In Depth: Bonus Depreciation Proposed Regs Issued; Taxpayers May Rely on Them Immediately

(Parker Tax Publishing August 2018)

The IRS issued proposed regulations on the additional first year depreciation deduction (i.e., bonus depreciation) available under Code Sec. 168(k) as a result of changes made by the Tax Cuts and Jobs Act of 2017 (TCJA). The proposed regulations address numerous issues such as the bonus depreciation deductions for qualified improvement property, used property, partnership property, as well as what constitutes a binding contract and other special rules. While the proposed regulations are not effective until finalized, the IRS has given permission for taxpayers to apply these rules until final regulations are issued. REG-104397-18 (8/8/18).

Background

The Tax Cuts and Jobs Act of 2017 (TCJA), which was signed into law on December 22, 2017, made substantial changes to business-related deductions for capital assets. One of the more significant changes was the increase in the additional first year depreciation (i.e., bonus depreciation) deduction. Under TCJA, the 50-percent additional depreciation allowance that had been available under prior law was increased to 100 percent; the property eligible for bonus depreciation deduction was expanded to include certain used depreciable property and certain film, television, or live theatrical productions; the placed-in-service date was extended from before January 1, 2020, to before January 1, 2027 (from before January 1, 2021, to before January 1, 2028, for longer production period property or certain aircraft property); and the date on which a specified plant is planted or grafted by the taxpayer was extended from before January 1, 2020, to before January 1, 2027.

The 100-percent allowance is phased down by 20 percent per calendar year for property placed in service, and specified plants planted or grafted, in tax years beginning after 2022 (after 2023 for longer production period property and certain aircraft).

For purposes of determining when property is acquired, property is not treated as acquired after the date on which a written binding contract is entered into for such acquisition. Thus, determining if and when a written binding contact was in place for the purchase of an asset is important in determining if a taxpayer is eligible for bonus depreciation.

TCJA also made changes to the depreciation rules for leasehold improvements. While leasehold improvement property is generally subject to a recovery period of 39 years, a shorter 15-year life had been carved out for the following property placed in service before 2018: (1) qualified leasehold improvements; (2) qualified retail improvement property; (3) qualified restaurant property that was also qualified improvement property; and (4) qualified improvement property. TCJA eliminated these separate categories, effective for property placed in service after 2017, and combined them into one category - qualified improvement property.

Finally, an asset's alternative depreciation system (ADS) life is important in determining whether an asset qualifies for bonus depreciation deductions. TCJA changed the ADS life of residential and nonresidential property from 39 years to 30 and 40 years, respectively.

Proposed Regulations

The IRS has now issued proposed regulations (REG-104397-18) relating to the bonus depreciation rules that apply as a result of the amendments made by TCJA. Taxpayers may rely on the proposed regulations until final regulations are issued. The proposed regulations not only update existing regulations, they also provide a new regulation, Reg. Sec. 1.168(k)-2, for property acquired and placed in service after September 27, 2017.

The proposed regulations clarify the requirements that must be met for depreciable property to qualify for bonus depreciation and describe how taxpayers calculate not only the bonus depreciation deduction, but also depreciation deductions otherwise allowable.

In the proposed regulations, the IRS addresses several issues that have been of concern to taxpayers, such as:

(1) whether or not the bonus depreciation rules apply to qualified improvement property;

(2) the situations in which a taxpayer can and cannot take a bonus depreciation deduction for used property;

(3) whether partnerships are eligible for bonus depreciation deductions with respect to basis adjustments under Code Sec. 734(b) and Code Sec. 743(b) and whether certain Code Sec. 704(c) adjustments, as well as the basis of distributed property determined under Code Sec. 732, qualify for bonus depreciation; and

(4) the definition of a "written binding contract."

Property Eligible for Bonus Depreciation Deduction

Following Code Sec. 168(k)(2), the proposed regulations provide that only qualified depreciable property is eligible for bonus depreciation. Depreciable property must meet the following four requirements to be considered qualified property:

(1) the depreciable property must be of a specified type (see below);

(2) the original use of the depreciable property must begin with the taxpayer or used depreciable property must meet the acquisition requirements of Code Sec. 168(k)(2)(E)(ii) (see below);

(3) the depreciable property must be placed in service by the taxpayer within a specified time period or must be planted or grafted by the taxpayer before a specified date; and

(4) the depreciable property must be acquired by the taxpayer after September 27, 2017.

