Businesses awaiting guidance on how to apply the Tax Cuts and Jobs Act’s bonus depreciation rules to used equipment are getting their first detailed look at Treasury’s plans.
The TCJA (P.L. 115-97) expanded section 168(k) bonus depreciation to 100 percent of the basis of qualified property and allowed used property new to the taxpayer to qualify. The proposed regulations (REG-104397-18) provide the IRS and Treasury’s initial answers to taxpayers’ pressing questions about how to apply the new provision, which includes property placed in service after September 27, 2017. Despite the importance of the 100 percent bonus depreciation provision to the TCJA’s scheme — it came with an $86.3 billion 10-year cost — the Office of Management and Budget passed on reviewing the draft regulations.
There have been calls to use the regulations to fix the drafting glitch in the TCJA that left qualified improvement property unqualified for bonus depreciation, meaning businesses that must do frequent updates to their buildings have been left out. However, the proposed regs don’t go further than the government has previously suggested the statute would take it, including only qualified improvement property acquired and placed in service between September 27, 2017, and December 31, 2017.
The proposal includes rules on elections to skip bonus depreciation entirely or to take only 50 percent bonus depreciation. While the statute would allow the former election to be made for each class of property, without similar language in the statutory provision for the latter election, the IRS and Treasury propose to allow it to apply only to all qualified property.
While the provisions in the new bonus depreciation regulations will be mandatory once they are finalized, until that happens the proposed regs allow that “a taxpayer may choose to apply these proposed regulations to qualified property acquired and placed in service or planted or grafted, as applicable, after September 27, 2017, by the taxpayer during taxable years ending on or after September 28, 2017.” Practitioners had been concerned about whether taxpayers would be able to rely on the proposed regs before the rules are finalized.
In a separate TCJA-related action on August 3, the IRS and Treasury released Rev. Proc. 2018-40, providing for the automatic accounting method changes stemming from the law’s increased small business tax accounting thresholds. The American Institute of CPAs sent a letter asking for clarification in July. (Related coverage: p. 1030.)
New to You
Another area of significant concern is the application of the expansion of bonus depreciation to used property. The proposed regs set out three requirements for when used property will qualify for bonus depreciation. First, neither the taxpayer nor a predecessor can have used the property before the acquisition potentially qualifying for bonus depreciation.
Second, the acquisition must meet the related-party and carryover basis requirements in section 179(d)(2) and reg. section 1.179-4(c). Finally, the cost of the acquired property cannot depend on the basis of other property held by the purchaser.
One unanswered question was what would happen if a taxpayer leasing a piece of property decided to buy that item. The proposed regs limit prior use of property that would fail the first condition when either the taxpayer or a predecessor “had a depreciable interest in the property at any time before the acquisition.”
Jane Rohrs of Deloitte Tax LLP said this limitation is an interpretation that will favor taxpayers. Under the proposed rules, “a lessee with no depreciable interest in property it leases would appear to be able to purchase the property and claim the additional first-year depreciation on such previously used property,” she said.
The proposed regs include consolidated return and related transaction rules to prevent potential attempts to avoid the related-party restrictions on prior use.
Contract Dates
The statute’s retroactive application date raises questions about the effective date for both existing contracts and self-created property.
The proposed regs apply the September 27, 2017, initial application both to discrete applications and for the date of a written binding contract for the acquisition of potentially qualifying property. For property created by the taxpayer, the same start date applies when the taxpayer begins manufacture, construction, or production. “Based on the preamble, the government appears to have applied a hard cutoff for the effective date, even for self-constructed property under a contract,” Rohrs said.
The proposed rules exclude letters of intent from the definition of written binding contract. They state that a closing or delivery date won’t alter the date of a written binding contract that has an “entered into” date.
The proposed regs don’t address the effect of contract modifications.
Partnerships
The proposed regs address questions on how to treat property contributed to a partnership under section 704(c) — which ensures the contributing partner is liable for any built-in gain — when the partner elects to use the remedial method of depreciating the tangible property.
