FGMK TAX ALERT: The Newly Issued Proposed Regulations and Their Impact on Section 168(k) Bonus Depreciation

On August 3, 2018, the government issued proposed regulations (REG-104397-18) (the “Proposed Regulations”) providing clarification to Section 168(k) of the Internal Revenue Code[1] (the “Code”), as modified by the Tax Cuts and Jobs Act of 2017 (the “Act”).  Section 168(k) provides for the immediate expensing of a percentage of the cost of qualified property in the first year qualified property is placed in service (“Bonus Depreciation”), as opposed to depreciating such qualified property incrementally over its “class life”.  The Act raised the available Bonus Depreciation percentage from 50% to 100% for property acquired and placed in service after September 27, 2017.  The following provides an overview of the key issues addressed in the Proposed Regulations based on the Act’s modifications to section 168(k).

Immediate Expensing

Under the Code, taxpayers are permitted to depreciate the cost of an asset used in their trade or business over a prescribed class life of the asset.[2]  In some cases, however, taxpayers are permitted to immediately expense the entire cost of the asset in the year placed in service. 

Under section 179, a taxpayer may elect to treat the cost of section 179 property as an expense which is not chargeable to a capital account and deduct such expense in the year the property is placed in service.[3] In order to take such an expense, section 179 imposes an overall limit on the costs of assets being expensed, as well as a phase out limitation.[4] While the type of limits under section 179 remain unchanged, the Act:

  • Increased the aggregate cost that may be taken into account for any taxable year from $500,000 to $1,000,000;[5] and
  •  Increased the limit at which a reduction applies to the aggregate cost that may be taken into account for taxable year from $2,000,000 to $2,500,000.[6]

In addition to taking the section 179 deduction, a taxpayer may avail itself of section 168(k), which permits Bonus Depreciation of “qualified property.”  Section 168(k)(2) provides four general requirements that a property must meet to constitute “qualified property.”

  • The property must be of a specified type.
  • The original use of the property begins with the taxpayer or the taxpayer’s depreciable interest in such property via an acquisition that meets the requirements of section 168(k)(2)(E)(ii).
  • The taxpayer acquires the property within a defined time period.
  • The taxpayer places the property in service within a defined time period.

The Proposed Regulations provide guidance on each of these requirements.  The following highlights key issues addressed by the Proposed Regulations.

Specified Type of Qualified Property

Modifications to Definition[7]

The Act modified the definition of qualified property under section 168(k)(2)(A).  In doing so, the Act created three general time periods for consideration as to what constitutes qualified property.[8]  The following chart identifies the specified types of qualified property for each defined time period.  The dates are driven by the Act’s amendments to sections 168(e)(6) through 168(e)(8) and their respective effective dates.

Property Acquired BEFORE 9/28/2017 and Placed in Service BEFORE 1/1/2018*

Property Acquired AFTER 9/27/2017 and Placed in Service BEFORE 1/1/2018

Property Acquired AFTER 9/27/2017 and Placed in Service AFTER 12/31/2017

1) Property to which IRC § 168 applies with   a recovery period of 20 years or less**

1) Property to which IRC § 168 applies with  a recovery period of 20 years or less**

1) Property to which IRC § 168 applies with   a recovery period of 20 years or less***

2) Computer software (as defined in IRC       § 167(f)(1)(B)

2)  Computer software (as defined in IRC       § 167(f)(1)(B)

2)  Computer software (as defined in IRC       § 167(f)(1)(B)

3) Water utility property;

3) Water utility property;

3) Water utility property;

4) Qualified improvement property

4)  Qualified film or television production

4) Qualified film or television production

 

 

5)  Qualified live theatrical production

5) Qualified live theatrical production

6)  Qualified improvement property

 

*     Property acquired BEFORE 9/28/2017 and placed in service AFTER 1/1/2018 is subject to the previous Bonus Depreciation regime, and therefore, subject to the prior phase out provisions.  Qualified improvement property acquired BEFORE 9/28/2017 but Placed in Service AFTER 1/1/2018 is not eligible for Bonus Depreciation.  In addition, property acquired BEFORE 9/28/2017 must be new property to be eligible for Bonus Depreciation.  Used property acquired BEFORE 9/28/2017 does not qualify for Bonus Depreciation.  

**      This includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, as each had a 15-year class life prior to the Act, and the Act did not effectuate the removal of such property, as defined by sections 168(e)(6), (e)(7), and (e)(8), respectively, for property placed in service before January 1, 2018 in the case of qualified leasehold improvement property or until such property is placed in service after December 31, 2017 in the case of qualified restaurant property and qualified retail improvement property.