Only the following types of depreciable property are eligible for bonus depreciation:

(1) MACRS property that has a recovery period of 20 years or less;

(2) computer software as defined in, and depreciated under, Code Sec. 167(f)(1);

(3) water utility property as defined in Code Sec. 168(e)(5) and depreciated under Code Sec. 168;

(4) a qualified film or television production as defined in Code Sec. 181(d) and for which a deduction would have been allowable under Code Sec. 181 without regard to Code Sec. 181(a)(2) and (g) or Code Sec. 168(k);

(5) a qualified live theatrical production as defined in Code Sec. 181(e) and for which a deduction would have been allowable under Code Sec. 181 without regard to Code Sec. 181(a)(2) and (g) or Code Sec. 168(k);

(6) a specified plant as defined in Code Sec. 168(k)(5)(B) and for which the taxpayer has made an election to apply the bonus depreciation rules; and

(7) qualified improvement property acquired after September 27, 2017, and placed in service after September 27, 2017, and before January 1, 2018 (see discussion of "qualified improvement property" below).

In determining the eligibility of MACRS property as qualified property, the recovery period applicable for the MACRS property under Code Sec. 168(c) of the general depreciation system (GDS) is used, regardless of any election made by the taxpayer to depreciate the class of property under the alternative depreciation system (ADS) of Code Sec. 168(g).

Qualified Improvement Property

Qualified property eligible for bonus depreciation includes "qualified improvement property" acquired after September 27, 2017, and placed in service after September 27, 2017, and before January 1, 2018.

Observation: For property placed in service after December 31, 2017, TCJA eliminated the 15-year modified accelerated cost recovery system (MACRS) property classification for qualified leasehold improvement property, qualified restaurant property that was also qualified improvement property, and qualified retail improvement property. TCJA also amended Code Sec. 168(k) to eliminate qualified improvement property as a specific category of qualified property. Instead, all of these classes of property are included under one classification - qualified improvement property.

Caution: While the TCJA committee reports and the Conference Report indicated that qualified improvement property was to have a 15-year life, the statute was never changed to include such language. Thus, qualified improvement property placed in service after December 31, 2017, has a 39-year recovery period and is not eligible for bonus depreciation.

The proposed regulations provide that MACRS property with a recovery period of 20 years or less includes the following MACRS property that is acquired by the taxpayer after September 27, 2017, and placed in service by the taxpayer after September 27, 2017, and before January 1, 2018: (1) qualified leasehold improvement property; (2) qualified restaurant property that is qualified improvement property; (3) qualified retail improvement property; and (4) qualified improvement property.

Property Ineligible for Bonus Depreciation

The following property is not qualified property and thus is not eligible for the bonus depreciation deduction:

(1) property excluded from the application of Code 168 as a result of Code Sec. 168(f) (i.e., certain public utility property, films and video tape, sound recordings, certain property placed in service in churning transactions, and certain property a taxpayer elects to exclude from Code Sec. 168);

(2) property that is required to be depreciated under the ADS (as described below);

(3) any class of property for which the taxpayer elects not to deduct the bonus depreciation under Code Sec. 168(k)(7);

(4) a specified plant placed in service by the taxpayer in the tax year and for which the taxpayer made an election to apply the bonus depreciation rules for a prior year under Code Sec. 168(k)(5)(D);

(5) any class of property for which the taxpayer elects to apply Code Sec. 168(k)(4) (this exclusion applies to property placed in service in any tax year beginning before January 1, 2018 since TCJA repealed Code Sec. 168(k)(4) for tax years beginning after 2017);

(6) property described in Code Sec. 168(k)(9)(A) (certain property used primarily in a trade or business of the furnishing or sale of (i) electrical energy, water, or sewage disposal services, (ii) gas or steam through a local distribution system, or (iii) transportation of gas or steam by pipeline) or Code Sec. 168(k)(9)(B) (certain property used in a business that has had floor plan financing debt); and

(7) qualified improvement property placed in service after December 31, 2017 (see discussion of "qualified improvement property" above).

