Extension and Expansion of Taxpayer Favorable Depreciation Rules
Crystal A. Germanese, CPA
In late September 2010, the Small Business Jobs Act of 2010 (the Jobs Act) retroactively restored the 50% first-year bonus depreciation and enhanced expensing under Section 179. Then, in late December 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the Tax Relief Act) allowed 100% first-year bonus depreciation, further extended 50% first-year bonus depreciation and extended the 15-year property rule for qualified leasehold, restaurant and retail property. Recently issued Rev. Proc. 2011-26 provides eagerly anticipated guidance on how the 100% bonus depreciation rules work and the options that are available to taxpayers.
50% & 100% Bonus Depreciation
The Small Business Jobs Act of 2010 extended the 50% bonus depreciation provisions to include eligible assets placed in service before January 1, 2011. The 2010 Tax Relief Act then provided for 100% first-year bonus depreciation (effectively writing off the entire cost of the asset in the year placed in service) for qualified property that is placed in service after September 8, 2010 and before January 1, 2012. The 2010 Tax Relief Act also reinstated 50% first-year bonus depreciation for qualified property placed in service in 2012.
Bonus depreciation (additional first-year depreciation) allows a taxpayer to expense 50% or 100% of an asset's cost in the first year of service. If 50% bonus depreciation is used, the remaining cost of the asset is depreciated using the "normal" rules. For example, a taxpayer buys new depreciable 5-year property that costs $10,000. If the property was eligible for 100% bonus depreciation, the taxpayer would get a deduction for $10,000 in year 1. If the property was eligible for 50% bonus depreciation the taxpayer would get to deduct $5,000 (50%) in year 1, and the remaining cost of $5,000 would be depreciated over the 5-year life. If half-year convention applied, then 20% of the remaining cost would be allowed as depreciation in year 1, or $1,000. Therefore, under the 50% bonus depreciation rules, $6,000 would be deducted in year 1.
For an asset to qualify for bonus depreciation, certain rules need to be met. First, the property must be considered qualified property. Qualified property is defined as property with a tax recovery period (under MACRS) of 20 years or less, purchased software, water utility property and qualified leasehold improvement property (explained below). Most tangible personal property will meet the 20-years-or-less requirement, and most real estate assets will fail to meet the definition. If any of the real estate assets can be broken out into assets with a 20-year-or-less life, for example through Real Estate Cost Segregation or as qualified leasehold improvement property, those assets would be eligible for bonus depreciation.
In order for an asset to qualify for bonus depreciation, the original use must commence with the taxpayer. In other words, the asset must be new rather than used. The asset must also be placed into service during the bonus depreciation time periods and the acquisition requirements must be met. In order to meet the acquisition requirement, the taxpayer cannot enter into a contract to buy the qualified asset before the commencement of the bonus depreciation periods. In order for an asset to be eligible for 50% bonus depreciation, the taxpayer cannot enter into a contract to buy the assets before January 1, 2008. To be eligible for 100% bonus depreciation that date is September 8, 2010. There are special rules for self-constructed property which may be eligible for bonus depreciation despite the contract dates.
Bonus depreciation is automatic unless a taxpayer elects not to take it. A taxpayer can elect out of bonus depreciation on their timely filed tax return (including extensions). If the election is made, bonus depreciation is not allowed for any assets in that class that are placed into service during that year. In other words, the election applies to property with the same tax recovery period; for example, all five-year property is one class and all 15-year property is another class. A taxpayer is not allowed to elect out of bonus depreciation asset by asset. The election is made annually and applies to the assets placed into service during that tax year.
The dollar amount of bonus depreciation a taxpayer may take on qualified property is not limited. However, it might not be the best idea to use bonus depreciation to bring net income to zero (or a loss) since it would eliminate income in a lower tax bracket. Since a taxpayer can only elect out of bonus depreciation by asset class, there is less flexibility to control this. Revenue Procedure 2011-26 does contain guidance on how to "step down" from 100% to 50% for the tax year that includes September 9, 2010 which might be a viable option. As of right now that step down is not available for a calendar year taxpayer's 2011 tax return.
Increased Section 179 Deduction
For tax years beginning in 2010 or 2011, a taxpayer can elect to expense up to $500,000 of qualifying property using the Section 179 deduction. The $500,000 limit is reduced dollar-for-dollar to the extent the taxpayer purchases more than $2,000,000 of qualifying property during the tax year. Accordingly, no Section 179 deduction is available for 2010 or 2011 if the total investment in qualifying property is $2,500,000 or more. The $500,000 deduction and the $2,000,000 phase-out threshold are scheduled to reduce to $125,000 and $500,000, respectively, for years beginning in 2012 (indexed for inflation).
The 179 deduction can be applied to new and used assets and also can be applied on an asset-by-asset basis (does not apply to the whole asset class) which can make it a more attractive depreciation option than bonus depreciation. However, there is a taxable income limitation for the 179 deduction. Whereas a taxpayer is able to create a net operating loss withbonus depreciation, the Section 179 deduction is limited to the taxpayer's aggregate taxable income derived from the active conduct of any trade or business.Active trade or business is based on facts and circumstances and requires a meaningful participation in the management or operation of the trade or business. Often the active trade or business rules preclude a taxpayer from benefiting from taking the 179 deduction on their passive rental real estate activities.
New for 2010, the Small Business Act added a provision for the expensing of qualified real property under Section 179. For tax years beginning in 2010 and 2011, taxpayers may expense up to $250,000 of qualified real property towards the $500,000 Section 179 limitation. Qualified real property is defined as qualified leasehold improvements, qualified restaurant property and qualified retail improvement property.
Qualified Leasehold, Restaurant and Retail improvements
The 2010 Tax Relief Act extends the 15-year life for qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property for two years by changing the date before which the three types of property must be placed in service from January 1, 2010 to January 1, 2012. Without this extension, the life of these types of property would generally be 39 years.
A qualified leasehold improvement is an improvement to an interior part of a building that is nonresidential real property. If the improvement is made under or according to a lease by the lessee (or any sublessee) or the lessor of that part of the building, that part of the building is to be occupied exclusively by the lessee (or any sublessee), and the improvement is placed in service more than 3 years after the date the building was first placed in service by any person. The improvement has to be part of the building but does not include any improvement attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area or the internal structural framework of the building. Also note that a lease between related persons is not treated as a lease and, as such, property would not qualify as qualified leasehold improvement property.
Qualified restaurant property is defined as a building or an improvement to a building in which more than 50% of the building’s square footage is devoted to the preparation of and seating for the on-premises consumption of prepared meals. The 50% test applies to a building as well as the improvements.
Qualified retail improvement property is defined as an improvement to an interior portion of a building that is nonresidential real property, if that portion of the building is open to the general public and is used in the retail trade or business of selling tangible personal property to the general public, and if such improvements are placed in service more than 3 years after the building was first placed in service. The rules to define the interior portion of the building are similar to the qualified leasehold improvement rules.
Qualified Restaurant and Retail Can Be Eligible for Bonus
Qualified leasehold improvement property is eligible for bonus depreciation as long as the acquisition date and placed-in-service date rules are met. Qualified restaurant and qualified retail improvement property are not eligible for bonus depreciation. However, the IRS clarified in Revenue Procedure 2011-26 that qualified restaurant and retail improvement property that also meets the definition of qualified leasehold improvement property is eligible for bonus depreciation.