***   Qualified Improvement Property is not included under this category as it currently has a 39-year class life as discussed below.

Qualified Improvement Property

For property placed in service before January 1, 2018, qualified improvement property (“QIP”), as well as qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property are eligible for Bonus Depreciation.[9] The Act eliminated qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property as specified types of qualified property and included each under the definition of QIP if placed in service after December 31, 2017. The definition of QIP includes certain structural components and certain depreciable tangible property used in providing lodging. However, due to a drafting error by Congress, QIP, and by extension qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, are not eligible for Bonus Depreciation if placed in service after December 31, 2017.

In drafting the Act, Congress struck section 168(k)(2)(A)(i)(IV), effective for property placed in service after December 31, 2017, which specifically identified QIP as qualified property.  It also struck section 168(k)(3), effective for property placed in service after December 31, 2017, which defined QIP for purposes of section 168(k)(2)(A)(i)(IV).  Congress struck these provisions as it intended to add QIP to the definition of “15-year property” under section 168(e)(3)(E), which would have made QIP eligible as qualified property under section 168(k)(2)(A)(i)(I) (property which has a recovery period of 20 years or less).  

The intent of Congress is clear in the Committee Report, as the Conference Agreement provides in pertinent part, “In addition, the conference agreement provides a general 15-year MACRS recovery period for qualified improvement property.”  Moreover, the alternative depreciation system chart in section 168(g)(3)(B) references a non-existent section 168(e)(3)(D)(v) provision which appears to be hold-over from the Senate amendment to the House bill, where the Senate proposed a 10-year MACRS class-life treatment for QIP.  Nonetheless, Congress failed to make these modifications to the final language of the Act.

The drafting error was compounded by Congress’ decision to use the Act to strike the provisions defining qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property as qualified property, effective for property placed in service after December 31, 2017.[10]   Although Congress added the definition of QIP in new section 168(e)(6), effective for property placed in service after December 31, 2017, with the intent that it would include qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property, the omission of QIP in section 168(e)(3) precludes the application of Bonus Depreciation to all such property placed in service after December 31, 2017.

The IRS has clearly indicated that it will apply the law as written, which is in accordance with legal principles of statutory interpretation.  As a result, unless Congress passes a law to amend the drafting error, QIP placed in service after December 31, 2017 does not qualify for Bonus Depreciation.[11]  This is the case regardless of whether the QIP was acquired before or after September 27, 2017.

The Proposed Regulations clarify that qualified property acquired after September 27, 2017 and placed in service before December 31, 2017 includes qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.[12] 

Due to the complexity related to QIP created by congressional drafting, it is advisable to speak with your tax advisor if you have placed in service any QIP in the past year or plan to do so moving forward. 

Original Use and Acquired Depreciable Interest

Used Property

Prior to the Act, qualified property qualified for Bonus Depreciation only if the original use of the property commenced with the taxpayer.  However, the Act relaxed this requirement for property acquired after September 27, 2017 and placed in service after that date.[13]  The key component of analysis is whether the taxpayer or a predecessor had a “depreciable interest” in the newly acquired property during the period prior to acquisition.  The focus is not on whether a taxpayer claimed a depreciation deduction, but on whether it had an interest in such property that would have allowed it to claim a depreciation deduction.[14] 

For property acquired after September 27,2017 and placed in service after that date, a taxpayer may take Bonus Depreciation on used property if:

  • The property was not used by the taxpayer or a predecessor at any time prior to the acquisition[15];
  • The acquisition meets the related party and carryover basis requirements of section 179(d)(2). (i.e. the property is not acquired from a related person or member of the same controlled group)[16]; and
  • The acquisition of the property meets the cost requirements of section 179(d)(3) (i.e. the basis of the property is not determined by reference to the basis of other property of the taxpayer).[17]

The Proposed Regulations added anti-abuse provisions to ensure that taxpayers are not able to take Bonus Depreciation on property which does not satisfy the above requirements.[18]  These included rules addressing related parties, including transactions among members of a consolidated group.  For example, the Proposed Regulations provide that, for purposes of the above test, only the original user and final user of property will be considered in applying the related party tests.  Therefore, if a father transfers property to an unrelated third party, who in turn transfers the property to the original user’s daughter, the intermediate step involving the unrelated party is ignored, and the related party relationship between the father and daughter will prevent the daughter from taking Bonus Depreciation.[19]  

