6.8 Bonus Depreciation

Bonus Depreciation – In General
Cost segregation studies are used by taxpayers most commonly to identify portions of real property that are separate tangible personal properties subject to shorter depreciable recovery periods. Some of these properties may also qualify for additional first-year depreciation, commonly referred to as “bonus” depreciation. Bonus depreciation allows taxpayers to deduct a specified percentage (30, 50, or 100 percent) of depreciation in the year the qualifying property is placed in service. The adjusted basis of the qualifying property is reduced by the allowable amount of bonus depreciation before the remaining depreciation deductions are computed for the placed-in-service year and subsequent years.

Eligible Property – In order to qualify for 30, 50, or 100 percent bonus depreciation, the original use of the property must begin with the taxpayer and the property must be: 1) MACRS property with a recovery period of 20 years or less, 2) depreciable computer software, 3) water utility property, or 4) qualified leasehold improvement property. Certain acquisition requirements and placed in service dates must also be met in order to qualify for 30, 50, or 100 percent bonus depreciation, and are discussed in more detail below.

Original Use of the Property – The term “original use” means the first use to which the property itself is put, whether or not that use corresponds to the use of the property by the taxpayer. The original use of the property by the taxpayer begins on the date the taxpayer uses the property primarily in its trade or business or for the production of income. Generally, this would be the date the property is placed in service. However, if a taxpayer initially acquires new tangible personal property and holds it as inventory primarily for sale to customers, but subsequently withdraws the property from inventory and uses it in their trade or business, the taxpayer is considered the original user of that property. A cost segregation study may also identify certain costs incurred by a taxpayer to acquire or construct reconditioned or rebuilt tangible personal property that is used in the real property. The cost to acquire or construct the reconditioned or rebuilt tangible personal property does not satisfy the original use requirement. Determining if tangible personal property is reconditioned or rebuilt is a question of fact, but property that contains used parts is not treated as reconditioned or rebuilt if the cost of the used parts is no more than 20 percent of the total cost of the property, whether the property is acquired or constructed by the taxpayer.

Qualified Leasehold Improvement Property – A cost segregation study may also identify the cost of leasehold improvement property. Qualified leasehold improvement property is any improvement to the interior portion of a building that is nonresidential real property if the following three conditions are satisfied:

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  1. It must be made under a lease by the lessee, sub-lessee, or lessor of that portion;
  2. The portion must be set for occupancy by the lessee or sub-lessee; and
  3. The improvement must be placed in service more than three years after the date the building was first placed in service.

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Qualified leasehold improvement property does not include any improvement for which the expenditure is 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.

Acquisition Requirements and Placed in Service Dates
Note, as of the date of this writing, bonus depreciation is not available for property placed in service after December 31, 2014 (December 31, 2015 for long production period property and specified aircraft).

30% Bonus Depreciation – Acquisition Requirements and Placed in Service Dates
To qualify for 30% bonus depreciation, the property must be placed in service by the taxpayer after September 10, 2001 and before January 1, 2005 (note that for 30%, 50%, and 100% bonus depreciation, special placed in service rules apply to long production period property and specified aircraft).

One of two alternative acquisition requirements must also be met:
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  1. The first requirement is met if the property is acquired by the taxpayer after September 10, 2001, and before January 1, 2005, but only if no written binding contract for the acquisition was in effect before September 11, 2001; or
  2. The second requirement is met if the property is acquired by the taxpayer pursuant to a written binding contract entered into after September 10, 2001, and before January 1, 2005.

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50% Bonus Depreciation– Acquisition Requirements and Placed in Service Dates
50% bonus depreciation is allowable for qualifying property placed in service during two different time periods:
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  1. Property placed in service after May 5, 2003 and before January 1, 2005, and
  2. Property placed in service after December 31, 2007 and before January 1, 2015.

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Property placed in service after December 31, 2004 and before January 1, 2008 is not eligible for bonus depreciation.

For property placed in service after May 5, 2003 and before January 1, 2005, one of two alternative acquisition requirements must also be met:

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  1. The first requirement is met if the property is acquired by the taxpayer after May 5, 2003, and before January 1, 2005, but only if no written binding contract for the acquisition was in effect before May 5, 2003; or
  2. The second requirement is met if the property is acquired by the taxpayer pursuant to a written binding contract entered into after May 5, 2003, and before January 1, 2005.

