IRS Finalizes Bonus Depreciation Regs; Clarifies Expansion of Qualifying Property

(Parker Tax Publishing October 2019)

The IRS issued final 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 final regulations adopt the proposed regulations issued in August 2018 (2018 proposed regulations) with some modifications and were issued concurrently with additional new proposed regulations under Code Sec. 168(k) (REG-106808-19), which address comments the IRS received in response to the 2018 proposed regulations. T.D. 9874.

Background

Under Code Sec. 168(k), taxpayers can claim a special additional first-year depreciation allowance (also referred to as "bonus depreciation") to recover part of the cost of certain qualified property placed in service during the tax year. No election is necessary to take the bonus depreciation for "qualified property." Taxpayers can elect out of the bonus depreciation rules, however. An election is necessary if a taxpayer wants to deduct bonus depreciation for specified plants. The allowance applies only for the first year the taxpayer places the property in service and is an additional deduction the taxpayer can take after any Code Sec. 179 deduction and before calculating regular depreciation for the year the taxpayer places the property in service. The bonus depreciation rules were initially meant to cover a limited number of years. However, the rules were extended and modified by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA amendments to Code Sec. 168(k) generally apply to property acquired and placed in service after September 27, 2017. However, property is not treated as acquired after the date on which a written binding contract is entered into for such acquisition.

Additionally, TCJA repealed Code Sec. 168(k)(4) (relating to the election to accelerate alternative minimum tax credits in lieu of the bonus depreciation deduction) for tax years beginning after December 31, 2017. Further, TCJA repealed Code Sec. 168(k)(3) (relating to qualified improvement property) for property placed in service after December 31, 2017. Thus, the 15-year modified accelerated cost recovery system (MACRS) property classification does not apply for qualified leasehold improvement property, qualified restaurant property that is also qualified improvement property, and qualified retail improvement property placed in service in tax years beginning after 2017. 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.

Observation: The IRS received multiple comments requesting clarification that qualified improvement property placed in service after 2017 also is qualified property eligible for bonus depreciation. The IRS noted that, while the legislative history of TCJA provided that qualified improvement property was to have a 15-year life, Code Sec. 168(e) 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.

In August of 2018, the IRS issued proposed regulations (REG-104397-18) (2018 proposed regulations) relating to the bonus depreciation rules that apply as a result of the amendments made by TCJA. The 2018 proposed regulations updated existing regulations and provided a new regulation, Reg. Sec. 1.168(k)-2, for property acquired and placed in service after September 27, 2017.

On September 13, the IRS issued final regulations in T.D. 9874. The final regulations reflect and clarify the increase of the bonus depreciation benefit and the expansion of the universe of qualifying property, particularly to certain classes of used property authorized by the TCJA. The final regulations affect taxpayers who deduct depreciation for qualified property acquired and placed in service after September 27, 2017.

Concurrently, the IRS issued additional proposed regulations under Code Sec. 168(k) (REG-106808-19) (2019 proposed regulations) that address comments the IRS received regarding the 2018 proposed regulations.

Used Film and Television Production

In response to practitioner questions on whether a used film or television production qualifies for bonus depreciation, the IRS explained that Code Sec. 168(k) does not apply to a used qualified film, television, or live theatrical production (that is, such production acquired after its initial release or broadcast, or after its initial live-staged performance, as applicable). The final regulations clarify that only production costs of the qualified film, television, or live theatrical production for which a deduction would have been allowable under Code Sec. 181 and the regulations under Code Sec. 181 are eligible for the bonus depreciation deduction. The final regulations also clarify that the owner, as defined in Reg. Sec. 1.181-1(a)(2), of the qualified film, television, or live theatrical production is the only taxpayer eligible to claim the bonus depreciation for such production and must be the taxpayer that places such production in service.

Property Required to Be Depreciated Under the ADS

Property is required to be depreciated under the alternative depreciation system (ADS) if the property is described in Code Sec. 168(g)(1)(A), (B), (C), (D), (F), or (G). In addition, other Code provisions require property to be depreciated under the ADS. Examples include property described in Code Sec. 263A(e)(2)(A) (i.e., property of the taxpayer used predominantly in the farming business and placed in service in any tax year during which a Code Sec. 263A(d)(3) election is in effect) and property described in Code Sec. 280F(b)(1) (i.e., listed property not predominantly used in a qualified business).

