Last week the IRS released the first proposed regulations on the expanded bonus depreciation provisions. These regulations provide clarification on which types of property qualify, when a taxpayer will not be considered to have previously used property, and the effect of certain partnership elections. The new anti-abuse provisions focus on ensuring that the deduction is not claimed by multiple entities in the same controlled group and that the original use requirement is not circumvented.
On a much anticipated issue, the IRS avoided discussion of a widely publicized legislative drafting error that left qualified improvement property (QIP) ineligible for bonus depreciation after Dec. 31, 2017. This is likely because the IRS concluded the change requires Congressional action.
For some businesses, there is a slight reprieve for improvements placed in service during the final quarter of 2017, as the drafting error does not affect 2017 activities. Essentially, qualified real property placed in service after Sept. 27, 2017 and before Jan. 1, 2018 qualifies at least for 50 percent bonus depreciation, and possibly 100 percent.
The New Regulations
The clarifications and anti-abuse rules in the new regulations are generally very straightforward and unsurprising. The regulations restate that for the property to be eligible, the property must:
- Be of a specified type;
- The original use requirement must be met;
- The placed in service date must fall within the timeframe specified in the code; and
- The property must have been acquired after Sept. 27, 2017.
The regulations also restate that property depreciated using ADS is not eligible property, and neither is property that is subject to a floor-plan financing arrangement. When considering the original use requirement, the regulations main focus is on used property. Such property may not have:
- Been used by the taxpayer or the taxpayer’s predecessor at any point prior to the acquisition;
- Been acquired from a related party in a transaction where the taxpayer received a carryover or stepped-up basis; and
- Any portion of the basis of newly acquired property determined by reference to any other property.
Any instance where the taxpayer had a depreciable basis in the property prior to acquisition will result in the taxpayer having to reduce the basis in the acquired property to account for this prior depreciable basis. For example, a taxpayer that previously leased property to which depreciable tenant improvements were made is subject to this criteria. When this taxpayer subsequently acquires the previously-leased property, it must reduce the basis available for bonus depreciation by the basis in the prior improvements (regardless of whether any depreciation was claimed). Similar reductions occur for property acquired by trade-in or other similar transactions. Property acquired by gift or inheritance is not eligible for bonus depreciation.
The other main focus of the new regulations is to specify how partnership elections to increase basis in the partnership’s property apply to the new bonus deprecation provisions. The regulations first state that an election to increase basis under Section 754 (generally used to equalize a new partner’s inside and outside basis) will not increase the basis of the property for bonus depreciation if the basis increase is obtained under Section 734 (resulting from transactions where the partnership redeems all or a portion of a partner’s interest in the partnership). This is because the property does not satisfy the original use requirement.
The same result applies to allocations made under the Section 704(c) remedial allocation method, and to the manner that Section 704(b) book depreciation is computed with respect to property that has a zero tax basis. Furthermore, property distributed by a partnership to a partner is ineligible because it is acquired from a related party with carryover basis. On the other hand, a basis increase for a partner that is a result of a Section 743(b) adjustment made pursuant to a Section 754 election (relating to certain transfers of a partnership interests among partners) will be considered when computing the affected partner’s bonus depreciation on the Section 743(b) adjustment.
The anti-abuse provisions are intended to prevent transfers of property between members of a consolidated group or between related parties through a transaction or series of transactions designed to result in additional bonus depreciation deductions. For consolidated groups, the regulations provide that for bonus depreciation purposes, each member of the group has a depreciable interest in all property held by current or previous members of the group. The rules regarding related parties focus on direct transfers between related parties, which are clearly ineligible transactions, and transfers utilizing an intermediary to avoid the direct transfer prohibition. An example included in the regulations involves a farmer who transfers property to an intermediary who then transfers it to the farmer’s daughter. This is a prohibited transaction under the regulations because the ultimate result is the same as if the farmer had simply transferred the property to his daughter.