Property is required to be depreciated under the ADS if the property is described in Code Sec. 168(g)(1)(A), (B), (C), (D), (F), or (G) or if other provisions of the Code require depreciation for the property to be determined under the ADS. Accordingly, MACRS property that is nonresidential real property, residential rental property, and qualified improvement property held by an electing real property trade or business (as defined in Code Sec. 163(j)(7)(B)), and property with a recovery period of 10 years or more that is held by an electing farming business are not eligible for the bonus depreciation deduction for tax years beginning after December 31, 2017. However, MACRS property for which the taxpayer makes an election under Code Sec. 168(g)(7) to depreciate the property under the ADS is eligible for the bonus depreciation deduction (assuming all other requirements are met).

Used Property Eligible for Bonus Depreciation

As previously noted, before the TCJA changes, bonus depreciation deductions were not available with respect to used property. Pursuant to Code Sec. 168(k)(2)(A)(ii) and Code Sec. 168(k)(2)(E)(ii), the proposed regulations provide that the acquisition of used property is eligible for the bonus depreciation deduction if such acquisition meets the following requirements:

(1) the property was not used by the taxpayer or a predecessor at any time prior to the acquisition;

(2) the acquisition of the property meets certain related party and carryover basis requirements; and

(3) the acquisition of the property meets the cost requirements of Code Sec. 179(d)(3) and Reg. Sec. 1.179-4(d).

With respect to elections under Code Sec. 338 and Code Sec. 336(e), the IRS noted that such elections share many of the same characteristics. Therefore, the proposed regulations modify Reg. Sec. 1.179-4(c)(2), which addresses the treatment of a Code Sec. 338 election, to include property deemed to have been acquired by a new target corporation as a result of a Code Sec. 336(e) election. Reg. Sec. 1.336-1(a)(1) provides that to the extent not inconsistent with Code Sec. 336(e) or the regulations under Code Sec. 336(e), the principles of Code Sec. 338 and the regulations under Code Sec. 338 apply for purposes of the regulations under Code Sec. 336. In the preamble to the proposed regulations, the IRS said that, to the extent that property is deemed to have been acquired by a "new target corporation," it reads Reg. Sec. 1.179-4(c)(2) as applying to the deemed acquisition of property by a new target corporation as a result of a Code Sec. 336(e) election, just as it applies as the result of a Code Sec. 338 election. However, the IRS said, to remove any doubt, the proposed regulations modify Reg. Sec. 1.179-4(c)(2) to provide that property deemed to have been acquired by a new target corporation as a result of a Code Sec. 338 or a Code Sec. 336(e) election will be considered acquired by purchase for purposes of Code Sec. 179 and thus eligible for bonus depreciation deductions.

The proposed regulations provide that the property is treated as used by the taxpayer or a predecessor at any time before its acquisition of the property only if the taxpayer or the predecessor had a depreciable interest in the property at any time before the acquisition, whether or not the taxpayer or the predecessor claimed depreciation deductions for the property. If a lessee has a depreciable interest in the improvements made to leased property and subsequently the lessee acquires the leased property of which the improvements are a part, the proposed regulations provide that the unadjusted depreciable basis, as defined in Reg. 1.168(b)-1(a)(3), of the acquired property that is eligible for the bonus depreciation deduction, assuming all other requirements are met, does not include the unadjusted depreciable basis attributable to the improvements.

Further, if a taxpayer initially acquires a depreciable interest in a portion of the property and subsequently acquires an additional depreciable interest in the same property, the proposed regulations also provide that such additional depreciable interest is not treated as being previously used by the taxpayer. However, if a taxpayer holds a depreciable interest in a portion of the property, sells that portion or a part of that portion, and subsequently acquires a depreciable interest in another portion of the same property, the proposed regulations provide that the taxpayer will be treated as previously having a depreciable interest in the property up to the amount of the portion for which the taxpayer held a depreciable interest in the property before the sale.

