On August 14, 2018, Wipfli provided a tax alert on new guidance on 100% bonus depreciation. This update will discuss key elements of these newly-issued proposed regulations in much greater detail.
The regulations provide that depreciable property must meet four requirements to be qualified property:
1. The property must be of a specified type.
The proposed regulations provide that the property must generally be MACRS property with a tax recovery period of 20 years or less, computer software that is depreciated over 36 months using the straight-line method, or water utility property.i For purposes of determining a property’s tax recovery period, its life under the General Depreciation System is used, even if the taxpayer has elected to depreciate the property using the Alternative Depreciation System. In the case of such an election, bonus depreciation may still be claimed on that property. However, if the use of the Alternative Depreciation System is mandatory with respect to a property (for example, because of the nature of the property, its use, or its location or as a result of the new 30% limitation on business interest), then bonus depreciation is not allowed to be claimed on that property.ii
2. Original use of the property must commence with the taxpayer or, if used property, must meet specific acquisition requirements.
The proposed regulations retain the original-use rules that applied to new property prior to the TCJA, other than the determination of original use in a sale-leaseback transaction. The rules for used property are discussed below under the heading “Qualified Used Property.”
3. The property must be placed in service by the taxpayer within a specified time period.
Generally, property must be placed in service after September 27, 2017, and before January 1, 2027. (Modified rules apply for longer production period property or certain aircraft property.) For tax purposes, under previously established law, property is deemed to be placed in service when it is in a condition or state of readiness and availability for a specifically assigned function.
4. The property must be acquired by the taxpayer after September 27, 2017.
This may perhaps be one of the unexpectedly trickier aspects of the proposed regulations. For purposes of this requirement, the property must be acquired by the taxpayer after September 27, 2017, or acquired by the taxpayer pursuant to a written binding contract that is entered into by the taxpayer after September 27, 2017. If the written binding contract states the date on which the contract was entered into and also states a closing date, delivery date, or other similar date, the date on which the contract was entered into is deemed the date the taxpayer acquired the property. A contract is considered binding only if (a) it is enforceable under state law against the taxpayer or a predecessor and (b) does not limit damages to a specified amount (for example, by use of a liquidated-damages provision). For this purpose, a contractual provision that limits damages to an amount equal to at least five percent of the total contract price will not be treated as limiting damages to a specified amount. In determining whether a contract limits damages, the fact that there may be little or no damages because the contract price does not significantly differ from fair market value of the property will not be taken into account. A letter of intent for an acquisition is generally not a binding contract.
If the property is to be manufactured, constructed, or produced for the taxpayer by another party under a written binding contract that is entered into prior to the manufacture, construction, or production of the property, that property is deemed acquired pursuant to a written binding contract, and the more taxpayer-favorable self-constructed property rules discussed below do not apply. This is a significant change from the previous rules on the interplay between the binding contract rules and the self-constructed property rules discussed below. Those previous rules provided that if a taxpayer contracted with another party to manufacture, construct, or produce property on its behalf, that property still would have been treated as self-constructed property for purposes of the prior bonus depreciation rules, allowing the property to be considered acquired until its manufacture, construction, or production had begun, rather than earlier when the contract was signed. Had the historical rules been retained, so long as construction of self-constructed property produced under a binding contract dated prior to September 28, 2017, actually commenced after September 27, 2017, such property would have been eligible for expensing. By now defining such property as binding contract property, the property is ineligible for expensing, even if its construction began after September 27, 2017.