Leasing Relationships

The Proposed Regulations address the circumstances in which in which a lessee acquires previously leased property.  If the lessee did not have a depreciable interest in the acquired property or improvement thereto prior to the acquisition, then the unadjusted depreciable basis of the acquired property, or such portion applicable to the improvement of which the lessee did not have a depreciable interest prior to the acquisition, is eligible for Bonus Depreciation.[20]  However, the Proposed Regulations clarify that if the lessee had a depreciable interest in the property, the property is then sold, and the lessee acquires a depreciable interest in another portion of the property, the newly acquired interest does not qualify for Bonus Depreciation.[21]  

Basis Adjustments

The Proposed Regulations clarify that basis increases related to partnerships, including adjustments related to section 704(c) remedial allocations, section 732 adjustments, and section 734(b) adjustments are not eligible for Bonus Depreciation.[22]  However, the Proposed Regulations provided that a section 743(b) “step-up” basis adjustment may be eligible for Bonus Depreciation, if the basis increase is related to an interest in property, which is new in the partner’s hands (i.e. the three-part test for used property is satisfied with respect to such interest).[23] 

If one partner acquires a partnership interest from another, unrelated partner, then the acquiring partner can take Bonus Depreciation on the additional basis attributed to the qualified property acquired via the partnership interest acquisition (assuming the interest in question has not previously been used by the taxpayer).[24] However, if the partnership redeems the departing partner’s interest in the partnership, the remaining partners would not be able to take Bonus Depreciation on their respective increased interest in the qualified property, because the partners and the partnership would be considered related under section 179(d)(2)(A), and thus would violate the second requirement of section 168(k)(2)(E)(ii).[25]   Additionally, a partnership interest inherited after the death of a partner with a stepped up basis under section 1014 would not qualify for Bonus Depreciation.[26]      

Acquisition Date of Property

Written Binding Contract

The Proposed Regulations provide that property is acquired for purposes of section 168(k) on the date that a binding, written contract for the acquisition of the property is signed, as well as a definition for what constitutes a binding written contract.[27]   However, a letter of intent is not a binding, written contract for purposes of Section 168(k).[28]  The Proposed Regulations also provide the following clarifications.

  • When property is produced by a third party for the taxpayer, the property is considered “acquired” on the date that the binding, written contract for the production of the property is signed, not the day the property is delivered.
  • For self-constructed property, the property is considered “acquired” on the date that the taxpayer begins significant physical work on the property.[29] The Proposed Regulations contain rules related to property constructed as distinct components as well.[30]

Placed-in-Service Date of Property[31]

The placed-in-service date is a critical consideration for the applicable percentage applied for Bonus Depreciation.  For qualified property acquired prior to September 28, 2017, the Bonus Depreciation percentage remains limited to 50% of the adjusted basis of the qualified property, as well as the Act’s respective rate reduction, whether it is placed in service before or after September 28, 2017.  Furthermore, used property acquired prior to September 28, 2017 will not be eligible for Bonus Depreciation.

However, for property acquired after September 27, 2017, the applicable Bonus Depreciation percentage is 100% if the property is placed-in-service before January 1, 2023.[32]  For such property placed in service, thereafter, the applicable percentage is determined based on the year the property is placed in service.  Property placed in service after December 31, 2026 does not receive Bonus Depreciation.[33]

Additional Issues of Interest

Technical Partnership Terminations

The Act eliminated the technical partnership rules under section 708(b)(1)(B).  The Proposed Regulations assert that for partnerships that underwent a technical termination under Section 708 prior to January 1, 2018, qualified property placed in service during the year of the termination is treated as originally placed in service by the new partnership on the date the property is contributed by the terminating partnership.[34]

Electing Real Property Trade or Business

An Electing Real Property Trade or Business is required to use the Alternative Depreciation System (“ADS”) for residential real property, non-residential real property, and QIP to avoid the interest deduction limitations under Section 163(j).[35]  As a result, the Electing Real Property Trade or Business will not be able to take Bonus Depreciation with respect to these three classes of property.[36]

  • As none of these classes of property are currently eligible for Bonus Depreciation (barring a technical correction for QIP), this may have little bearing on such entities’ decision to forego Bonus Depreciation to avoid the application of the 30% interest deduction limitation under new section 163(j).
  • Other classes of property held by an Electing Real Property Trade or Business are not required to utilize ADS, and as such remain eligible for Bonus Depreciation.[37]

Bonus Depreciation Election Planning

While the majority of the Proposed Regulations pertain to dates and timing issues, as well as the impact of becoming an Electing Real Property Trade or Business on Bonus Depreciation, there is potential planning around the timing of depreciation.  However, the Act did eliminate the election to accelerate AMT credits in lieu of Bonus Depreciation, effective for tax years beginning after December 31, 2017.[38]

For any class of property, a taxpayer may elect not to take Bonus Depreciation, and may instead depreciate the property over its entire class life.[39]  If the taxpayer is in a significant loss position, it may be more beneficial to spread depreciation over the life of the asset rather than add to the loss by taking all the year the property is placed in service.  