The Bonus Depreciation Issue
The bonus depreciation issue was created when the TCJA eliminated the three categories (qualified leasehold improvements, qualified restaurant property and qualified retail improvement property) of qualified real property and replaced them with a general category called QIP. The intent of the QIP provision under the TCJA is to describe such property for purposes of determining a depreciable life, whereas the QIP definition under prior law was somewhat different and relevant only for bonus depreciation eligibility.
The TCJA defines QIP as property that is:
- An improvement to an interior portion of a building which is nonresidential real property;
- Placed in service after the date the attendant building is first placed in service;
- Not attributable to the enlargement of the building;
- Not an elevator or escalator; and
- Not attributable to the internal structural framework of the building.
The TCJA definition for QIP essentially is a consolidation of the various qualified real property definitions under former law with some additional differences that fall outside the scope of this article. Although the TCJA provides a clear definition of QIP, it failed to ascribe a depreciable life for QIP. The previous categories of qualified real property were each assigned a 15-year depreciable life under former law. The TCJA removed those categories of qualified real property from the definition of 15-year property, but drafters neglected to replace them with anything under the 15-year property definition. This results in a default 39-year property classification which then removes QIP from the list of property eligible for bonus depreciation in most cases; however, this is not the case for qualified real property placed in service during the 2017 eligibility period.
There are two important effective dates to bear in mind under the TCJA. The new bonus depreciation rates under the TCJA apply to property acquired after Sep. 27, 2017, and placed in service after such date. On the other hand, the changes to the QIP definition and the removal of the former provisions describing qualified real property are effective for property placed in service after Dec. 31, 2017.
Because the changes to the QIP definition and the removal of definitions pertaining to qualified real property do not affect property placed in service during 2017, the legislative oversight pertaining to QIP does not have any relevance to property placed in service during 2017. This means that traditional 15-year depreciable lives continue to apply to property that meets the various qualified real property definitions during that time. This also has critical implications on the determination of the bonus depreciation rate.
Recall that property with a depreciable life of 20 years or less is eligible for bonus depreciation. This provision did not change under the TCJA. Because the prior definitions of qualified real property and QIP (i.e., the QIP definition pertaining to bonus eligibility) are still in force during 2017, the new bonus depreciation rates under the TCJA apply to such property.
Before celebrating the prospect of 100 percent bonus depreciation on QIP placed in service after Sep. 27, 2017 and before Jan. 1, 2018, taxpayers must clear one more hurdle for eligibility. The TCJA provides that the bonus depreciation rate changes apply to property acquired after Sep. 27, 2017; however, property is not treated as acquired after the date on which the taxpayer enters into a written binding contract to acquire the property. Given the nature of QIP, it is highly likely that written binding contracts for its purchase and installation existed prior to Sep. 28, 2017. In this event, QIP placed in service during this timeframe will not satisfy the criteria of the law’s new bonus depreciation rates, and the old 50 percent bonus depreciation rule will apply. The proposed regulations provide further clarifications on the nature of binding contracts for this purpose.
Takeaway
The proposed regulations focus on clarifying the new bonus depreciation provisions, defining some key criteria to ensure that it is claimed on eligible property, and rules to prevent abuse of this new deduction. Although the proposed regulations do not take effect until the time they are finalized, the IRS provided that taxpayers are permitted to rely on them during taxable years ending on or after Sep. 27, 2017.
The proposed regulations do not fix the legislative drafting error that resulted in the exclusion of QIP property from bonus depreciation eligibility in most cases after Dec. 31, 2017. As a result it is theoretically possible to have 100 percent bonus depreciation apply to QIP placed in service after Sep. 27, 2017 and before Jan. 1, 2018, but 50 percent bonus depreciation deduction is more likely for property placed in service between these dates. In the meantime, QIP acquired after Jan. 1, 2018 is ineligible for the bonus depreciation as a result of the IRS’s lack of authority to fix the Congressional mistake.
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