Congress recently reinstated the bonus depreciation deduction, retroactively, for property placed in service in calendar years 2010, 2011, and 2012. As an additional incentive for capital investment, Congress provided an expensing regime—in the form of a 100% bonus depreciation deduction—for qualified property acquired and placed in service on or after September 9, 2010, through December 31, 2011. For qualified property acquired or placed in service in 2010 through 2012, but before or after this period, 50% of the basis of the qualified property is allowed as a deduction in the tax year the property is placed in service.
This edition of KPMG’s TaxNewsFlash describes:
- The basic requirements for the 50% bonus depreciation deduction, and for the 100% bonus (expensing) deduction.
- Another, related provision Congress enacted, which allows a corporation to elect to claim alternative minimum tax credits in excess of the amount otherwise allowed, if the corporation agrees to forego the bonus depreciation on its qualified property placed in service in 2011 and 2012 and depreciate that property using the straight-line method
Background: Bonus Depreciation
Since 2008, a bonus depreciation deduction has been allowed to a taxpayer that places in service qualified property, at the time the property is placed in service. The bonus depreciation deduction has been 50% of the basis of the qualified property. The remaining basis of the qualified property is depreciated under the general depreciation rules—i.e., the MACRS rules of section 168—or, for eligible computer software, on the straight-line method over a 36-month period beginning with the month the software is placed in service.
The bonus depreciation deduction is the normal treatment for qualified property, unless the taxpayer elects out of such treatment. An election-out requires a statement to be attached to the timely filed tax return for the year the property is placed in service, specifying the classes of property for that tax year for which the bonus deduction will not be claimed.
The categories of qualified property are:
- Any tangible property depreciated under the MACRS rules with a recovery period of 20 years or less
- Any water utility property (which generally has a MACRS recovery period of 25 years)
- Any “qualified leasehold improvement property” and
- Any computer software that would be depreciated, as noted above, over a 36-month period
Under this regime, the only types of tangible MACRS property that are excluded from being qualified property are nonresidential real property (i.e., generally, commercial buildings, which are depreciated over a 39-year period or over a 15-year period if “qualified retail improvement property” or “qualified restaurant property”) and residential rental property (i.e., generally, apartment buildings, which are depreciated over a 27.5-year period). However, the qualified leasehold improvement property classification applies to certain improvements that would, otherwise, be classified as nonresidential real property.
Subject to certain exclusions, the improvement must be to an interior portion of a building, must be made under or pursuant to a lease by either the lessee or the lessor of such property, and must be occupied exclusively by the lessee of such portion. The building itself must be at least three years’ old.
[Any portion of the basis of qualified leasehold improvement property that is not allowed as a bonus depreciation deduction is depreciated on the straight-line method over 15 years.]
Property will not be qualified property if it is required to be depreciated using the Alternative Depreciation System, rather than the general MACRS rules.
In addition, to be qualified property—
- The property must have been acquired by the taxpayer after December 31, 2007, without a written binding contract in effect before 2008; and
- The original use of the property must have commenced with the taxpayer after December 31, 2007.
For property that is considered to be constructed by the taxpayer for its own use, the “acquisition” requirement is satisfied if construction was not considered to have begun before January 1, 2008, even if there was a binding contract before that date for another person to have performed the work.
For MACRS property that is qualified property, the same depreciation deduction is allowed for both regular tax purposes and in computing alternative minimum taxable income (AMTI). That is, the same 50% of basis has been allowed in computing AMTI in the year the property is placed in service, and the remaining basis is depreciated using the general MACRS rules, with no adjustment in computing AMTI.
The Termination Rules for Bonus Depreciation
The bonus depreciation rules have always been temporary. Until the recent legislation, the bonus was generally not available for property acquired by the taxpayer after December 31, 2009, and generally the property needed to be placed in service before January 1, 2010. An additional year (through December 31, 2010) was allowed to place in service two classes of otherwise qualified property:
- Certain property with a recovery period of at least 10 years, and certain property to be used in commercial transportation, that cost at least $1 million and was expected to take at least one year to produce (generally referred to as “long-production period property”)
- Certain aircraft not used in commercial transportation, with a cost of more than $200,000 and a production period of more than four months (generally referred to as “qualified corporate aircraft”)
Such property, if otherwise qualified, would be eligible if there was at least a written binding contract for the acquisition by December 31, 2009. Only pre-January 1, 2010, basis would have been eligible for the deduction.