Observation: The IRS is requesting comments on whether a safe harbor should be provided on how many tax years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property. Practitioners wishing to comment should provide the number of tax years recommended for the look-back period and the reasoning for such number.

Rules Applicable to Consolidated Groups

While members of a consolidated group generally are treated as separate taxpayers, the IRS believes that the bonus depreciation deduction should not be permitted to 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 because permitting such a deduction would not clearly reflect the group's income tax liability. To implement this position, 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. For purposes of this rule, a consolidated group will be treated as having a depreciable interest in property if any current or previous member of the group had a depreciable interest in the property while a member of the group.

The IRS also believes that the bonus depreciation deduction should not be allowed when, as part of a series of related transactions, one or more members of a consolidated group acquire both the stock of a corporation that previously had a depreciable interest in the property and the property itself and the proposed regulations deny the deduction in such circumstances.

Additionally, if the acquisition of property is part of a series of related transactions that also includes one or more transactions in which the transferee of the property ceases to be a member of a consolidated group, then whether the taxpayer is a member of a consolidated group is tested immediately after the last transaction in the series.

Rules Applicable to Partnerships

In 2003, the IRS issued temporary regulations which provided that any increase in the basis of qualified property due to a Code Sec. 754 election generally is not eligible for bonus depreciation. The IRS explained that any increase in basis due to a Code Sec. 754 election does not satisfy the original use requirement. The final regulations retained the rule for increases in basis due to Code Sec. 754 elections. Since TCJA amended the depreciation rules to allow bonus depreciation deductions for certain used property in addition to new property, the IRS reconsidered whether basis adjustments under Code Sec. 734(b) and Code Sec. 743(b) qualify for the bonus depreciation deduction. The IRS also discussed in the proposed regulations whether certain Code Sec. 704(c) adjustments as well as the basis of distributed property determined under Code Sec. 732 should qualify for a bonus depreciation deduction.

The proposed regulations provide that remedial allocations under Code Sec. 704(c) do not qualify for bonus depreciation deductions. According to the IRS, notwithstanding the language of Reg. Sec. 1.704-3(d)(2) that any method available to the partnership for newly purchased property may be used to recover the portion of the partnership's book basis in contributed property that exceeds its adjusted tax basis, remedial allocations do not meet the requirements for being considered qualified property. Because the underlying property is contributed to the partnership in a Code Sec. 721 transaction, the partnership's basis in the property is determined by reference to the contributing partner's basis in the property, which violates the rules in Code Sec. 179(d)(2)(C) and Code Sec. 168(k)(2)(E)(ii)(II) as to the type of property that qualifies for bonus depreciation deductions. In addition, the IRS said, the partnership has already had a depreciable interest in the contributed property at the time the remedial allocation is made, which is in violation of the rules defining qualified property as well as the original use requirement. The same rule applies in the case of revaluations of partnership property (i.e., reverse Code Sec. 704(c) allocations). Further, the proposed regulations provide that bonus depreciation is not allowed on property contributed to the partnership with a zero adjusted tax basis because, with the bonus depreciation deduction, the partners have the potential to shift built-in gain among partners.

Under Code Sec. 732(a)(1), the basis of property (other than money) distributed by a partnership to a partner other than in liquidation of the partner's interest is its adjusted basis to the partnership immediately before the distribution. Code Sec. 732(a)(2) provides that the basis determined under Code Sec. 732(a)(1) cannot exceed the adjusted basis of the partner's interest in the partnership reduced by any money distributed in the same transaction. Code Sec. 732(b) provides that the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner's interest is equal to the adjusted basis of the partner's interest in the partnership reduced by any money distributed in the same transaction. According to the IRS, property distributed by a partnership to a partner fails to satisfy the original use requirement because the partnership used the property before the distribution and thus fails to satisfy the applicable acquisition requirements. Any portion of basis determined by Code Sec. 732(a)(1) fails to satisfy Code Sec. 179(d)(2)(C) because such basis is determined by reference to the partnership's basis in the distributed property. Similarly, any portion of basis determined by Code Sec. 732(a)(2) or (b) fails to satisfy Code Sec. 179(d)(3) because it is determined by reference to the distributee partner's basis in its partnership interest (reduced by any money distributed in the same transaction).