Additionally, for property placed in service during the 2017 tax year, the taxpayer may elect to only take 50% Bonus Depreciation rather than 100%.[40] This allows the taxpayer to have consistent treatment of property placed in service before and after September 27, 2017 and allows a taxpayer in a loss position to slow down depreciation if helpful.[41] 

Effective Date of Proposed Regulations

The Proposed Regulations apply to qualified property placed in service or planted or grafted, as applicable, by the taxpayer during or after the taxpayer’s taxable year that includes the date of publication of a Treasury’s decision adopting these regulations as final in the Federal Register.  Taxpayers may choose to apply the Proposed Regulations to qualified property acquired and placed in service or planted or grafted, as applicable, after September 27, 2017.

 

For any questions regarding the Proposed Regulations’ effect on Bonus Depreciation, please contact FGMK.

Randy Markowitz                             Perry Weinstein                                   Jeffrey Golds

Partner                                                Partner                                                  Manager

847.940.3241                                     847.940.3233                                      847.940.3260

RMarkowitz@fgmk.com                   PWeinstein@fgmk.com                     JGolds@fgmk.com

 

 

[1] All tax code references are references to the Internal Revenue Code of 1986, as amended.

[2] IRC § 168

[3] IRC § 179(a)

[4] IRC § 179(b)

[5] IRC § 179(b)(1), as amended by the Tax Cuts and Jobs Act of 2017 §13101(a)(1);

[6] IRC § 179(b)(2), as amended by the Tax Cuts and Jobs Act of 2017 §13101(a)(2)

[7] Note that any references to property acquisition dates also pertain to qualified property planted or grafted as of such dates.

[8] This discussion of time periods does not take into account property having a longer production periods treated as qualified property.  Such property must be placed in service before January 1, 2028.

[9] Prop. Treas. Reg. § 1.168(k)-2(b)(2)(i)(A)

[10] Tax Cuts and Jobs Act of 2017 §13204(a)

[11] See Prop. Treas. Reg. § 1.168(b)-1(a)(5)(i)(C)

[12] Prop. Treas. Reg. § 1.168(k)-2(b)(2)(i)(A)

[13] IRC § 168(k)(2)(A)(ii).

[14] See Prop. Treas. Reg. § 1.168(k)-2)(b)(3)(iii)(B)

[15] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iii)(A)(1)

[16] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iii)(A)(2)

[17] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iii)(A)(3)

[18] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iii)(C)

[19] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iv) (Example 18)

[20] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(B)(2)

[21] Id.

[22] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iv)

[23] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iv)(D)

[24] Id.

[25] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iv)(D)(1), citing § IRC 179(d)(2)(A), citing IRC § 707(b)

[26] Prop. Treas. Reg. § 1.168(k)-2(b)(3)(iv) (Example 15)

[27] Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iii)

[28] Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iii)(D)

[29] Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iv)(A)

[30] Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iv)(C)

[31] See IRC § 168(k)(6)(B) for rules for property with longer production periods.

[32] IRC § 168(k)(6)(A)(i)

[33] IRC § 168(k)(6)(A)

[34] Prop. Treas. Reg. § 1.168(k)-2(b)(4)(v)

[35] IRC § 168(g)(8)

[36] Prop. Treas. Reg. § 1.168(k)-2(b)(2)(ii)(B)

[37] Id.

[38] Pub. L. 115-97, Sec. 12001(b)(13).

[39] Prop. Treas. Reg. § 1.168(k)-2(e)(1)

[40] Prop. Treas. Reg. § 1.168(k)-2(e)(3)

[41] This election might also be helpful in partnerships with specific allocations of losses.  If Bonus Depreciation is taken in year 1, it might cause the partner being specifically allocated the losses to have a negative capital account before sufficient minimum gain has been generated to allow for the allocations.  In this case, losses would be allocated away from the partner to other partners with positive capital accounts, and the desired allocations would not be in effect. 

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