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For property placed in service after December 31, 2007 and before January 1, 2015, one of two alternative acquisition requirements must also be met:

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  1. The first requirement is met if the property is acquired by the taxpayer after December 31, 2007, and before January 1, 2015, but only if no written binding contract for the acquisition was in effect before January 1, 2008; or
  2. The second requirement is met if the property is acquired by the taxpayer pursuant to a written binding contract entered into after December 31, 2007, and before January 1, 2015.

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100% Bonus Depreciation – Acquisition Requirements and Placed in Service Dates
As part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Congress added §168(k)(5). As a result of this Act, certain 50% qualified property that is acquired after September 8, 2010, and before January 1, 2012, and which is placed in service by the taxpayer before January 1, 2012 (January 1, 2013, in the case of long production period property and specified aircraft) is eligible for the 100% first-year depreciation allowance.

To qualify for 100% bonus depreciation, the property must meet one of the following two alternative acquisition requirements:

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  1. The first requirement is met if the property is acquired by the taxpayer after September 8, 2010 and before January 1, 2012, but only if no written binding contract for the acquisition was in effect before January 1, 2008; or
  2. The second requirement is met if the property is acquired by the taxpayer pursuant to a written binding contract entered into after December 31, 2007, and before January 1, 2012.

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Rev. Proc. 2011-26, 2011-16 I.R.B. 664, provides a limited exception to the above rule, which allows taxpayers to elect to treat all qualified property of any particular class of property, acquired during their tax year that includes September 9, 2010, as subject to the 50% additional first-year depreciation allowance rather than the 100% bonus depreciation allowed for property acquired after September 8, 2010, without regard to whether the property was acquired before or after September 8, 2010.

Acquisition Requirement – In General
The bonus depreciation regulations provide special rules for determining the timing of a taxpayer’s acquisition of qualifying property. One set of rules addresses acquired property and the other set deals with self-constructed property. Both sets of rules can apply in the context of a cost segregation study.

Acquisition Requirement – Acquired Property
As discussed above, a cost segregation study may identify certain acquired tangible property that potentially qualifies for bonus depreciation. This can include tangible personal property that is acquired by the taxpayer and used in the construction by the taxpayer (or a third party under contract with the taxpayer) of new real property, or the expansion, refreshment, or restoration of the taxpayer’s existing real property. Provided it is otherwise qualifying property (i.e., MACRS property having a recovery period of 20 years or less, etc.), tangible personal property that is acquired under a written binding contract qualifies for bonus depreciation if the placed in service dates and either of the two alternative acquisition requirements are met for the 30%, 50%, or 100% property, respectively.

Acquisition Requirement – Self-Constructed Property
Similarly, a cost segregation study may identify certain self-constructed tangible personal property that potentially qualifies for bonus depreciation. This can include tangible personal property that is manufactured, constructed, or produced by the taxpayer and used in the construction by the taxpayer (or a third party under contract with the taxpayer) of new real property, or in the expansion, refreshment, or restoration of the taxpayer’s existing real property used in its trade or business or for the production of income.

If a taxpayer manufactures, constructs, or produces property for use in its trade or business or for the production of income, the acquisition requirement is satisfied if the taxpayer begins manufacturing, constructing, or producing the property during the following dates:

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  1. After September 10, 2001 and before January 1, 2005 for 30% property;
  2. After May 5, 2003 and before January 1, 2005 for 50% property;
  3. After December 31, 2007 and before September 9, 2010, or after December 31, 2011 and before January 1, 2015 for 50% property; and
  4. After September 8, 2010 and before January 1, 2012 for 100% property.

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Property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into before the manufacture, construction, or production of the property for use by the taxpayer in its trade or business or for the production of income begins is considered to be manufactured, constructed, or produced by the taxpayer.

Treas. Reg. § 1.168(k)-1(b)(4)(iii)(B)(1) provides that the manufacture, construction, or production of property begins when physical work of a significant nature begins. Physical work does not include preliminary activities such as planning or designing, securing financing, exploring, or researching. The determination of when physical work of a significant nature begins depends on the facts and circumstances. Alternatively, the taxpayer may choose to determine when physical work of a significant nature begins in accordance with the safe harbor rule provided in Treas. Reg. § 1.168(k)-1(b)(4)(iii)(B)(2). Under this safe harbor rule, physical work of a significant nature does not begin before more than 10 percent of the total cost of the property (excluding the cost of any land and preliminary activities such as planning or designing, securing financing, exploring, or researching) is incurred by an accrual basis taxpayer or paid by a cash basis taxpayer. When property is manufactured, constructed, or produced for the taxpayer by another person, as in the present case, this safe harbor rule must be satisfied by the taxpayer. A taxpayer chooses to apply the safe harbor rule by filing an income tax return consistent with the safe harbor rule for the placed-in-service year of the property that determines when physical work of a significant nature begins.