With respect to Code Sec. 734(b) adjustments, the IRS noted that because a Code Sec. 734(b) basis adjustment is made to the basis of partnership property (i.e., non-partner specific basis) and the partnership used the property before the partnership distribution giving rise to the basis adjustment, a Code Sec. 734(b) basis adjustment fails the original use test of the bonus depreciation requirement and the proposed regulations therefore provide that Code Sec. 734(b) basis adjustments are not eligible for the bonus depreciation deduction.

With respect to Code Sec. 743(b) adjustments, the IRS noted that, before TCJA, a Code Sec. 743(b) basis adjustment would always fail the original use requirement because partnership property to which a Code Sec. 743(b) basis adjustment relates would have been previously used by the partnership and its partners before the transfer that gave rise to the Code Sec. 743(b) adjustment. After TCJA, while a Code Sec. 743(b) basis adjustment still fails the original use test, a transaction giving rise to a Code Sec. 743(b) basis adjustment may satisfy the used property clause in Code Sec. 168(k)(2)(A)(ii) because the used property acquisition requirements depend on facts and circumstances. Because a Code Sec. 743(b) basis adjustment is a partner specific basis adjustment to partnership property, the proposed regulations take an aggregate view and provide that, in determining whether a Code Sec. 743(b) basis adjustment meets the used property acquisition requirements of the bonus depreciation rules, each partner is treated as having owned and used the partner's proportionate share of partnership property. In the case of a transfer of a partnership interest, the bonus depreciation use requirements will be satisfied if the partner acquiring the interest, or a predecessor of such partner, has not used the portion of the partnership property to which the Code Sec. 743(b) basis adjustment relates at any time before the acquisition (that is, the transferee has not used the transferor's portion of partnership property prior to the acquisition), notwithstanding the fact that the partnership itself has previously used the property. Similarly, for purposes of applying the bonus depreciation acquisition requirements, the partner acquiring a partnership interest is treated as acquiring a portion of partnership property, and the partner who is transferring a partnership interest is treated as the person from whom the property is acquired.

Under the proposed regulations, the same result will apply regardless of whether the transferee partner is a new partner or an existing partner purchasing an additional partnership interest from another partner. Assuming that the transferor partner's specific interest in partnership property that is acquired by the transferee partner has not previously been used by the transferee partner or a predecessor, the corresponding Code Sec. 743(b) basis adjustment will be eligible for a bonus depreciation deduction in the hands of the transferee partner, provided all other requirements are satisfied. According to the IRS, this treatment is appropriate notwithstanding the fact that the transferee partner may have an existing interest in the underlying partnership property, because the transferee's existing interest in the underlying partnership property is distinct from the interest being transferred.

Finally, the proposed regulations provide that a Code Sec. 743(b) basis adjustment is a class of property (not including the property class for Code Sec. 743(b) basis adjustments) that may be recovered using the bonus depreciation deduction under Code Sec. 168(k) without regard to whether the partnership elects out of the bonus depreciation deduction under Code Sec. 168(k)(7) for all other qualified property in the same class of property and placed in service in the same tax year.

The proposed regulations provide that a partnership may make the election out of the bonus depreciation deduction for a Code Sec. 743(b) basis adjustment in a class of property (not including the property class for Code Sec. 743(b) basis adjustments), and this election will not bind the partnership to such election for all other qualified property of the partnership in the same class of property and placed in service in the same taxable year.

The proposed regulations also provide a syndication transaction rule. For new or used property, the proposed regulations provide that if (1) a lessor has a depreciable interest in the property and the lessor and any predecessor did not previously have a depreciable interest in the property, (2) the property is sold by the lessor or any subsequent purchaser within three months after the date the property was originally placed in service by the lessor (or, in the case of multiple units of property subject to the same lease, within three months after the date the final unit is placed in service, so long as the period between the time the first unit is placed in service and the time the last unit is placed in service does not exceed 12 months), and (3) the user (lessee) of the property after the last sale during the three-month period remains the same as when the property was originally placed in service by the lessor, then the purchaser of the property in the last sale during the three-month period is considered the taxpayer that acquired the property and the taxpayer that originally placed the property in service, but not earlier than the date of the last sale. Thus, if a transaction is within these rules, the purchaser of the property in the last sale during the three-month period is eligible to claim the bonus depreciation for the property (assuming all requirements are met), and the earlier purchasers of the property are not.