Extension of the Bonus Depreciation Rules; Expensing Regime
The bonus depreciation rules had generally expired at the end of 2009. On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010 (the “Jobs Act”), which, among other things, extended the termination dates for property to be qualified property by one year (i.e., generally through December 31, 2010).
More recently, on December 17, 2010, President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the “2010 Act”). The 2010 Act further extended the termination dates for bonus depreciation to, generally, property acquired and placed in service on or before December 31, 2012.
Furthermore, more auspiciously, the 2010 Act provided an expensing regime for qualified property that is acquired and placed in service on or after September 9, 2010, and on or before December 31, 2011, by allowing a bonus depreciation deduction in the tax year the qualified property is placed in service of 100% of basis—rather than 50%.
For long-production period property and qualified corporate aircraft, the general placed in service deadline is correspondingly extended through December 31, 2013, and the placed in service deadline for the 100% bonus deduction is December 31, 2012.
There were no other changes made to the rules about what property is qualified property.
The 100% bonus depreciation deduction, simply described, has the effect of allowing any taxpayer to expense any investment in qualified property acquired and placed in service from September 9, 2010, through December 31, 2011. That is, the full amount of the basis will be deducted in the tax year it is placed in service.
Except for the change in the rate, and the specific effective dates in which property much be acquired and placed in service, the rules for the 100% bonus deduction are the same as for the 50% bonus deduction. There is no limit on the amount of qualified property to which the 100% bonus deduction can be applied. There is no size limit on the type of taxpayer that is allowed this deduction.
The 2010 Act does not change the rule that the bonus deduction is the normal treatment of property that is qualified property, and a basis reduction is required for the amount of bonus depreciation allowed or allowable, along with other depreciation expense.
Neither the 50% bonus deduction nor the 100% bonus (expensing) deduction applies to nonresidential real property and residential real property, with the singular exception of qualified leasehold improvement property (QLHI). Note also that neither applies to nonresidential real property that is “qualified restaurant property” or “qualified retail improvement property,” as discussed below.
The cost recovery for a qualified improvement to the interior portion of a commercial building, within a leasehold, will be much more advantageous than for improvements used by the owner of the building. The taxpayer that owns the QLHI can be either the landlord or the tenant, but the premises must be occupied and used by the tenant (or a subtenant). There are rules denying QLHI status where the lease is between related persons, such as members of the same consolidated group of corporations and certain parties with 80% or more common ownership.
The 2010 Act also extended rules for so-called “qualified restaurant property” and “qualified retail improvement property,” to allow property that meets those definitions and is placed in service in calendar years 2010 and 2011 a 15-year depreciation period (using the straight-line method). [The 2010 Act also coterminously extended the 15-year depreciation treatment of QLHI.] These categories, like the QLHI category, apply to certain portions of certain buildings (or, in the case of qualified restaurant property, certain entire buildings), but they are not restricted to leased property. Some qualified restaurant property and qualified retail improvement property may also meet the definition of QLHI. However, as indicated above, property that meets the description of qualified restaurant property or qualified retail improvement property cannot be qualified property for purposes of the bonus depreciation deduction. There is no exception from this rule for qualified restaurant property and qualified retail improvement property that also meets the definition of QLHI; thus, such “dual characterization” property does not appear to be eligible for the bonus depreciation deduction.
Binding Contract Exception
While qualified property must be acquired and placed in service on or after September 9, 2010, to be eligible for the 100% bonus deduction, there is no specific rule in the legislation that disqualifies the property if there was a binding contract for its acquisition before September 9, 2010. In fact, the Joint Committee on Taxation explanation of the 100% bonus provision indicates that such property is eligible so long as the binding contract was not in effect before January 1, 2008.
The date at which property is acquired can be different than, and likely earlier than, the date at which the property is placed in service. There are Treasury regulations that state that “property shall be deemed to be acquired when reduced to physical possession, or control.” This is a question of fact; the terms of any contracts between the taxpayer and the party from whom the property is acquired may be relevant.