Components of Larger Self-Constructed Properties – General Rules
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  • If a written binding contract is entered into to acquire a component of a larger self-constructed property before the relevant acquisition date (for the 30%, 50%, or 100% property respectively, as described above), or the manufacture, construction, or production of a self-constructed component begins before the relevant acquisition date, neither the acquired or self-constructed component qualifies for bonus depreciation, even though the larger self-constructed property may qualify. See Example 6 of Treas. Reg. § 1.168(k)-1(b)(4)(v).
  • If the manufacture, construction, or production of a larger self-constructed property begins before the relevant acquisition date, neither the larger self-constructed property nor any of the acquired or self-constructed components are eligible to be treated as qualified property for bonus depreciation purposes, regardless of when the component is acquired or when construction begins on the component. See Example 7 of Treas. Reg. § 1.168(k)-1(b)(4)(v).
  • If a binding contract to acquire a component is entered into after the relevant acquisition date, or the manufacture, construction, or production of a self-constructed component begins after the relevant acquisition date, but the manufacture, construction, or production of the larger self-constructed property does not begin before the close of the relevant acquisition period, the component itself would qualify for bonus depreciation under the acquisition rules even though the larger self-constructed property does not. See Example 13 of Treas. Reg. § 1.168(k)-1(b)(4)(v).

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Components of Larger Self-Constructed Properties – Special Rule for 100% Bonus Property
There are two limited exceptions to the general rules above with respect to qualified property eligible for the 100% first-year bonus depreciation:

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  • First, the otherwise qualifying components of a larger self-constructed property are not required to be acquired by the taxpayer under a written binding contract; and
  • Second, in contrast to the general rule that denies qualified property treatment to both the components and the larger self-constructed property, where the larger self-constructed property does not meet the relevant acquisition date or placed in service date requirements, taxpayers may elect to treat any otherwise qualifying acquired or self-constructed components of a non-qualifying larger self-constructed property as eligible for the 100% first-year depreciation deduction. Under this election, the component must be qualified property and must be acquired or self-constructed by the taxpayer after September 8, 2010, and before January 1, 2012 (before January 1, 2013, in the case of long production period property and specified aircraft).

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Rev. Proc. 2011-26, 2011-16 I.R.B. 664, provides the applicable election procedures. The election must be made by the due date (including extensions) of the federal tax return for the taxpayer’s taxable year in which the larger self-constructed property is placed in service by the taxpayer. The election is made by attaching a statement to that return indicating that the taxpayer is making the election provided in Section 3.02(2)(b) of Rev. Proc. 2011-26. The attached statement must also indicate whether the taxpayer is making the election for all, or only a portion of, the components eligible under the rule. Finally, relief is available for taxpayers who have already filed their federal tax returns (on or before April 18, 2011) for the taxable year in which the larger self-constructed property was placed in service. Therefore, taxpayers receive an automatic six month extension from the due date of its return (excluding extensions) to make the election to treat the qualifying components of non-qualifying larger self-constructed property as property eligible for the 100% first-year bonus depreciation allowance.

Chief Counsel Guidance on the Application of Bonus Depreciation Regulations to a Cost Segregation Study – FAA 20140202F:
In a building construction project, the building (including its structural components) is not eligible for bonus depreciation, because buildings generally have a MACRS recovery period of greater than 20 years. However, the § 1245 properties identified in a cost segregation study generally meet the MACRS recovery period requirement (20 years or less), but each § 1245 property must also meet the other bonus requirements to determine its eligibility for bonus depreciation (including the original use, acquisition, and placed in service requirements).