The final regulations clarify that using ADS to determine the adjusted basis of the taxpayer's qualified business asset investment under Code Sec. 250(b)(2)(B) or Code Sec. 951A(d)(3) does not cause the taxpayer's tangible property to be ineligible for bonus depreciation. The final regulations also clarify that using ADS to determine the adjusted basis of the taxpayer's tangible assets for allocating business interest expense between excepted and non-excepted trades or businesses under Code Sec. 163(j) does not make that property ineligible for bonus depreciation. In both instances, however, this rule does not apply if the property is required to be depreciated under the ADS pursuant to Code Sec. 168(g)(1)(A), (B), (C), (D), (F), or (G), or other provisions of the Code other than Code Sec. 163(j), Code Sec. 250(b)(2)(B), or Code Sec. 951A(d)(3).

With respect to property to which Code Sec. 168(h)(6) (relating to property owned by partnerships treated as tax-exempt use property) applies, the final regulations clarify that only the tax-exempt entity's proportionate share of the property (as opposed to the entire property) is ineligible for bonus depreciation because, under Code Sec. Code Sec. 168(h)(6)(A), only the tax-exempt entity's proportionate share of the property is treated as tax-exempt use property.

New and Used Property

With respect to new property, the final regulations generally retain the original use rules in Reg. Sec. 1.168(k)-1(b)(3), which largely provide that the property's original use must begin with the taxpayer in order to be qualified property. In accordance with Code Sec. 168(k)(2)(A)(ii), the final regulations do not provide any date by which the original use of the property must begin with the taxpayer. The final regulations define original use as meaning the first use to which the property is put, whether or not that use corresponds to the use of the property by the taxpayer.

As for used property, pursuant to Code Sec. 168(k)(2)(A)(ii) and Code Sec. 168(k)(2)(E)(ii), the final regulations provide that the acquisition of used property is eligible bonus depreciation if the acquisition meets the following requirements:

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

(2) the acquisition of the property meets certain related party and carryover basis requirements of Code Sec. 179(d)(2)(A), (B), and (C) and Reg. Sec. 1.179-4(c)(1)(ii), (iii), and (iv), or Reg. Sec. 1.179-4(c)(2); and

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

The final regulations define "predecessor" to include (1) a transferor of an asset to a transferee in a transaction to which Code Sec. 381(a) applies, (2) a transferor of an asset to a transferee in a transaction in which the transferee's basis in the asset is determined, in whole or in part, by reference to the basis of the asset in the hands of the transferor, (3) a partnership that is considered as continuing under Code Sec. 708(b)(2), (4) the decedent in the case of an asset acquired by an estate, or (5) a transferor of an asset to a trust. Under the final regulations, property is treated as used by the taxpayer or a predecessor at any time before acquisition by the taxpayer or predecessor if the taxpayer or the predecessor had a depreciable interest in the property at any time before such acquisition, whether or not the taxpayer or the predecessor claimed depreciation deductions for the property.

Observation: Responding to a request for a definition of "depreciable interest," the IRS stated that the term has the same meaning as that term is used for purposes of Code Sec. 167. That is, the property must be used in the taxpayer's trade or business or held by the taxpayer for the production of income. In addition, the person who made the capital investment in the property is the person entitled to a return on that capital by means of claiming a depreciation deduction. The IRS explained that legal title and the right of possession are not determinative. Instead, the question is which party actually invested in the property. According to the IRS, because the determination of whether a person has a depreciable interest in property depends on the facts and circumstances and concerns whether the property is eligible for the depreciation deduction under Code Sec. 167, the request for a definition of depreciable interest was beyond the scope of the final regulations.

The final regulations provide a safe harbor on the number of tax years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor had a depreciable interest in the property. The look-back period is five calendar years immediately prior to the taxpayer's current placed-in-service year of the property. To determine if the taxpayer or a predecessor had a depreciable interest in the property at any time prior to acquisition, only the five calendar years immediately prior to the taxpayer's current placed-in-service year of the property are taken into account. If the taxpayer and a predecessor have not been in existence for this entire five-year period, only the number of calendar years the taxpayer and the predecessor have been in existence is taken into account.