If the taxpayer manufactures, constructs, or produces the property for its own use, the regulations state that the written binding contract rule above does not apply to determine whether the post- September 27, 2017, requirement is satisfied. Instead, this requirement is satisfied if the taxpayer begins manufacturing, constructing, or producing the property after September 27, 2017. Special rules and a safe harbor are provided to assist with the determination of when manufacturing, construction, or production has begun. It is important to restate that for purposes of the acquisition date requirement, these favorable self-constructed property rules in the proposed regulations do not apply to property that is manufactured, constructed, or produced for the taxpayer by another person. Instead, the binding contract rules discussed earlier apply. (An exception is made in the case of long production period property or certain aircraft property, where such property, even though manufactured, constructed, or produced by another party, is still deemed to be self- constructed by the taxpayer. Such property must have a recovery period of at least 10 years, be subject to the UNICAP rules under Sec. 263A, and have an estimated production period exceeding one year and an estimated cost exceeding $1 million.)
Qualified Used Property
Under the proposed regulations, used property must meet the following requirements to qualify for bonus depreciation:
• The property cannot have been used by the taxpayer or a predecessor at any time prior to the acquisition.
For this purpose, property is treated as having been used by the taxpayer or a predecessor if the taxpayer or the predecessor had a depreciable interest in the property at any time prior to such acquisition, whether or not the taxpayer or the predecessor actually claimed depreciation deductions for the property. (In the proposed regulations, the IRS requests comments on whether a safe harbor should be provided for how many taxable years a taxpayer or a predecessor must look back to determine whether they previously held a depreciable interest in the property.) If the taxpayer or predecessor has a partial interest in the property and then acquires an additional interest, that additional interest is eligible for bonus depreciation unless the taxpayer had disposed of that initial interest prior to the current acquisition.
• The property must have been acquired by purchase, as that term is used for purposes of Sec. 179.
Property is acquired by purchase under Sec. 179 if it is not acquired from a related party, it is not acquired from a member of a controlled group, and the basis of the property in the hands of the purchaser is not determined either (a) in whole or in part by reference to the adjusted basis of the property in the hands of the person from whom the property was acquired or (b) under Sec. 1014(a), relating to property acquired from a decedent. The proposed regulations clarify that property which is deemed to have been acquired by a new target corporation as a result of a Sec. 338 election (qualified stock purchases) or Sec. 336(e) election (qualified stock dispositions) will be considered acquired by purchase for purposes of this requirement.
• The cost of the property eligible for bonus depreciation does not include any portion of the property’s basis that is determined by reference to the basis of other property held at any time by the taxpayer.
This requirement relates to like-kind exchanges or involuntary conversions under Sec. 1031 or Sec. 1033, respectively, if the replacement property is used property, not new. See the discussion below under the heading “Like-Kind Exchanges.”
In another pro-taxpayer move, the proposed regulations allow a taxpayer who purchases property they have been leasing from a third party to claim 100% bonus depreciation on the purchase of that property, assuming all other requirements of the bonus depreciation rules are satisfied. If the taxpayer improved the property while they were leasing it, the improvements themselves will not be eligible for bonus depreciation, but the underlying property will be eligible (i.e., the improvements to the property will not taint the whole property). The amount qualified for bonus will therefore be the acquisition cost reduced by the basis attributable to the improvements.
Qualified Improvement Property
Prior to the TCJA, real property assets that met the definition of Qualified Leasehold Improvement Property, certain Qualified Restaurant Property, or Qualified Retail Improvement Property were eligible for bonus depreciation. However, effective for property placed in service after December 31, 2017, those three categories of property were eliminated and replaced by a single category, Qualified Improvement Property.
Qualified Improvement Property (QIP) is any improvement to an interior portion of a building that is nonresidential real property if such improvement is placed in service after the date the building was first placed in service. It does not include any improvement that is attributable to the enlargement of the building, an elevator or escalator, or the internal structural framework of the building. QIP is, in general, a much broader category than the prior three categories it replaced, with fewer requirements.
However, one of the most unfortunate drafting errors in the TCJA was the accidental treatment of QIP placed in service after December 31, 2017, as 39-year property rather than 15-year property, as the Conference Committee Report indicated Congress actually intended. As 39-year property, QIP is not eligible for bonus depreciation. The proposed regulations do not fix this “glitch.” Therefore, it appears that any fix will require Congress to pass a technical corrections bill, which is not expected to happen until after the midterm elections this fall.