One interesting aspect of using the remedial method of depreciating property is that the difference between the asset’s book basis and adjusted tax basis can be recovered and depreciated using any method used for the same property type if it were newly purchased. But when property is contributed to a partnership, the partnership’s basis in that property is determined by reference to the contributing partner’s basis, which violates section 168(k)(2)(E)(ii)(II) , according to the proposed rules. Also, the partnership would have already had a depreciable interest in the contributed property when the remedial allocation is made, which violates section 168(k) .
The proposed regs address questions on how to do basis adjustments made on account distributions or new partners buying into a partnership. Under section 734(b) , when property is distributed to a partner and a section 754 election is in effect, the partnership will increase or decrease its adjusted basis in the remaining partnership property by the amount of gain or loss the distributee partner recognized, as well as other adjustments based on the basis adjustments of the property distributed. The proposed regs say that because the section 734(b) adjustment happens at the partnership level and the partnership used the property before the distribution, both the original use and used property requirements in section 168(k) are violated.
Opening the Door
However, the proposed regs open the door for full expensing for basis adjustments under section 743(b). Under section 743(b), if a section 754 election is made, a new partner in a partnership will receive a stepped-up basis in partnership property to eliminate disparities between that new partner’s inside and outside basis.
The proposed regs say a section 743(b) adjustment will always fail the original use requirement in section 168(k), but that it may satisfy the used property clause. “Based on the preamble, the government provided a favorable rule for section 743(b) adjustments, taking an aggregate approach and generally permitting 100 percent bonus depreciation for section 743(b) adjustments,” Rohrs said.
According to the proposal, “because a section 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 section 743(b) basis adjustment meets the used property acquisition requirements of section 168(k)(2)(E)(ii), each partner is treated as having owned and used the partner’s proportionate share of partnership property.”
In the transfer of a partnership interest, the proposed rules say the used property requirement in section 168(k) will be satisfied if the new partner hasn’t used the portion of the property to which the section 743(b) adjustment relates. The transferor and transferee partners cannot have a prohibited relationship under section 179 and cannot be part of a controlled group in order to take advantage of the expensing provisions, the proposed regs say.
Structuring Matters
Practitioners will have to take a hard look at how to structure clients’ partnership deals in light of the new bonus depreciation rules. Determining whether a client wishing to enter a partnership should purchase a piece of an interest from an existing partner or contribute the cash to the partnership for the interest will have to be done when taking advantage of the rules.
Adam M. Cohen of Holland & Hart LLP said the approach Treasury adopted in applying the section 168(k) regs will put the focus on how partners should enter into a partnership if bonus depreciation is a viable option.
Cohen explained that if A and B are partners in a partnership with eligible property and unrelated C purchased part of A’s interest in the partnership and a section 743 adjustment was made, C would be able to write off the entire section 743 amount in the year the interest was purchased. But if C contributed cash to the partnership for her interest and the existing property was booked up, the remedial method could be used to allocate depreciation to C, Cohen said. Under the proposed regs, full expensing wouldn’t be an option for C, he added.
Cohen said that to take advantage of bonus depreciation in some situations, it makes more sense to purchase part of an existing partner’s interest or to purchase an interest in a new partnership between the new partner and the old partnership rather than to put that money directly into the partnership. “The proposed regulations will create another situation where well-advised taxpayers may be able to structure a transaction to obtain an advantageous result,” Cohen said.
Preventing Potential Abuse
The proposed regs address how to treat situations in which property owned by a disregarded entity is depreciated after the entity is converted into a partnership.
That scenario was presented in Situation 1 of Rev. Rul. 99-5, 1999-1 C.B. 434, in which a wholly owned limited liability company owned by A holds depreciable tangible property and then B pays A $5,000 for an interest in the entity, turning it into a partnership.
Practitioners said the proposed regs treat the transaction in Situation 1 as if B purchased the property in the LLC from A, and then both A and B made proportionate property contributions to the partnership. Thus, B gets the additional depreciation deduction, but A doesn’t because she already had a depreciable interest in the property.
Rohrs said this is meant to prevent a “perceived potential abuse under the normal rules that would have allowed depreciation to be allocated back to partner A in the example above, even though partner A had a previous depreciable interest in the property.” Rohrs noted that this abuse prevention mechanism isn’t in the used property rules but in the provisions for section 168(i)(7) transactions.