Understand common complexities when applying bonus depreciation
INSIGHT ARTICLE |
The authority for additional first-year depreciation (commonly referred to as “bonus” depreciation) is found in section 168(k) of the Internal Revenue Code. Under that section, taxpayers may claim, in the year qualified property is first placed in service, a deduction equal to fifty percent (in 2016 and 2017) of the adjusted basis of that qualified property as an accelerated first-year depreciation deduction. The remaining basis is then depreciated under the standard rules for the property type, beginning in that first year. For example, a $100,000 piece of qualified property having a five year life under the Modified Accelerated Cost Recovery System (MACRS) that is placed in service during 2016 or 2017 will have allowable depreciation expenses as follows:
While the concept of bonus depreciation is fairly simple, its application does have some complicated rules for which taxpayers should be aware. The sections below highlight a few of these complexities with the ultimate goal of providing the reader a roadmap to the most common considerations taxpayers should address when applying the bonus depreciation provisions.
The default rule
Terminology such as “special,” “additional allowance,” “taking,” or “claiming” bonus belie the actual nature of bonus depreciation as the default rule for qualified property. Put simply, taxpayers must take additional first year depreciation when they place qualified property into service unless they affirmatively elect out of doing so, on a class-by-class basis, annually. This allows taxpayers the ability to choose which classes of assets bonus depreciation is claimed, and if desired, which will be depreciated without bonus.
While taxpayers typically hold the acceleration of deductions as an advantageous tax planning strategy, certain taxpayers may prefer that bonus depreciation not apply. These can include taxpayers with net operating losses (wishing to minimize current deductions and maximize future deductions after NOLs are utilized), those anticipating an increase in tax rates (again preserving maximum deductions for future years), or those who wish to defer deductions into later years for other planning purposes to offset future income. These taxpayers may affirmatively elect out of bonus by attaching a statement to their tax return each year that new qualified property is placed in service, stating that bonus depreciation is being forgone for the specific asset classes selected.
To be qualified property, a depreciable item must meet three requirements. First, the item must be the right type of property. The most common categories of qualified property are machinery, equipment, and furniture that fall under five or seven year MACRS treatment; however, this element is satisfied by any item that is depreciable under MACRS with a recovery period of twenty years or less. Depreciable computer software also qualifies. However, taxpayers should be aware that software acquired as part of an asset acquisition is an amortizable section 179 intangible, and not depreciable computer software, unless it is readily available to the general public, subject to a non-exclusive license, and has not been substantially modified for the taxpayer’s business. Finally, the Protecting Americans from Tax Hikes Act of 2015 (PATH act) established an additional category of qualified property called “qualified improvement property” (QIP). QIP assets are discussed in the Real Property section, below.
The second requirement for a depreciable item to be considered qualified property states that the item’s original or first use must begin with the taxpayer; however newly-acquired, previously-used assets do not qualify. One area where taxpayers may want to pay particular attention to this requirement is in corporate restructuring and business acquisitions. Assets acquired from a target organization are often used assets that would not satisfy the original or first use requirement.
The third and final requirement states that the item must be placed in service by the taxpayer prior to Jan. 1, 2020. This time frame is extended to Jan. 1, 2021 for long production period property – generally, property taking longer than one year to produce – and certain aircrafts. For long production period property, the taxpayer must purchase the item, enter into the purchase contract, or begin self-construction of the asset prior to Jan. 1, 2020.
It is also important to remember that you cannot take depreciation, bonus or regular for items placed in service and disposed of in the same year. Care and attention should be used when dealing with capital structure changes that may cause a disposition to occur.
Since the majority of real property assets have lives exceeding twenty years, real property tends to fail the first requirement for qualified property and be excluded from bonus depreciation. Before the PATH act created the QIP category, the primary exception to this was Qualified Leasehold Improvement Property (QLIP). QLIP is otherwise 39-year property that is allowed a 15-year recovery period and also qualifies for bonus depreciation. To be considered QLIP, an asset must:
- be an improvement to a lessee-occupied interior portion of a nonresidential building,
- be placed in service more than three years after the building is placed in service,
- not be an enlargement of the building, an escalator or elevator, any structural component benefitting a common area, or part of the internal structural framework of the building, and
- be made pursuant to a lease between unrelated parties.
Two other code provisions allow for 15-year treatment; however, prior to the creation of the QIP category, those sections did not allow for bonus depreciation unless the assets were also QLIP. The first of those provisions concerns Qualified Restaurant Property (QRP). To be considered QRP, an asset must be a building or an improvement to a building, and fifty percent of that building’s square footage must be used for the preparation and consumption of meals. The second provision concerns Qualified Retail Improvement Property (QRIP). The QRIP rules are very similar to the QLIP rules, except that in lieu of the lease-related provisions, to be considered QRIP, the improved area must be open to the general public and be used in the retail trade or business of selling tangible personal property to the general public.
