On August 8, 2018, the IRS issued proposed regulations addressing changes made by the Tax Cuts and Jobs Act (TCJA) to bonus depreciation, the additional first-year depreciation deduction under section 168(k) of the Internal Revenue Code. The proposed regulations affect taxpayers who deduct depreciation for qualified property acquired and placed in service after September 27, 2017.
The TCJA made sweeping changes to the depreciation rules that had previously existed. Among the most notable was the adjustment of the bonus depreciation rate from 50% to 100%. So taxpayers can now deduct 100% of the adjusted basis of qualified property acquired and placed in service after September 27, 2017 and before January 1, 2023 (this date was extended to January 1, 2024 for certain aircraft and property with longer production periods). For assets acquired and placed in service on or after January 1, 2023, the bonus depreciation rate is reduced to 80% for 2023, 60% for 2024, 40% for 2025, and 20% for 2026.
The TCJA also allows bonus depreciation to be applied to used property, whereas the prior rules limited the application of bonus depreciation to new property only. This change amplified the benefit of cost segregation studies, which now allow taxpayers to fully expense many building components identified in those studies, on both newly constructed buildings as well as acquired buildings.
Also, the TCJA eliminated the separate definitions of qualified leasehold improvements, qualified restaurant property and qualified retail improvement property, instead providing for one category of “qualified improvement property.” This is defined as any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date the building was first placed in service, excluding expenses attributable to the enlargement of a building, elevators or escalators, and internal structural framework (IRC section 168(e)(6)).
The proposed regulations follow Internal Revenue Code section 168(k)(2) (as amended by the TCJA) to provide that depreciable property must meet four requirements to be qualified property for bonus depreciation purposes. Those requirements are:
- The depreciable property must be of a specified type
- The original use of the depreciable property must commence with the taxpayer or used depreciable property must meet the acquisition requirements of Internal Revenue Code section 168(k)(2)(A)(ii) and 168(k)(2)(E)(ii)
- 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
- The depreciable property must be acquired by the taxpayer after September 27, 2017
The proposed regulations also provide that qualified property must be one of the following:
- MACRS property that has a recovery period of 20 years of less
- Computer software as defined in, and depreciated under, IRC section 167(f)(1)
- Water utility property as defined in IRC section 168(e)(5) and depreciated under section 168
- A qualified film or television production as defined in section 181(d) and for which a deduction would have been allowable under section 181 without regard to section 181(a)(2) and (g) or section 168(k)
- A qualified live theatrical production as defined in section 181(e) and for which a deduction would have been allowable under section 181 without regard to section 181(a)(2) and (g) or section 168(k)
- A specified plant as defined in section 168(k)(5)(B) and for which the taxpayer has made an election to apply section 168(k)(5)
Qualified Improvement Property
The TCJA removed qualified improvement property (“QIP”) from the list of qualified property for bonus depreciation purposes. Based on Congressional Committee Reports, it is believed that Congress intended to assign a 15-year life to QIP, which would therefore make it eligible for bonus depreciation because the recovery period would be less than 20 years. Due to what is widely considered a drafting error in the TCJA, Congress did not assign a 15-year life to QIP, and therefore is depreciated over the default 39-year period.
Many taxpayers (especially those in industries where building improvements are commonplace, such as restaurants and retailers) were hoping that IRS regulations would clarify this drafting error and assign a 15-year life to QIP. However, the proposed regulations do not make this clarification, instead noting that QIP is considered qualified property only if it is placed in service after September 27, 2017 and before January 1, 2018. Therefore, pending further guidance, QIP is assigned a 39-year recovery period and is not eligible for bonus depreciation.
Date of Acquisition
As stated above, eligible property must be acquired by the taxpayer after September 27, 2017 to be considered qualified property for bonus depreciation purposes. The proposed regulations (pursuant to section 1320(h)(1)(A) of the TCJA) clarify 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. 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. The proposed regulations retain the rules in IRC §1.168(k)-1(b)(4)(ii) defining a binding contract. Additionally, the proposed regulations provide that a letter of intent for an acquisition is not a binding contract.
So, for example, if an agreement is entered into on August 1, 2017 to purchase a piece of real estate with a closing date of October 1, 2017, that acquisition would not meet the test of being acquired after September 27th, because the written binding contract was entered into prior to September 27th, 2017.
For self-constructed property (e.g., new building construction, building improvements, etc.), if a taxpayer manufactures, constructs or produces property for its own use, the “written binding contract” rule in section 13201(h)(1) of the TCJA does not apply. In those cases, the proposed regulations provide that the acquisition rules in section 13201(h)(1) of the Act 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 §1.168(k)-1(b)(4)(iii)(B) for defining when manufacturing, construction or production begins.
It is important to note that these proposed regulations do not require mandatory compliance by taxpayers. The regulations must be applied by taxpayers during or after the taxpayer’s taxable year that includes the date of publication of an IRS decision adopting the regulations as final regulations. Before the regulations are adopted as final, taxpayers have the option of applying the regulations to qualified property placed in service after September 27, 2017. If a taxpayer chooses not to take advantage of the 100 percent bonus depreciation, they must elect out and must do so on a timely-filed income tax return.
Please contact your CSH advisor if you have any questions about these proposed regulations.