Substantially Renovated Property

The final regulations retain the original use rules in Reg. Sec. 1.168(k)-1(b)(3)(i) with respect to substantially renovated property. Under these rules, the cost of reconditioned or rebuilt property does not satisfy the original use requirement. However, if the cost of the used parts in such property is not more than 20 percent of the total cost of the property, whether acquired or self-constructed, the property is treated as meeting the original use requirement.

Consistent with the original use rules, the final regulations provide that if a taxpayer acquires and places in service substantially renovated property and the taxpayer or a predecessor previously had a depreciable interest in the property before it was substantially renovated, that taxpayer's or predecessor's depreciable interest is not taken into account for determining whether the substantially renovated property was used by the taxpayer or a predecessor at any time before its acquisition by the taxpayer. Property is substantially renovated if the cost of the used parts is not more than 20 percent of the total cost of the substantially renovated property, whether acquired or self-constructed.

Section 336(e) Elections

The federal income tax consequences of a Code Sec. 336(e) election made with respect to a qualified stock disposition not described, in whole or in part, in Code Sec. 355(d)(2) or Code Sec. 355(e)(2) are similar to the federal income tax consequences of a Code Sec. 338 election. Accordingly, the final regulations modify Reg. Sec. 1.179-4(c)(2) to include property deemed to have been acquired by a new target corporation pursuant to a Code Sec. 336(e) election made with respect to such a qualified stock disposition. Property deemed to have been acquired by a new target corporation as a result of either a Code Sec. 338 election or a Code Sec. 336(e) election made with respect to a qualified stock disposition not described, in whole or in part, in Code Sec. 355(d)(2) or Code Sec. 355(e)(2) is considered acquired by purchase for purposes of Reg. Sec. 1.179-4(c)(1) and thus eligible for bonus depreciation.

Conversely, if a Code Sec. 336(e) election is made with respect to a qualified stock disposition that is described, in whole or in part, in Code Sec. 355(d)(2) or Code Sec. 355(e)(2), old target is treated as selling its assets to an unrelated person but then purchasing the assets back (sale-to-self model). Because the sale-to-self model does not deem a new target corporation to acquire the assets from an unrelated person, practitioners questioned whether assets deemed purchased in such a qualified stock disposition should be considered acquired by purchase for purposes of Reg. Sec. 1.179-4(c)(1). The final regulations clarify that the reference to Code Sec. 336(e) in Reg. Sec. 1.179-4(c)(2) does not include dispositions described in Code Sec. 355(d)(2) or Code Sec. 355(e)(2) because, under the sale-to-self model, old target will be treated as acquiring the assets in which it previously had a depreciable interest.

Rules Applicable to Partnerships

The final regulations address whether certain Code Sec. 704(c) allocations, the basis of distributed property determined under Code Sec. 732, and basis adjustments under Code Sec. 734(b) and Code Sec. 743(b) qualify for bonus depreciation.

Under the final regulations, remedial allocations under Code Sec. 704(c) do not qualify for bonus depreciation. The same rule applies in the case of revaluations of partnership property (i.e., reverse Code Sec. 704(c) allocations). In addition, Code Sec. 734(b) basis adjustments are not eligible for bonus depreciation.

The final regulations provide that, in determining whether a Code Sec. 743(b) basis adjustment meets the used property acquisition requirements of Code Sec. 168(k)(2)(E)(ii), 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, Code Sec. 168(k)(2)(E)(ii)(I) is 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 before the acquisition), notwithstanding the fact that the partnership itself has previously used the property. Similarly, for purposes of applying Code Sec. 179(d)(2)(A), (B), and (C), 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.

The final regulations also provide that a Code Sec. 743(b) basis adjustment in a class of property (not including the property class for Code Sec. 743(b) basis adjustments) may be recovered using bonus depreciation 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 and placed in service in the same tax year. Similarly, a partnership may elect out of the bonus depreciation deduction under Code Sec. 168(k)(7) 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 tax year.