Placed-in-Service Date

The proposed regulations provide that, in order to qualify for bonus depreciation, qualified property must be placed in service by the taxpayer after September 27, 2017, and before January 1, 2027, or, in the case of property described in Code Sec. 168(k)(2)(B) or (C) (i.e., certain longer-production period property or aircraft), before January 1, 2028. The TCJA removed the rules regarding sale-leaseback transactions and, thus, the proposed regulations do not retain the placed-in-service date rules regarding such transactions, including a sale-leaseback transaction followed by a syndication transaction.

If the taxpayer has made an election to apply the bonus depreciation rules for a specified plant, the proposed regulations provide that the specified plant must be planted before January 1, 2027, or grafted before January 1, 2027, to a plant that has already been planted, by the taxpayer in the ordinary course of the taxpayer's farming business, as defined in Code Sec. 263A(e)(4).

Pursuant to Code Sec. 168(k)(2)(H), the proposed regulations also provide that a qualified film or television production is treated as placed in service at the time of initial release or broadcast as defined under Reg. Sec. 1.181-1(a)(7), and a qualified live theatrical production is treated as placed in service at the time of the initial live staged performance. The proposed regulations also provide that the initial live staged performance of a qualified live theatrical production is the first commercial exhibition of a production to an audience. An initial live staged performance does not include limited exhibition, prior to commercial exhibition to general audiences, if the limited exhibition is primarily for purposes of publicity, determining the need for further production activity, or raising funds for the completion of production. For example, the initial live staged performance does not include a preview of the production if the preview is primarily to determine the need for further production activity.

Written Binding Contract

The proposed regulations provide that bonus depreciation 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. Under the proposed regulations, property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into before the manufacture, construction, or production of the property for use by the taxpayer in its trade or business or for its production of income is acquired pursuant to a written binding contract. Further, if the written binding 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.

A contract is 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). For this purpose, a contractual provision that limits damages to an amount equal to at least 5 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 will not be taken into account.

Example: Taxpayer A entered into an irrevocable written contract to purchase an asset for $100 and the contract did not contain a provision for liquidated damages. The contract is considered binding notwithstanding the fact that the asset had a fair market value of $99 and under local law the seller would only recover the difference in the event the purchaser failed to perform. If the contract provides for a full refund of the purchase price in lieu of any damages allowable by law in the event of breach or cancellation, the contract is not considered binding.

A contract is binding even if subject to a condition, as long as the condition is not within the control of either party or a predecessor. A contract will continue to be binding if the parties make insubstantial changes in its terms and conditions or if any term is to be determined by a standard beyond the control of either party. A contract that imposes significant obligations on the taxpayer or a predecessor will be treated as binding notwithstanding the fact that certain terms remain to be negotiated by the parties to the contract.

Under the proposed regulations, an option to either acquire or sell property is not a binding contract; nor is a letter of intent for an acquisition a binding contract. A binding contract also does not include a supply or similar agreement if the amount and design specifications of the property to be purchased have not been specified. The contract will not be a binding contract for the property to be purchased until both the amount and the design specifications are specified. For example, if the provisions of a supply or similar agreement state the design specifications of the property to be purchased, a purchase order under the agreement for a specific number of assets is treated as a binding contract.

A binding contract to acquire one or more components of a larger property will not be treated as a binding contract to acquire the larger property. If a binding contract to acquire a component does not satisfy the acquisition date requirements, the component does not qualify for the bonus depreciation deduction.

