Tax Alert: IRS Issues Proposed Regulations on Bonus Depreciation after Tax Cuts and Jobs Act

The IRS has released proposed regulations providing guidance regarding the additional first year depreciation deduction under IRC Section 168(k), often referred to as “bonus depreciation”. These proposed regulations reflect changes made by the Tax Cuts and Jobs Act (TCJA) enacted in December 2017. The regulations affect taxpayers who deduct depreciation for qualified property acquired and placed in service after September 27, 2017. These are only proposed regulations and the IRS has provided a comment period which runs through October 9. The following is a short summary of the more significant regulations.

Eligibility Requirements

The proposed regulations describe and clarify the statutory requirements that must be met for depreciable property to qualify for bonus depreciation. The proposed regulations provide the depreciable property must meet four requirements to be qualified property:

  • The depreciable property must be of a specified type
  • The original use of the property must commence with the taxpayer or used property must meet certain acquisition requirements
  • The property must be placed in service within a specified time period (or in the case of certain agricultural property, must be planted or grafted before a specified date) and
  • The property must be acquired by the taxpayer after September 27, 2017

Used Property

Certain used property now qualifies for bonus depreciation if these criteria are met:

  • The property was not used by the taxpayer or a predecessor at any time prior to the acquisition,
  • The acquisition of the property meets the related party and carryover basis requirements of sections 179(d)(2)(A), (B) and (C) and section 1.179-4(c)(1)(ii), (iii), (iv) or (c)(2), and
  • The acquisition of the property meets the cost requirements of section 179(d)(3) and section 1.179-4(d)

Qualified Improvement Property

The proposed regulations partially address an issue for taxpayers with property classified as qualified improvement property (QIP). Under the TCJA, Section 168 was modified to remove these three property categories: qualified leasehold, qualified restaurant, and qualified retail improvement and combined them into one category: qualified improvement property. It appears that Congress intended for QIP to be classified as 15-year property, and thus eligible for bonus depreciation. Unfortunately, Congress failed to include in the modified Section 168 a provision that gives a 15-year property classification to QIP. Most guidance seems to suggest this omission was inadvertent. Although the IRS regulations did not fix this for all property, the regulations do provide some relief to taxpayers for the 2017 year. The regulations clarify that qualified improvement property acquired after September 27, 2017 and placed in service before January 1, 2018 will be treated as qualified property for purposes of the first year additional depreciation deduction.

Electing Out of Bonus Depreciation

There may be reasons why a taxpayer would not want to claim bonus depreciation for a particular tax year. In such case, there is an option to opt-out of the additional first year depreciation deduction and take a lesser deduction. Taxpayers who so elect out are required to do so on a timely filed tax return. A taxpayer who has already filed their 2017 return and wishes to change how they treated depreciation may do so on an amended tax return.

Acquisition Date

The proposed regulations contain a couple of rules in determining the acquisition date of property that apply to certain taxpayers:

Self-Constructed Property

Where a taxpayer constructs property themselves, the rules provide that property is eligible if the taxpayer begins manufacturing, constructing or producing the property after September 27, 2017. For such property, the acquisition date is the date when work of a significant nature begins, with a safe-harbor rule of 10% of the total expected cost (other than land) being incurred and considered “significant”.

Property Produced by Another Person

Where a taxpayer engages another person to manufacture, construct or produce property under a written binding contract, so long as that contract is entered into before the manufacture, construction or production of that property, it will be considered property acquired under a written binding contract. This differs from the previous bonus depreciation language, which treats such property as self-constructed property, and is not subject to the written binding contract rules.

Per the proposed regulations, a taxpayer who entered into a written binding contract with a third-party contractor on or before September 27, 2017 to construct property on the taxpayer’s behalf will not be eligible to claim 100% bonus depreciation on such property even if they do not break ground or begin construction until after September 27, 2017. If placed in service after September 27, 2017 and before January 1, 2018, the contracted property would be eligible for 50%  bonus depreciation. If the contracted property is placed in service in the 2018 tax year, such property would only be eligible for 40% bonus depreciation based upon the extensions of bonus depreciation included within the Protecting Americans from Tax Hikes Act of 2016 (PATH Act). The bonus depreciation percentage allowable drops to 30% for previously contracted property placed in service in the 2019 tax year and down to zero beyond 2019.

This could be a major issue for certain taxpayers. Contracts can sometimes be in place long before production/construction of a significant nature begins. This could also be an important consideration as it relates to Qualified Improvement Property. If a taxpayer contracted with a third party under a written binding contract to construct QIP prior to September 27, 2017 even if that property was placed in service after September 27, 2017 and before January 1, 2018, it appears 100% bonus depreciation would not be applicable under these circumstances.

Written Binding Contracts

Because of the importance of written binding contracts with respect to determining whether property is eligible for bonus depreciation, it is important to understand the criteria for whether a contract would meet that definition. Such contracts must be enforceable under state law against the taxpayer or a predecessor, the contract does not limit damages to less than 5% of the contract price, and is not subject to modifications. Letters of intent and options to purchase are not considered binding contracts, nor are supply agreements that are not specific to both price and design specifications. A purchase order may be considered a binding contract if the supply agreement that supports the purchase order meets the definition of a written binding contract.

Bonus Depreciation in Partnership Basis Step-up

One very beneficial provision in the proposed regulations is that which allows property acquired as a result of a Section 743(b) partnership basis adjustment to qualify as eligible for the additional first year depreciation deduction. This assumes that the other requirements of the new bonus depreciation rules are met. Under prior law, such a basis adjustment was considered to have failed the “first use” requirement; under the TCJA such a basis adjustment will be treated as acquisition of used property. The partner who acquires a new or additional partnership interest is considered as acquiring partnership property, so the bonus depreciation would be available to either new or existing partners.

Computing the Additional First Year Depreciation Deduction

The proposed regulations instruct taxpayers how to determine the bonus depreciation deduction and depreciation otherwise allowable. Rules are also provided on bonus depreciation as it applies to partnership property and limitations on used property where the taxpayer (or a predecessor) previously had an interest in the property. Regulations additionally address special rules for qualified film, television, live theatrical productions and certain plants.

Steps You Should Take Now

  • Review all fixed asset additions after September 27, 2017 to determine whether they were under a written binding contract before September 27, 2018
  • Consider eligibility requirements (specified type, first use for used property, etc.)
  • Confirm that assets were placed in service in the period reflected in the depreciation schedules
  • Consider whether any partnership investments might give rise to a bonus depreciation deduction under the Section 743(b) rules
  • If your 2017 tax return has already been filed without taking the proposed regulations into effect, evaluate whether an amended return should be filed.

We Can Help

If you have questions about how the new rules for bonus depreciation may impact your taxes, please contact your Elliott Davis tax advisor.