Similar rules would appear to apply in determining whether property constructed, manufactured, or produced by the taxpayer for its own use is eligible for the 100% bonus deduction. That is, there is no requirement that the construction have begun on or after September 9, 2010, so long as it is not considered to have begun before January 1, 2008.
Capital Improvements to Existing Property and Reconditioned or Rebuilt Property
The current Treasury regulations on bonus depreciation recognize that certain capital improvements to existing property are themselves qualified property, eligible for the bonus deduction, even if the underlying property is not qualified. The regulations frame the question of whether such improvements can be qualified property by asking whether the original use of the improvements commences with the taxpayer.
[A]dditional capital expenditures incurred by a taxpayer to recondition or rebuild property acquired or owned by the taxpayer satisfies the original use requirement.
If the additional capital expenditures are considered acquired and placed in service on or after September 9, 2010, and before 2012, and are otherwise qualified property, they would be allowed a 100% bonus depreciation deduction.
The regulations note that the cost of reconditioned or rebuilt property would not satisfy the original use requirement. There is one bright-line test stated: Property that contains used parts will not be treated as reconditioned or rebuilt (whether the property is acquired or is self-constructed), and thus would not be disqualified under the original use requirement, if the cost of the used parts is not more than 20% of the total cost of the property. Otherwise, the question is one of fact.
If the cost of the used parts in an otherwise qualified property is more than 20% of the total cost, the property would not per se be disqualified. To be eligible for the bonus deduction, however, the taxpayer would need to establish that, despite these used parts, the property acquired or self-constructed should not, as a factual matter, be considered reconditioned or rebuilt property.
Property Acquired in a Like-Kind Exchange
Property acquired in a like-kind exchange (or following an involuntary conversion) will be eligible for a bonus depreciation deduction on the full amount of its basis, if the property is otherwise qualified property. That is, both the carryover basis from the surrendered or converted property and any new basis are eligible for the bonus deduction. The character of the surrendered or converted property makes no difference to whether the replacement property is qualified property.
Section 280F Limitations
While there is no general limitation on the amount of bonus depreciation allowed for any qualified property, there is a limitation under section 280F on the amount of depreciation allowed (including bonus depreciation) for certain passenger automobiles in the year they are placed in service.
- For an automobile placed in service in 2010, the general limitation is $3,060.
- For an automobile that is qualified property, the limit is raised by $8,000, setting the 2010 limit on bonus depreciation, regular depreciation, and any section 179 expensing at an aggregate $11,060.
Deciding Whether to Elect out of Bonus Depreciation
Not all taxpayers will welcome the extension of bonus depreciation, or the 100% bonus deduction rate. For example, a taxpayer using the percentage of completion method to determine the income recognized on long-term contracts using a formula that recognizes income in proportion to the percentage of the costs allocated to the contract that are incurred during the tax year. Generally, an acceleration of depreciation deductions allocable to the contract would accelerate income.
The Jobs Act provided a special rule that allowed bonus depreciation on MACRS property with a recovery period of seven (7) years or less to be disregarded in this computation. However, this rule applies only to qualified property placed in service in the 2010 calendar year. It was not extended by the 2010 Act along with the general extension of the bonus deduction into 2011 and 2012. Other tax situations in which increased deductions, or smaller taxable income, might be unwelcome include the computation of percentage depletion deductions and the AMT preference for excess intangible drilling costs.
A taxpayer may elect out of taking the 100% bonus deduction only by electing out of taking the bonus deduction on all property in that same class placed in service in the tax year. [However, see the discussion below about the election to accelerate minimum tax credits.] There is no ability to take only a 50% bonus deduction on qualified property acquired and placed in service from September 9, 2010, through December 31, 2011. There is no ability to elect out of the bonus entirely for such property and still deduct the 50% bonus on other qualified property in the same class placed in service in the same tax year.
Changes in Use for and Dispositions of Qualified Property
The bonus depreciation regulations provide that, after qualified property has been placed in service and the bonus deduction has been allowed in a tax year, a change of use of the property in a later year will not require a redetermination of the bonus deduction. Thus, a taxpayer that begins to use qualified property in a later tax year in a manner that requires the property to be depreciated using the Alternative Depreciation System (ADS) (for example, by leasing it to a tax-exempt person, or using the property predominantly outside the United States) would not retroactively revoke the 100% bonus deduction.