With respect to self-constructed property, if a taxpayer manufactures, constructs, or produces property for its own use, the acquisition rules are treated as met if the taxpayer begins manufacturing, constructing, or producing the property after September 27, 2017. The proposed regulations provide rules similar to those in Reg. Sec. 1.168(k)-1(b)(4)(iii)(B) for defining when manufacturing, construction, or production begins, including the safe harbor, and in Reg. Sec. 1.168(k)-1(b)(4)(iii)(C) for a contract to acquire, or for the manufacture, construction, or production of, a component of the larger self-constructed property. The self-constructed rules in the proposed regulations do not apply to property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into prior to the manufacture, construction, or production of the property.

The proposed regulations provide that a qualified film or television production is treated as acquired on the date principal photography begins, and a qualified live theatrical production is treated as acquired on the date when all of the necessary elements for producing the live theatrical production are secured. These elements may include a script, financing, actors, set, scenic and costume designs, advertising agents, music, and lighting.

Longer Production Period Property or Certain Aircraft Property

The proposed regulations provide rules for determining when longer production period property or certain aircraft property meets the acquisition requirements. Under the proposed regulations, such property must be acquired by the taxpayer before January 1, 2027, or acquired by the taxpayer pursuant to a written binding contract that is entered into before January 1, 2027. These acquisition requirements are in addition to those in TCJA, which require the acquisition to occur after September 27, 2017.

The proposed regulations provide that the written binding contract rules for longer production period property and certain aircraft property are the same rules that apply for purposes of determining whether the acquisition requirements of TCJA are met. With respect to self-constructed property relating to certain aircraft and longer production period property, the proposed regulations follow the acquisition rule in Code Sec. 168(k)(2)(E)(i) for self-constructed property and provide that the acquisition requirements of Code Sec. 168(k)(2)(B)(i)(III) or (k)(2)(C)(i), as applicable, are met if a taxpayer manufactures, constructs, or produces the property for its own use and such manufacturing, construction, or productions begins before January 1, 2027.

Further, where such property is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into before the manufacture, construction, or production of the property for use by the taxpayer in its trade or business or for its production of income, it is considered to be manufactured, constructed, or produced by the taxpayer. The proposed regulations also provide rules similar to those in Reg. Sec. 1.168(k)-1(b)(4)(iii)(B) for defining when manufacturing, construction, or production begins, including the same safe harbor, and in Reg. Sec. 1.168(k)-1(b)(4)(iii)(C) for a contract to acquire, or for the manufacture, construction, or production of, a component of the larger self-constructed property.

Computing Bonus Depreciation and Otherwise Allowable Depreciation

Under the proposed regulations, the allowable bonus depreciation deduction for qualified property is equal to the applicable percentage (as defined in Code Sec. 168(k)(6)) of the unadjusted depreciable basis of the property. For longer production-period property, the unadjusted depreciable basis of the property is limited to the property's basis attributable to the manufacture, construction, or production of the property before January 1, 2027, as provided in Code Sec. 168(k)(2)(B)(ii). Pursuant to Code Sec. 168(k)(2)(G), the proposed regulations also provide that the bonus depreciation deduction is allowed for both regular tax and alternative minimum tax (AMT) purposes. However, for AMT purposes, the amount of the bonus depreciation deduction is based on the unadjusted depreciable basis of the property for AMT purposes. The amount of the bonus depreciation deduction is not affected by a tax year of less than 12 months for either regular or AMT purposes.

Before determining the amount of depreciation otherwise allowable for qualified property, the proposed regulations require the taxpayer to first reduce the unadjusted depreciable basis of the property by the amount of the bonus depreciation deduction allowed or allowable, whichever is greater (the remaining adjusted depreciable basis). Then, the remaining adjusted depreciable basis is depreciated using the applicable depreciation provisions of the Code for the property (e.g., Code Sec. 168 for MACRS property, Code Sec. 167(f)(1) for computer software, and Code Sec. 167 for film, television, or theatrical productions). This amount of depreciation is allowed for both regular tax and AMT purposes, and is affected by a tax year of less than 12 months.

However, for AMT purposes, the amount of depreciation allowed is determined by calculating the remaining adjusted depreciable basis of the property for AMT purposes and using the same depreciation method, recovery period, and convention that applies to the property for regular tax purposes. If a taxpayer uses the optional depreciation tables in Rev. Proc. 87-57 to compute depreciation for qualified property that is MACRS property, the proposed regulations also provide that the remaining adjusted depreciable basis of the property is the basis to which the annual depreciation rates in those tables apply.