After the PATH act, any QLIP, QRP, or QRIP must also be a QIP asset in order to qualify for bonus. For an asset to be considered QIP, the asset must:
- be an improvement to the interior portion of a building,
- be placed in service after the building is placed in service, and
- not be an enlargement of the building, an escalator or elevator, or part of the internal structural framework of the building.
Each of the above requirements is also present among the requirements for the QLIP and QRIP categories, and the QRP rules specifically state that a QRP asset only qualifies for bonus depreciation if it is also a QIP asset. Therefore, QIP is now the standard by which improvements to real property qualify for bonus depreciation. While the QLIP, QRP, or QRIP categories still exist, taxpayers only need to consider them for purposes of determining the proper depreciable life. For example, if improvements qualifying for QIP status are also made to a building that is greater than three years old and are made pursuant to a lease between unrelated parties, that improvement would also qualify as a QLIP and the remaining basis will be depreciated over a 15-year life rather than a 39-year life.
Foreign and tax-exempt use assets
Taxpayers with foreign operations should be aware that property depreciated under the alternative depreciation system (ADS) – unless done so by election – is specifically excluded from qualified property. One of the most common situations where the ADS rules apply is when a taxpayer uses a piece of tangible property predominantly outside of the United States. Several exceptions to this foreign property rule are found in section 168(g)(4), the majority of which relate to transportation.
In addition to assets used outside of the United States, tax-exempt use property (i.e. owned in whole or part by a tax-exempt organization), tax-exempt bond financed property, and imported property covered by certain executive orders are also subject to the required use of ADS and thus do not qualify for bonus depreciation.
Alternative Minimum Tax (AMT)
An additional that benefit bonus depreciation affords taxpayers is the elimination or reduction of the depreciation adjustment necessary to arrive at the taxpayer’s alternative minimum taxable income (AMTI). In other words taxpayers are not required to adjust their depreciation deduction for a certain asset from MACRS to the method required for AMT if bonus depreciation was taken on that asset.
On the other hand, if an asset does not qualify for bonus, an adjustment must be booked. For example, using the same $100,000 five-year MACRS asset as the example above, a taxpayer with property that does not qualify for bonus depreciation (for example, used property or non-QIP real property depreciated over 39 years) would need to book the following adjustments to arrive at AMTI:
One item to take particular note of is that, under current law, this exception from the AMT adjustment turns upon whether or not an asset qualifies for bonus. This is a change from the pre-2016 rule, which turned upon whether or not bonus depreciation was actually claimed. The result of this change is that an election out of bonus depreciation no longer prohibits assets from being the “qualified property” that is excluded from the AMT adjustment requirement.
If in a later year, a taxpayer realizes that it neither took bonus depreciation nor filed the necessary election to opt out of bonus during that earlier year, the taxpayer can generally file form 3115, Application for Change in Accounting Method to change its method of accounting to the proper method and claim the missed bonus depreciation as a historical adjustment under section 481(a). In order to make the accounting method change either the taxpayer must still own the asset at the beginning of the year of change or has continued to depreciate the asset in the year of change.
- In summary, ensuring the proper application of the bonus depreciation rules requires the consideration of several disparate factors:
- Is bonus depreciation appropriate given the taxpayer’s tax-planning strategies?
- If not, have the appropriate elections been made currently and in previous years?
- If bonus depreciation is desirable, does the particular asset meet the requirements concerning property type, original use, and date placed in service?
- Is the asset subject to any special rules such as those concerning real, foreign, or tax-exempt property?
While the sections above are intended to generally introduce the reader to these common issues, they do not examine every nuance or area of complexity surrounding them. Taxpayers should, therefore, consult their tax advisor in order to determine the proper application of the bonus depreciation rules and whether an accounting method change may be necessary for any historical adjustments.
 Unless otherwise indicated by the context, references herein to “section” are to provisions of the Internal Revenue Code of 1986 (“Code”), and references applicable Treasury Regulations.
 The applicable percentages are set to phase out over the next few years: 50% for 2016 and 2017; 40% for 2018; and 30% for 2019.
 Section 168(k)(2)(A)(i)(I); Section 168(k)(2)(D).
 Section 168(k)(2)(A)(i)(II).
 Section 197(e)(3).
 Section 168(k)(2)(A)(i)(IV).
 Section 168(k)(2)(A)(ii).
 Section 168(k)(2)(A)(iii).
 Section 168(k)(2)(B),(C).
 Section 168(k)(2)(B)(i)(III);
 Section 168(e)(6).
 Section 168(k)(3).
 Section 168(e)(7).
 Section 168(e)(8).
 Section 168(k)(3).
 Section 168(e)(6).
 Section 168(k)(2)(D).
 Section 168(g)(1).
 Section 168(k)(2)(G).