 (or during 2010 for certain long-lived property).
- Special rules expand the 50% bonus depreciation to “qualified disaster assistance property” and “qualified cellulosic biofuel plant property.”
Observations: These accelerated tax benefits are aimed to help the economy by reducing taxes imposed on corporations, self-employed persons, and shareholders, partners and members of entities engaged in trade or business. Various industries that produce property eligible for these benefits may also see a stronger demand for their products.
This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.