Recent changes made by the IRS and Congress have greatly expanded taxpayers' ability to currently deduct the costs of property purchased for business use, instead of having to depreciate those costs over many years. Three provisions allow taxpayers to accelerate deductions for the costs of capital assets and other property and avoid depreciation: bonus depreciation, expanded Sec. 179 expensing, and the de minimis exception to the tangible property, or "repair," regulations. Taxpayers can use all three provisions in the same year (although not on the same costs), and taxpayers and their advisers should understand the new rules to take full advantage of them.
Taxpayers that use bonus depreciation got good news at the end of 2015: The special provision for 50% "bonus" first-year depreciation was extended by the Protecting Americans From Tax Hikes (PATH) Act, P.L. 114-113; the bad news is that it was not made permanent, and its value will decline in the years before it expires. Taxpayers should take this into account when planning capital investments over the next few years. The PATH Act also made the $500,000 limit on Sec. 179 expensing permanent and adjusted the limit for inflation.
DE MINIMIS EXPENSING SAFE HARBOR
Before turning to Sec. 179 and bonus depreciation, taxpayers should consider the de minimis safe harbor for expensing amounts under the repair regulations. Under Regs. Sec. 1.263(a)-1(f), taxpayers with applicable financial statements can expense amounts paid to acquire or produce units of tangible property to the extent those amounts are deducted by the taxpayer for financial reporting purposes or in keeping books and records. The amount deductible is up to $5,000 per invoice or per item substantiated by the invoice. Taxpayers without applicable financial statements can expense amounts paid for units of property up to $2,500 (this amount was increased from $500 by Notice 2015-82, effective for tax years beginning on or after Jan. 1, 2016).
The safe harbor allows businesses to avoid having to determine whether items purchased for a small cost are deductible or must be capitalized, but it also eliminates the need to depreciate a large number of purchases of small-dollar capital assets. Taxpayers can also use a higher threshold if they can establish that it clearly reflects their income (Rev. Proc. 2015-20).
The de minimis safe harbor does not apply to property that is included in inventory; amounts paid for land; amounts paid for rotable, temporary, and standby emergency spare parts that the taxpayer elects to capitalize and depreciate under the tangible property regulations; and amounts paid for rotable and temporary spare parts that the taxpayer accounts for under the tangible property regulations' optional method of accounting for rotable parts.
The amount paid for the property to which the de minimis safe harbor is applied is not treated as a capital expenditure under Regs. Sec. 1.263(a)-2(d)(1) or 1.263(a)-3(d) or as a material and supply under Regs. Sec. 1.162-3, and the amount can be deducted under Regs. Sec. 1.162-1 in the tax year it is paid, provided the amount otherwise constitutes an ordinary and necessary expense.
The election, if made, applies to all amounts paid for all property that meets the requirements for the safe harbor. To elect the safe harbor, the taxpayer should attach a statement to that year's timely filed federal income tax return titled "Section 1.263(a)-1(f) de minimis safe harbor election." Making the safe-harbor election does not count as a change in accounting method and therefore does not require the taxpayer to file Form 3115, Application for Change in Accounting Method.
Electing to use the safe harbor does not preclude the taxpayer from deducting amounts over $5,000 or $2,500 (as applicable) if those amounts are otherwise deductible.
Note that under the repair regulations, expenses for materials and supplies (as defined in the regulations) that cost up to $200 are deductible without any election (Regs. Sec. 1.162-3(a)).
SEC. 179 EXPENSING
Taxpayers should next consider Sec. 179 expensing, which provides an opportunity to deduct up to $500,000 of the cost of certain qualifying tangible property instead of depreciating it.
The $500,000 limit is reduced if the taxpayer places into service during the year Sec. 179 property in excess of an "investment ceiling." That ceiling is $2,000,000, as adjusted for inflation ($2,010,000 for 2016), and the $500,000 limit is reduced, dollar for dollar, for every dollar the taxpayer's Sec. 179 property cost goes over that ceiling.
These increased amounts for the limit and the ceiling were not permanent and had reverted to their much-lower statutory amounts before the PATH Act retroactively extended the higher amounts and made them permanent. The PATH Act also indexed the amounts for inflation.
In addition, before the PATH Act, a taxpayer could revoke a Sec. 179 election without IRS consent only for tax years beginning before 2015. The PATH Act makes that feature permanent.
Property eligible for Sec. 179 expensing and limitations
To be eligible for Sec. 179 expensing, the property must be used primarily in the active conduct of a trade or business. Eligible property includes tangible personal property or off-the-shelf computer software that is Sec. 1245 property (i.e., most depreciable property, other than buildings) and qualified real property. It does not include:
- Certain property used predominantly to furnish lodging or in connection with the furnishing of lodging;
- Property used predominantly outside the United States, except property described in Sec. 168(g)(4);
- Property used by certain tax-exempt organizations, except property used in connection with the production of income subject to the tax on unrelated trade or business income;
- Property used by governmental units or foreign persons or entities, except property used under a lease with a term of less than six months;
- Air conditioning or heating units placed in service in tax years beginning before 2016. The exclusion of air conditioning and heating units from the definition of eligible Sec. 179 property was removed by the PATH Act, but only prospectively.