The 2018 proposed regulations provided that a Code Sec. 743(b) basis adjustment was eligible for the bonus depreciation deduction provided all of the requirements of Code Sec. 168(k) were met and assuming Reg. Sec. 1.743-1(j)(4)(i)(B)(2) did not apply. Practitioners asked for clarification regarding the application of Reg. Sec. 1.743-1(j)(4)(i)(B)(2) which provides that, if a partnership uses the remedial allocation method under Reg. Sec. 1.704-3(d) with respect to an item of the partnership's recovery property, then the portion of any Code Sec. 743(b) basis increase for that property that is attributable to Code Sec. 704(c) built-in gain is recovered over the remaining recovery period for the partnership's excess book basis in the property. Reg. Sec. 1.743-1(j)(4)(i)(B)(2) further provides that any remaining portion of a Code Sec. 743(b) basis increase is recovered under Reg. Sec. 1.743-1(j)(4)(i)(B)(1), which treats a Code Sec. 743(b) basis increase as newly-purchased property placed in service when the transfer of the partnership interest occurs. Reg. Sec. 1.743-1(j)(4)(i)(B)(1) also provides that any applicable recovery period and method may be used for the basis increase.

Under the final regulations, a partnership is permitted to use bonus depreciation with respect to the portion of the Code Sec. 743(b) basis increase that is attributable to Code Sec. 704(c) built-in gain, even if the partnership is using the remedial allocation method with respect to the property. This exception applies only in the case of a partnership that is not a publicly traded partnership and that is recovering a Code Sec. 743(b) basis increase using the bonus depreciation deduction. If this exception applies, the entire Code Sec. 743(b) basis increase is eligible for the bonus depreciation.

Date of Acquisition

TCJA generally provides that the amendments to Code Sec. 168(k) apply to property which is (1) acquired after September 27, 2017, and (2) placed in service after such date. For purposes of this rule, property is not treated as acquired after the date on which a written binding contract is entered into for such acquisition.

The final regulations provide that this rule applies to all property, including self-constructed property or property described in Code Sec. 168(k)(2)(B) or (C). The final regulations provide that the 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.

Observation: The 2018 proposed regulations provided that property that was manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that was 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 was acquired pursuant to a written binding contract. According to the IRS, many practitioners thought this position was not supported by the legislative history of the TCJA, was a departure from the self-constructed property rules in Reg. Sec. 1.168(k)-1(b)(4)(iii), and was administratively burdensome. The IRS reconsidered and, accordingly, the final regulations provide that 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 not acquired pursuant to a written binding contract but is self-constructed property.

With respect to the date a contract is entered into, the final regulations provide that the acquisition date of property that the taxpayer acquired pursuant to a written binding contract is the later of (1) the date on which the contract was entered into; (2) the date on which the contract is enforceable under state law; (3) if the contract has one or more cancellation periods, the date on which all cancellation periods end; or (4) if the contract has one or more contingency clauses, the date on which all conditions subject to such clauses are satisfied. For this purpose, a cancellation period is the number of days stated in the contract for any party to cancel the contract without penalty, and a contingency clause is one that provides for a condition (or conditions) or action (or actions) that is within the control of any party or a predecessor.

The 2018 proposed regulations provided that a contract is binding only if it is enforceable under state law against the taxpayer or a predecessor, and did 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 was not treated as limiting damages to a specified amount. In response to practitioners' questions regarding how to apply the 5-percent liquidated damages rule when the contract has multiple damage provisions, the final regulations clarify that only the provision with the highest damages is taken into account in determining whether the contract limits damages.

If a taxpayer manufactures, constructs, or produces property for its own use, the written binding contract rule does not apply. In such case, the final regulations provide that the acquisition rules are treated as met if the taxpayer begins manufacturing, constructing, or producing the property after September 27, 2017. The final regulations provide that 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 not acquired pursuant to a written binding contract but is self-constructed property. In this case, the final regulations also provide that the acquisition rules are treated as met if the taxpayer begins manufacturing, constructing, or producing such property after September 27, 2017. The final 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.