However, if property is “listed property”—a category that includes certain passenger automobiles, aircraft, and certain computers—a requirement to use ADS can be triggered if 50% or more of the use of the property is by the taxpayer, 5% owners of the taxpayer, or certain other related persons. If the trigger occurs in a tax year after the property is placed in service, prior depreciation in excess of the ADS amount may need to be recaptured into gross income. For listed property that becomes subject to ADS in this manner, the excess earlier depreciation would include any bonus depreciation deduction.
Bonus depreciation is also not revoked by a disposition of the qualified property in a tax year after the year it was placed in service. However, the bonus depreciation deduction is subject to the section 1245 and section 1250 recapture rules that recharacterize gain on the disposition as ordinary income to the extent of prior depreciation. For qualified property on which a 100% bonus deduction was allowed, the adjusted basis of the property would be zero. Any proceeds recognized on a disposition of qualified section 1245 property would be characterized as ordinary income, unless the proceeds exceeded the original basis. [The recharacterization rules for qualified leasehold improvement property and other section 1250 real property are more complex, though usually less harsh.]
Correcting Errors in Computing Bonus Depreciation
Some taxpayers may not accurately account for the changes in the bonus depreciation rules for property placed in service in 2010 when they file their tax returns for 2010, and fiscal year taxpayers may have already filed returns that reported depreciation on 2010 additions without taking into account the extension of the bonus into 2010 or the new 100% bonus depreciation deduction.
Generally, a failure to deduct the full amount of bonus depreciation allowed on qualified property can be characterized as an improper method of accounting for depreciation. Generally, a taxpayer may correct the improper method of accounting with an automatic accounting method change on the tax return for a later tax year, and recognize the deductions that were missed in earlier tax years as a section 481(a) adjustment on the tax return for the year of the accounting method change, rather than file amended returns. In some situations, however, amended returns can be filed, or a net operating loss carryover can be adjusted without any additional filings. There are numerous issues to consider, however, which can be discussed with a tax professional of KPMG’s Washington National Tax Accounting Methods group (contact information is provided below).
Because the Jobs Act and the 2010 Act extended the termination date for the bonus past the earlier December 31, 2009 deadline out to December 31, 2012, qualified property that would potentially have been described as long-production period property or qualified corporate aircraft will be allowed the bonus depreciation deduction when placed in service in 2010, 2011, or 2012 without needing to meet all the additional requirements for an extended placed in service deadline.
However, if such property is acquired on or after September 9, 2010, and is placed in service in 2012, the determination whether it is allowed the 100% bonus or the 50% will depend on whether it met those additional requirements and whether there had been at least a binding contract for the acquisition in place by December 31, 2011. And there will be an opportunity for the bonus (at the 50% rate) on such property placed in service in calendar year 2013 if it met the additional requirements at the end of 2012.
Election to Trade Bonus Depreciation for Additional Minimum Tax Credits
The 2010 Act includes a provision allowing a corporation to elect to forego bonus depreciation deductions on all of its qualified property placed in service in calendar years 2011 and 2012 and to instead claim additional minimum tax credits (MTCs) above the amount that would generally be allowed. A similar election had been in place in 2008 and 2009, but it applied to both research credits and MTCs. The effect of the election would be not only to forego any bonus depreciation deduction on the qualified property, but also to require that such property be depreciated using the straight-line method.
The election would apply to all property that becomes qualified property solely by reason of the extension of the bonus deduction in the 2010 Act. That is, it would apply to qualified property placed in service in 2011 and 2012, and to long-production period property and qualified corporate aircraft placed in service in 2013. [Long-production period property and qualified corporate aircraft placed in service in 2011 would not be subject to this election, as it became qualified property under the Jobs Act.]
Making the election would allow a corporate taxpayer to increase the amount of MTCs that could be used in the tax years ending after December 31, 2010, in the aggregate, by as much as $30 million. For a corporation, MTCs are generated when there is alternative minimum tax (AMT) for a year. The MTCs can be used, generally, when regular tax, reduced by most nonrefundable credits allowed for the tax year, exceeds tentative minimum tax (TMT) for the tax year. Thus, a taxpayer with an operating loss or that has significant TMT (whether or not it has AMT) may not be able to use its MTCs. Unused MTCs are carried forward indefinitely.