In addition, the deduction generally cannot be claimed by noncorporate lessors for leased property. The Sec. 179 deduction cannot exceed the taxable income from the taxpayer's active trades or businesses, computed without regard to the Sec. 179 deduction, the deduction for one-half of self-employment tax, net operating loss carrybacks and carryforwards, and deductions suspended under other Code sections, such as the passive loss rules. Amounts that cannot be deducted because of the taxable income limitation can generally be carried forward until they can be deducted.
If the business use of the property is reduced to 50% or less during a recapture period (which is the recovery period for the property), the Sec. 179 deduction that was taken for that property will be recaptured. The recapture amount equals the Sec. 179 deduction taken minus the amount of modified accelerated cost recovery system (MACRS) depreciation that would have been allowed on the property up until the year of recapture. Recapture is reported on Form 4797, Sales of Business Property.
Trusts and estates cannot claim the Sec. 179 deduction.
Computer software and qualified real property
The PATH Act also made the application of Sec. 179(d)(1)(A)(ii) to depreciable computer software permanent. For these purposes, computer software means "any program designed to cause a computer to perform a desired function" (as defined in Sec. 197(e)(3)(B)) and does not include a database, unless the database is in the public domain and is incidental to the operation of otherwise qualifying software. The software must be "readily available for purchase by the general public, ... subject to a nonexclusive license, and ... not [have] been substantially modified" (Sec. 197(e)(3)(A)(i)).
Sec. 179(f)'s special treatment for qualified real property was also made permanent by the PATH Act. Qualified real property, for these purposes, means qualified leasehold improvement property as defined in Sec. 168(e)(6), qualified restaurant property as defined in Sec. 168(e)(7), and qualified retail improvement property as defined in Sec. 168(e)(8).
The previous $250,000 cap on Sec. 179 expensing of qualified real property was also removed, for tax years beginning in 2015.
Note that while the category of qualified leasehold improvement property has been eliminated for bonus depreciation purposes (see below), it remains for Sec. 179 purposes.
SUVs and listed property
Sec. 179(b)(5) limits the amount of the Sec. 179 deduction that can be taken for certain SUVs to $25,000. The limit applies to passenger vehicles that weigh between 6,000 and 14,000 pounds and are primarily designed to carry passengers on public streets, with the exception of certain cargo and passenger vans.
Listed property that is used less than 50% for business is not eligible for the Sec. 179 election (Temp. Regs. Sec. 1.280F-3T(c)(1)). Listed property includes passenger automobiles and many other types of property used as a means of transportation, property used for entertainment, computers (except if used exclusively at the taxpayer's business establishment), and other types of property specified in the regulations.
Making the Sec. 179 election
The Sec. 179 election is made on Form 4562, Depreciation and Amortization, Part I. The taxpayer must describe the property and costs the Sec. 179 election applies to on the form.
Next, the bonus depreciation provision (Sec. 168(k)) allows taxpayers to take an additional depreciation deduction in the first year qualified property is placed in service. Currently, bonus depreciation allows taxpayers to deduct up to 50% of the cost of eligible property in the year it is placed in service, but after 2017 the amount will be reduced. Bonus depreciation is taken after any Sec. 179 deduction and before regular depreciation (IRS Publication 946, How to Depreciate Property).
Only certain property qualifies for bonus depreciation: It must be new, tangible property that has a MACRS recovery period of no more than 20 years, be water utility property, be computer software, or be "qualified improvement property." Under the current rules, the property must be placed in service before Jan. 1, 2020 (except for certain long-production-period property, as discussed below).
If the taxpayer manufactures, constructs, or produces property for its own use, the requirement that the property be acquired before Jan. 1, 2020, is considered met if the taxpayer begins manufacturing, constructing, or producing the property before that date.
Property that is being depreciated under the alternative depreciation system or that is listed property with limited business use under Sec. 280F(b) is not eligible for bonus depreciation.
Bonus depreciation is also, generally, not available for otherwise qualified property that is disposed of in the same tax year it was acquired. One exception is where property acquired by a partnership in the year of a technical termination is contributed by the terminating partnership to a new partnership, in which case the new partnership claims the bonus depreciation. However, if the new partnership disposes of the property in the same year it receives it, neither partnership can claim bonus depreciation. Another exception is for qualified property transferred in a nonrecognition transaction described in Sec. 168(i)(7) in the same year it was placed in service by the transferor. In that case, the bonus depreciation deduction is allocated between the transferor and the transferee under rules described in Regs. Sec. 1.168(d)-1(b)(7).
The PATH Act introduced a phasedown in the amount of the bonus depreciation deduction. For property placed in service between Jan. 1, 2012, and Dec. 31, 2017 (2018, for long-production-period property), the deduction amount is 50%. For qualified property placed in service in 2018 (2019 for long-production-period property), the amount is 40%. The rate drops to 30% for qualified property placed in service in 2019 (2020 for long-production-period property). After that, bonus depreciation is scheduled to expire.