In Field Attorney Advice (FAA) 20140202F (1/10/2014), the IRS concluded that the taxpayer is required to separately identify the properties associated with a building construction project to determine which assets constitute “qualified property.” Each property is to be analyzed under the rules of § 168(k) to determine its eligibility for bonus depreciation. The taxpayer has the burden of proof to show which properties are subject to bonus depreciation. This FAA states that the first step in determining whether a property is eligible for bonus depreciation is to determine whether it is “qualified property.” As discussed above, the § 168(k) and regulations thereunder define qualified property for bonus depreciation purposes. Significantly, the plain language of § 168(k)(2)(A) makes it clear that eligibility for bonus depreciation in the context of components of real property is determined with reference to factors related to each property at issue rather than with reference to the project at issue. This means a taxpayer cannot argue that a property qualifies for bonus depreciation simply because the “project” to which said property relates qualifies (based on contract date, acquisition date and placed in service date of the “project”). Rather, a taxpayer is required to separately identify the properties associated with a project to determine which assets constitute “qualified property.” Taxpayers may do this by performing a cost segregation study, which properly identifies separate § 1245 property constructed in conjunction with § 1250 property. Only after the properties are segregated can the individual properties be considered for bonus depreciation eligibility.

The taxpayer in the FAA acquired a number of properties based on the terms of a building construction contract with a third party contractor. As discussed above, property that is constructed for the taxpayer by another person under a written binding contract that is entered into before the construction of the property begins is considered to be self-constructed by the taxpayer. The taxpayer accounted for its entitlement to bonus depreciation based on a cost segregation study. The cost segregation study identified a number of separately identifiable properties including sidewalks, paving, and landscaping. These properties, if new, have a MACRS recovery period of less than 20 years so they would be qualified property and eligible for bonus depreciation as long as they meet the other requirements of the regulations. The “building” also has other separately identifiable properties. An example is “decorative lighting” which includes the fixtures, lamps, and electrical wiring to the lighting as well as the direct cost of the installation of the lighting and the indirect cost of the design. All of these costs together would be included in the cost basis of the “decorative lighting”, which would be qualified properties (as long as the lighting is new) because their recovery period would be 20 years or less, depending on the Asset Class of Rev. Proc. 87-56 applicable to the taxpayer’s business activity in which the decorative lighting is primarily used.

After performing the cost segregation study and identifying each property, the next step is to determine whether the property meets the other requirements of the bonus depreciation regulations, including the acquisition requirement. As discussed above, self-constructed property is acquired when construction begins on that property. The determination of when construction begins generally depends on the facts and circumstances, but a taxpayer may choose to determine when construction begins in accordance with the safe harbor rule provided in the regulations. Under this safe harbor rule, construction does not begin before more than 10 percent of the total cost of the property (excluding the cost of any land and preliminary activities such as planning or designing, securing financing, exploring, or researching) is incurred by an accrual basis taxpayer or paid by a cash basis taxpayer. When property is manufactured, constructed or produced for the taxpayer by another person, as in the present case, this safe harbor rule must be satisfied by the taxpayer.

The taxpayer in the FAA chose to apply the 10% safe harbor rule in order to determine when construction began on the properties identified in its cost segregation study. Because the taxpayer used the accrual method of accounting for the acquisition of property pursuant to § 461, the taxpayer needed to determine when 10% of the cost of each property was incurred. Generally, a liability is incurred for the acquisition of property under the regulations when all events have occurred fixing the liability and economic performance has occurred. In the case of property acquired, economic performance occurs when the property is delivered or accepted, or when title to the property passes to the taxpayer. In this case, the taxpayer’s liability for each qualified property was incurred when the taxpayer accepted the property after the third party contractor submitted a pay application. Pay applications were used as the formal certification from the third party contractor which showed the total contract amount, the amount of the construction completed and a completion figure. As each request for a progress payment was made by the contractor, the taxpayer reviewed the amount, ascertained that the work had been completed and met the standards set forth in the contracts, accepted the work, and soon afterwards, released the progress payment as provided under the contract. At the point when taxpayer accepted the work, the all events test and the economic performance test is met. With each acceptance, the taxpayer incurred costs for that property.

However, the FAA holds that the taxpayer did not meet its burden of proof that the 10% safe harbor was met, and as a result, the taxpayer was not entitled to bonus depreciation on any of the qualified properties identified in the cost segregation study. Neither the pay applications nor the cost segregation study provided by the taxpayer clearly indicated when the costs of any of the separately identifiable properties were incurred. Specifically, as the pay applications were not broken down to the individual properties, it was not possible to determine when the total costs of separate properties, such as the landscaping, business signage, or decorative items, were incurred. The burden is on the taxpayer to prove which separately identifiable property, if any, was acquired under the safe harbor rules after December 31, 2007.