Special Rules

The proposed regulations provide a number of special rules, including one for qualified property that is placed in service in a tax year and then contributed to a partnership under Code Sec. 721(a) in the same tax year when one of the other partners previously had a depreciable interest in the property. The IRS cited Situation 1 of Rev. Rul. 99-5 as an example of such a fact pattern. The bonus depreciation deduction associated with the contributed property would be allocated between the contributing partner and the partnership based on the proportionate time the contributing partner and the partnership held the property throughout the tax year. The partnership could then allocate a portion of the deduction to the partner with a previous depreciable interest in the property. According to the IRS, allocating any portion of the deduction to a partner who previously had a depreciable interest in the property would be inconsistent with the bonus depreciation rules regarding the acquisition of property not being used by the taxpayer at any time before such acquisition. Therefore, the proposed regulations provide that, in this situation, the bonus depreciation deduction with respect to the contributed property is not allocated under the general rules. Instead, the bonus depreciation deduction is allocated entirely to the contributing partner before the Code Sec. 721(a) transaction and not to the partnership.

With respect to like-kind exchanges and involuntary conversions, current regulations provide that the exchanged basis and excess basis, if any, of replacement property is eligible for the bonus depreciation deduction if the replacement property is qualified property. The proposed regulations retain this rule if the replacement property also meets the original use requirement. The proposed regulations also 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 also meets the used property acquisition requirements. These rules also apply when a taxpayer makes the election to treat, for depreciation purposes only, the total of the exchanged basis and excess basis, if any, in the replacement MACRS property as property placed in service by the taxpayer at the time of replacement and the adjusted depreciable basis of the relinquished MACRS property as disposed of by the taxpayer at the time of disposition. The proposed regulations also retain the other rules in the regulations for like-kind exchanges and involuntary conversions, but update the definitions to be consistent with the definitions in Reg. Sec. 1.168(i)-6, which addresses how to compute depreciation of property involved in like-kind exchanges or involuntary conversions.

Electing Out of the Bonus Depreciation Deduction

The proposed regulations provide rules for electing out of the bonus depreciation deduction under Code Sec. 168(k)(7) and for making the election to apply the bonus depreciation rules in Code Sec. 168(k)(5) to a specified plant. Under Prop. Reg. Sec. 1.168(k)-2(e)(1), a taxpayer may make an election not to deduct the bonus depreciation for any class of property that is qualified property placed in service during the tax year. If this election is made, the election applies to all qualified property that is in the same class of property and placed in service in the same tax year, and no bonus depreciation deduction is allowable for the property placed in service during the tax year in the class of property, except as provided in Reg. Sec. 1.743-1(j)(4)(i)(B)(1).

The election must be made by the due date, including extensions, of the federal tax return for the tax year in which the qualified property is placed in service by the taxpayer. The election is made by filing Form 4562, Depreciation and Amortization, and is made separately by each person owning qualified property (for example, for each member of a consolidated group by the common parent of the group, by the partnership (including basis adjustments in the partnership assets under Code Sec. 743(b)), or by the S corporation). If a taxpayer does not make the election within the time and in the manner described, the amount of depreciation allowable for that property under Code Sec. 167(f)(1) or Code Sec. 168, as applicable, must be determined for the placed-in-service year and for all subsequent taxable years by taking into account the bonus depreciation deduction. Thus, the election cannot be made by the taxpayer in any other manner (for example, the election cannot be made through a request under Code Sec. 446(e) to change the taxpayer's method of accounting).

The proposed regulations provide that a taxpayer may elect to apply the bonus depreciation rules to one or more specified plants that are planted, or grafted to a plant that has already been planted, by the taxpayer in the ordinary course of the taxpayer's farming business, as defined in Code Sec. 263A(e)(4). If this election is made for a specified plant, such plant is not treated as qualified property for purposes of the bonus depreciation rules.

For a discussion of the bonus depreciation rules, see Parker Tax ¶94,200.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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