Long-production-period property and aircraft
Special rules apply for qualified property that is considered long-production-period property. Long-production-period property must have a recovery period of at least 10 years or be transportation property and be subject to the uniform capitalization rules of Sec. 263A. It must also have an estimated production period of more than one year and a cost of over $1 million. For these purposes "transportation property" simply means "tangible personal property used in the trade or business of transporting persons or property" (Sec. 168(k)(2)(B)(iii)).
Such property must be acquired by the taxpayer before Jan. 1, 2020 (or acquired pursuant to a contract entered into before that date), and must be placed in service before Jan. 1, 2021.
A new aircraft that is acquired by the taxpayer before Jan. 1, 2020 (or acquired pursuant to a contract entered into before that date), and placed in service before Jan. 1, 2021, is also eligible for bonus depreciation, even if it does not qualify as "transportation property" other than for agricultural or firefighting purposes. The aircraft must be purchased, and the purchaser must make a nonrefundable deposit of the lesser of 10% of the cost or $100,000. It must have an estimated production period of more than four months and cost more than $200,000.
Qualified improvement property
The PATH Act introduced a new category of property that is eligible for bonus depreciation: qualified improvement property. It replaces the former category of qualified leasehold improvement property (for bonus depreciation purposes), effective for property placed in service on or after Jan. 1, 2016.
Qualified improvement property is any improvement to the interior of any nonresidential real property that is placed in service after the building is placed in service. However, expenditures for enlarging a building, for an elevator or an escalator, or for the internal structural framework of a building are not eligible for bonus depreciation under the qualified improvement property rules.
Under the qualified leasehold improvement rules in effect for property placed in service before Jan. 1, 2016, the qualifications for bonus depreciation were stricter. Those improvements had to be made pursuant to a lease, the portion of the building had to be occupied exclusively by the lessee, the improvement had to be placed in service more than three years after the building was placed in service by any person, and the improvement had to be a structural component of the building. Those restrictions do not apply to qualified improvement property.
Fruit-bearing and nut-bearing plants
The PATH Act gave farmers special bonus depreciation rules that apply to fruit-bearing and nut-bearing plants and accelerate the placed-in-service date for those plants, for bonus depreciation purposes. Under these rules, bonus depreciation can be claimed for eligible plants that are planted before Jan. 1, 2020, or grafted before that date to a plant that has already been planted. The planting or grafting must take place in the ordinary course of the taxpayer's farming business.
Normally, for depreciation purposes, fruit-bearing and nut-bearing plants are not considered to be placed in service until they reach "an income-producing stage" (Regs. Sec. 1.46-3(d)(2), flush language), but for bonus depreciation purposes, the placed-in-service date is moved up to the year of planting or grafting. (Note that bonus depreciation can be taken only once on such plants: It is not available again in the year the plant is placed in service for regular depreciation purposes.)
$8,000 increase in first-year depreciation limit for passenger automobiles
Automobiles are subject to special bonus depreciation rules. For passenger automobiles that are qualified property and placed in service before Jan. 1, 2020, the limit on first-year depreciation is increased by $8,000. The normal first-year depreciation limit is $3,160 (for automobiles placed in service in 2016). So for eligible automobiles, that limit is increased to $11,160.
For trucks and vans that are classified as passenger automobiles, the normal limit for 2016 is $3,560, so the increased limit for vehicles eligible for bonus depreciation is $11,560.
As with bonus depreciation for other property, the PATH Act introduced a phasedown of this amount. For automobiles placed in service during calendar year 2018, the limit will be increased by $6,400. For automobiles placed in service during calendar year 2019, the limit will be increased by $4,800.
Also note that automobiles (and other listed property) that are used less than 50% for business are not eligible for bonus depreciation (Secs. 168(k)(2)(D)(ii) and 280F(b)(1)).
Electing out of bonus depreciation
Taxpayers can elect out of bonus depreciation for any class of property for any tax year. For these purposes, class of property means the classes of property in Sec. 168(e) (which lists the various class lives and defines residential rental and nonresidential real property), water utility property, computer software, and qualified improvement property. The election must be made by the due date (including extensions) of the federal tax return for the tax year the property is placed in service, by attaching a statement to the return indicating the class of property for which the election is being made and that, for that class, the taxpayer is electing not to claim any special depreciation allowance. The election out of bonus depreciation can be revoked only with the IRS's written consent, which requires the submission of a letter ruling request (Regs. Sec. 1.168(k)-1(e)(7)).
If a taxpayer fails to elect out of bonus depreciation properly, the basis in the property will be considered to have been reduced by the amount of the bonus depreciation, even if the taxpayer did not claim a bonus depreciation deduction for the year the property was placed in service (Regs. Secs. 1.167(a)-10 and 1.168(k)-1(e)(5)).
Practitioners should be helping clients plan now to take advantage of these provisions over the next few years when planning asset acquisitions. As currently structured, bonus depreciation is scheduled to be reduced and then disappear. Taxpayers should be apprised of this so they can get the full benefit of these three attractive tax provisions.
About the author
Alistair Nevius is the JofA's editor-in-chief, tax. To comment on this article or to suggest an idea for another article, contact him at firstname.lastname@example.org or 919-402-4052.
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