As a result of this glitch, until there is a technical correction, taxpayers are faced with two separate sets of bonus rules for similar property, depending on when the property was placed in service. If acquired after September 27, 2017, and placed in service before January 1, 2018, the property is eligible for 100% bonus. If acquired after September 27, 2017, but not placed into service until after December 31, 2017, it is not eligible for bonus and must instead be depreciated using the straight-line method over 39 years.iii
Taxpayers Electing Out of 30% Business Interest Limitation and Taxpayers With Floor Plan Interest
Under the TCJA, business interest expense is generally limited to 30% of a taxpayer’s adjusted taxable income. See here for further details regarding this limitation. There are several exceptions to this business interest limitation. See here for further details regarding these exceptions.
One exception applies to certain real property or farming businesses if they make an irrevocable election to avoid the 30% interest expense limitation, which then mandates that they depreciate certain assets using the Alternative Depreciation System instead of MACRS depreciation. If the taxpayer makes this election, the proposed regulations clarify that the taxpayer then cannot claim bonus depreciation on their residential and nonresidential real property or QIPiv, but they can still claim bonus depreciation on their personal property. Another exception to the business interest expense limitation applies to businesses with floor plan interest and average revenue of more than $25 million who are prevented from claiming bonus depreciation on any of their assets.
The proposed regulations address several aspects of bonus depreciation that apply only to partnerships and LLCs that are taxed as partnerships. Under pre-TCJA rules, step-up adjustments to a partnership’s assets under Sec. 734 and Sec. 743 would not have been eligible for bonus depreciation because of the prohibition against claiming bonus depreciation on used property. However, with the TCJA now allowing bonus depreciation on certain used property, new guidance was required with respect to transactions that would create such step-up adjustments.
- New or existing partner acquires a partnership interest from an existing partner – Any resulting step-up adjustment under Sec. 743 is eligible for 100% bonus depreciation (unless the entity becomes a disregarded entity as a result of the sale; see below). The proposed regulations do caution that bonus depreciation in this case may still be disallowed if the sale is between related parties or members of the same consolidated group. The regulations also indicate that the partner can claim bonus depreciation on their Sec. 743 adjustment, even if the partnership has elected out of bonus depreciation on any or all classes of partnership property.
- Redemption of a partner’s interest by the partnership – Any resulting step-up adjustment under Sec. 734 is not eligible for 100% bonus depreciation. Planning strategy: Because a redemption of a partnership interest will not allow bonus depreciation on the resulting step-up, but a cross- purchase of partnership interest between partners will allow bonus depreciation on the resulting step-up related to qualified property, this creates another significant difference between a sale or redemption transaction, and this will need to be considered by all the parties to a proposed transaction. For example, a proportionate cross-purchase by all of the remaining partners will provide them with greater tax benefit than a redemption of the departing partner; however, it may cause increased tax liability to the departing partner in a real estate partnership because of the application of the Sec. 1250 recapture rules to the sale of a partnership interest, but not a redemption of a partnership interest. Thus, the facts and circumstances of each specific transaction and the tax implications to each party will now need to be further scrutinized to take into account this additional Sec. 754 implication.
- Death of a partner – Any resulting step-up adjustment under Sec. 743 is not eligible for 100% bonus depreciation.
- New or existing partner acquires all of the other interests in the partnership, resulting in a disregarded entity – Although this is not technically a situation where a step-up adjustment under Sec. 743 occurs, 100% bonus depreciation may be claimed on the portion of the partnership assets that the purchasing partner is deemed to have purchased from the selling partner(s).