Practitioners requested clarification on whether the cost of a component of a larger self-constructed property that is acquired under a binding contract entered into before September 28, 2017, is included in the safe harbor for determining when manufacturing, construction, or production of the larger self-constructed property begins. Under the final regulations, the cost of such component is taken into account for determining whether the taxpayer has paid or incurred more than 10 percent of the total cost of the property (excluding the cost of any land and preliminary activities such as planning or designing, securing financing, exploring, or researching) under the safe harbor. If the cost of the acquired component is more than 10 percent of the total cost of the property (excluding the cost of any land and preliminary activities such as planning or designing, securing financing, exploring, or researching), the manufacture, construction, or production of the larger self-constructed property begins on the date on which the taxpayer paid or incurred the cost of such component.

The final regulations also clarify that bonus depreciation is not allowable for self-constructed property owned by a trade or business described in Code Sec. 163(j)(7)(A)(iv) where the construction of such property begins after September 27, 2017, and the property is placed in service in a tax year beginning after 2017.

Computing Bonus Depreciation and Otherwise Allowable Depreciation

Under the final regulations, the allowable bonus depreciation deduction for qualified property equals the applicable percentage (as defined in Code Sec. 168(k)(6)) of the unadjusted depreciable basis (as defined in Reg. Sec. 1.168(b)-1(a)(3)) 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 final regulations also provide that bonus depreciation is allowed for both regular tax and alternative minimum tax purposes. Rules similar to those in Reg. Sec. 1.168(k)-1(d)(2) for determining the amount of depreciation otherwise allowable for qualified property are also provided.

The final regulations revise the definition of unadjusted depreciable basis in Reg. Sec. 1.168(b)-1(a)(3) to reflect the reduction in basis for the amount the owner of a qualified film, television, or live theatrical production elects to treat as an expense under Code Sec. 181(a).

Electing Out of the Bonus Depreciation Deduction

The final 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. Additionally, the final regulations provide rules for making the election under Code Sec. 168(k)(10) to deduct 50 percent, instead of 100 percent, bonus depreciation for qualified property acquired after September 27, 2017, by the taxpayer and placed in service or planted or grafted, as applicable, by the taxpayer during its tax year that includes September 28, 2017.

Observation: Practitioners requested relief to make late elections under Code Sec. 168(k)(7) or (10) for property placed in service during the taxpayer's tax year that includes September 28, 2017, because some taxpayers already filed the tax returns for that tax year before the 2018 proposed regulations were issued. The IRS noted that it issued Rev. Proc. 2019-33 to address this request by providing additional time for taxpayers to make an election, or revoke an election, under Code Sec. 168(k)(5), (7), or (10) for property acquired after September 27, 2017, and placed in service during the taxpayer's tax year that includes September 28, 2017.

Special Rules

The final regulations provide a special rule 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. Situation 1 of Rev. Rul. 99-5 is an example of such a fact pattern. In this situation, the 2018 proposed regulations provided that the bonus depreciation deduction with respect to the contributed property was not allocated under the general rules of Reg. Sec. 1.168(d)-1(b)(7)(ii). Instead, the bonus depreciation deduction was allocated entirely to the contributing partner before the Code Sec. 721(a) transaction and not to the partnership. The contributing partner was deemed to place in service the qualified property before the Code Sec. 721(a) transaction, and the contributing partner deducted the entire bonus depreciation for such property. The contributing partner contributed the property to the partnership with a zero basis, and the contributed property was Code Sec. 704(c) property in the hands of the partnership.

Several practitioners questioned how the 2018 proposed regulations would apply to a Code Sec. 743(b) adjustment when there is a purchase of a partnership interest followed by a subsequent transfer of that partnership interest. Under the final regulations, if a partnership interest is acquired and disposed of during the same tax year, bonus depreciation is not allowed for any Code Sec. 743(b) adjustment arising from the initial acquisition. However, if a partnership interest is purchased and disposed of in a Code Sec. 168(i)(7) transaction in the same tax year, the Code Sec. 743(b) adjustment is allowable, provided all of the requirements of Code Sec. 168(k) are satisfied. The Code Sec. 743(b) adjustment is apportioned between the purchaser/transferor and the transferee under the same rules that apply to transfers of qualified property.

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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