MTCs that become available under this election are refundable, if they exceed tax liability for the year.
The potential $30 million of additional MTCs is limited, however, to the lesser of two other amounts:
- 6% of the total amount of MTCs that were generated in tax years beginning before January 1, 2006, that had not been used in a tax year ending on or before March 31, 2008, or
- The so-called “bonus depreciation amount”—20% of the amount of depreciation deductions that would be allowed on qualified property placed in service in the election period (i.e., generally calendar years 2011 and 2012), including bonus depreciation deductions, in excess of the amount of depreciation deductions that would be allowed on such qualified property without any bonus depreciation, using the full amount of MACRS depreciation that would be allowed
As a brief example of the second limitation, consider a $100 investment in 2011 in an asset that is 5-year MACRS recovery property and would ordinarily have a $20 first-year MACRS depreciation deduction. The bonus depreciation amount would be $16: 20% of the $100 bonus depreciation deduction that would be allowed in 2011 in excess of the $20 MACRS deduction that would be allowed (20% x ($100 - $20)).
Thus, a taxpayer that had a bonus depreciation amount of $16 million in calendar tax year 2011, and had $550 million of eligible unused MTCs at the end of its 2007 tax year, would be allowed to claim $16 million of additional MTCs on its 2011 tax return, i.e., the smallest of:
- $30 million
- 6% of $550 million ($33 million)
- $16 million
If this taxpayer had an $18 million bonus depreciation amount in 2012, it would be allowed to use another $14 million of MTCs, i.e., the smallest of:
- $14 million ($30 million reduced by the $16 million used in 2011)
- $17 million ($33 million reduced by the $16 million used in 2011)
- $18 million
The corporation would not be allowed any bonus depreciation on the qualified property it placed in service in the election period, and would be required to compute its taxable income using the straight-line method for such property. In addition, if the corporation is a partner in any partnership, it would be required to make an adjustment at the partner level to compute its depreciation deduction for any partnership qualified property placed in service in the election period using the straight-line method, without any bonus depreciation.
All corporations in the same controlled group of corporations are treated as a single taxpayer for purposes of making the election and computing the limitations.
Presumably, a corporation will need to determine whether to use this election when it timely files its tax return for the first tax year ending after December 31, 2010 (whether or not it placed any qualified property in service in the portion of 2011 in that tax year). The ability to make this election for MTCs in 2011 and 2012 is independent of any election to accelerate MTCs and research credits in 2008 and 2009.
Deciding whether to make this election can have enormous implications for tax liability for potentially three or more tax years. There is no ability to make the election for qualified property placed in service in 2011 and not have it apply to qualified property placed in service in 2012. Furthermore, any revocation of the election requires the consent of the IRS.
To determine the full comparative benefit, a corporation may need a reliable forecast of the amount of qualified property it will place in service through 2013. There are numerous complex and strategic considerations. For example, corporations with operating losses—either current or carried over from earlier tax years—may find little or no benefit from bonus depreciation deductions. Apart from the election, they might have little expectation of being able to use their old MTCs in the near future, and the election may provide an opportunity for a tax refund in 2011 or 2012. Each situation needs to be assessed on its own facts.
This discussion presents a very general description and analysis of the effect of the extension of the bonus depreciation deduction, and institution of a 100% bonus deduction. Taxpayers need to be mindful that a larger deduction in the year the qualified property is placed in service means smaller (or no) depreciation deductions for the property in later years, and there could be larger taxable income in later years than had been anticipated.
Note, also, that both changes to the bonus depreciation deduction rules in 2010 applied retroactively. The September 2010 extension of the bonus through 2010 applied to property placed in service as early as January 1, 2010; the December 2010 institution of the 100% bonus applied to property placed in service as early as September 9, 2010. Many taxpayers will need to update their fixed asset records to adjust the treatment of assets placed in service in those earlier periods.
For more information, contact a tax professional with KPMG’s Washington National Tax Accounting Methods group:
Lynn Afeman, (202) 533-4092, email@example.com
David Culp, (202) 533-4104, firstname.lastname@example.org
Cathy Fitzpatrick, (202) 533-3168, email@example.com
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ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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