Additional guidance is included in the proposed regulations to address the impact of the expanded bonus depreciation rules on several other partnership-specific tax provisions:
- Sec. 704(c) and reverse Sec. 704(c) remedial allocations – These provisions are applicable when a partner contributes property to a partnership and the property has a fair market value that is higher than its tax basis. The proposed regulations provide that any deemed asset created by a Sec. 704(c) remedial allocation is not eligible for bonus depreciation. This is a beneficial result for the contributing partner, since the application of bonus depreciation would completely eliminate the gain deferral benefit otherwise available to the contributing partner. Similarly, any deemed asset created by a reverse 704(c) remedial allocation (applicable when a new partner comes into an existing partnership) would not be eligible for bonus depreciation, which is a beneficial result for the historical partners. For a good discussion of the Sec. 704(c) rules in general, see here. For a good discussion of the application of the remedial allocation method, see here.)
- Sec. 732 – This provision is applicable when the distributee partner takes a tax basis in the distributed assets that is greater than the tax basis the partnership had in those assets. The proposed regulations provide that the distributed asset is not eligible for bonus depreciation in the distributee partner’s hands.
The TCJA narrowed the availability of the like-kind exchange rules under Sec. 1031 so that the provision now applies only to real property and not to personal property or intangibles. A grandfather provision provided that personal property and intangibles would still be eligible under Sec. 1031 if the transaction was initiated in 2017 and completed in 2018. The proposed regulations on bonus depreciation provide an interesting distinction between replacement property that is new versus replacement property that is used.
- New replacement property – Both the remaining basis in the relinquished property and the excess basis of the replacement property are eligible for bonus depreciation.
- Used replacement property – Only the excess basis of the replacement property is eligible for bonus depreciation.
Related Parties and Consolidated Groups
The proposed regulations contain anti-abuse rules to prevent a taxpayer from claiming 100% bonus depreciation on property purchased from a related party. There are also specific anti-abuse rules related to consolidated groups. In the case of a series of related transactions, the transfer of property will be treated as directly transferred from the original transferor to the ultimate transferee, so the use of an unrelated intermediary will not serve to avoid these related-party or consolidated-group rules.
Election to Use 50% Bonus Depreciation
The proposed regulations provide that for a taxpayer’s first tax year ending after September 27, 2017, a taxpayer can elect to claim 50% bonus depreciation rather than 100%. However, if this election is made, it is an all-or-nothing election and will therefore apply to all assets that are bonus eligible. Therefore, this 50% election is unlike the taxpayer’s election to not claim bonus depreciation at all, which can be made on an asset-class-by-asset-class basis. The election to claim 50% bonus depreciation must be made by the due date, including extensions, of the taxpayer’s return for the tax year containing September 28, 2017. If a timely election is not made, the taxpayer cannot file a change in accounting method to switch to the 50% deduction.
Application of Bonus to Vehicles
Although vehicle depreciation is not covered in the proposed regulations, the IRS separately released the depreciation limits for business passenger autos placed in service in 2018 and that are subject to the luxury auto limits (Rev. Proc. 2018-25). These updated amounts are significantly higher than in prior tax years, primarily because they reflect the TCJA’s increase in bonus depreciation from 50% to 100%. These higher depreciation limits are not the only thing that differs from 2017 depreciation rules for vehicles. In 2017, different depreciation deduction limits applied for trucks and vans versus passenger autos. It appears the limits will now be the same for trucks and vans as for passenger autos. For further discussion of these increased bonus amounts for luxury autos and their application, please see here.
i This update intentionally does not include a discussion of the bonus depreciation rules as they apply to certain plants that are planted or grafted or to film, television, or live theatrical productions. If you are interested in the rules as they apply to such assets, please contact your Wipfli relationship executive.
ii See the section entitled “Taxpayers Electing Out of 30% Business Interest Limitation and Taxpayers With Floor Plan Interest” for more details on the availability of bonus depreciation to certain taxpayers who are not subject to the new 30% limitation on business interest.
iii To make matters more confusing, if the property was acquired before September 28, 2017, the pre-TCJA bonus rules would apply (e.g., 40% bonus for qualifying property placed in service in 2018).
iv This assumes that a technical corrections bill will adjust the depreciable life of QIP to 15 years, making it eligible for bonus depreciation.