Method of Accounting Issues Related to Bonus Depreciation
Unless the taxpayer elects out of bonus depreciation, they are required to deduct the 30%, 50%, or 100% bonus depreciation on qualified property depending on the year the property is placed in service. Accordingly, the adjusted basis of the qualified property must be reduced by the amount of allowable bonus depreciation before computing the depreciation deduction for that property under § 167(f)(1) or § 168, as applicable, for the placed-in-service year and for all subsequent taxable years. A taxpayer that fails to make the proper election not to deduct bonus depreciation and doesn’t deduct bonus depreciation on its filed return is using an impermissible method of accounting.

Cost segregation studies performed contemporaneously with the taxable year that qualified property is placed in service should allow enough time before the tax return for that year is filed to determine the amount of bonus depreciation and depreciation allowable on that property. On the other hand, when a cost segregation study is performed after the tax return is filed for the year the qualified property is placed in service, the taxpayer probably did not claim bonus depreciation on that property, and as a consequence is using an impermissible method of accounting. Generally, taxpayers can file an amended tax return for the property’s placed-in-service year to claim the bonus depreciation and adjust the depreciation allowable on the qualified property, provided that the amended tax return is filed before the taxpayer files its tax return for the first taxable year succeeding the placed-in-service year. However, if the first taxable year succeeding the placed-in-service year is already filed before the cost segregation study is performed and the qualified property is identified, the taxpayer has adopted an impermissible method of accounting and must change from an impermissible method to a permissible method by filing a Form 3115. If this occurs, please contact the Deductible and Capital Expenditure (DCE) or the Method of Accounting and Timing (MAT) Practice Networks for assistance. See the following Revenue Procedures for additional guidance:
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  1. Rev. Proc. 2008-52 applies to tax years ending on or after December 31, 2007 and before April 30, 2010, and allows the taxpayer to file an amended return for the property’s placed-in-service year provided that the amended return is filed before the taxpayer files its tax return for the first taxable year succeeding the placed-in-service year. Alternatively, the taxpayer can change from an impermissible method of accounting to a permissible method by filing a Form 3115 for the first taxable year succeeding the placed-in-service year.
  2. Rev. Proc. 2011-14 provides similar rules for a year of change ending on or after April 30, 2010.
  3. Rev. Proc. 2011-26 provides a special rule for a taxpayer that did not claim the 50% additional first year depreciation for some or all of the qualified property placed in service by the taxpayer after December 31, 2009, on its federal tax return for its taxable year beginning in 2009 and ending in 2010 (2009 taxable year), or its taxable year of less than 12 months beginning and ending in 2010 (2010 short taxable year).

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If Rev. Proc. 2011-26 applies, the taxpayer can claim the additional first year depreciation for that property by filing either:

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  • An amended federal tax return for the 2009 taxable year or the 2010 short taxable year, as applicable, before the taxpayer files its federal tax return for the first taxable year succeeding the 2009 taxable year or the 2010 short taxable year, or
  • A Form 3115 with the taxpayer’s timely filed federal tax return for the first or second taxable year succeeding the 2009 taxable year or the 2010 short taxable year, as applicable, provided the taxpayer owns the property as of the first day of the year of change.

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Under Rev. Proc. 2011-26, taxpayers who do not retroactively elect bonus depreciation by claiming the 50% bonus depreciation deduction on their 2009 or 2010 short taxable year, or by filing an amended return or a Form 3115 as described above, are deemed to have elected to not deduct 50% bonus depreciation for a class of qualified property. Further, if a taxpayer is deemed to have elected not to apply the 50% bonus depreciation retroactively, the deemed election out applies to both 2009 qualified property and 2010 qualified property of the same class, including property in the same class acquired by the taxpayer after September 8, 2010 that would have qualified for 100% bonus depreciation.

Election Out of Bonus Depreciation
In general, taxpayers may elect out of bonus depreciation for any qualifying property placed in service during the taxable year. The election applies to all property of the same property class that is placed in service by the taxpayer in the same year. For bonus depreciation purposes, eligible property is in one of the classes described in § 168(k)(2): MACRS property with a recovery period of 20 years or less, depreciable computer software, water utility property, or qualified leasehold improvement property. The election may be revoked only with the consent of the Commissioner, obtained by requesting a letter ruling. However, there is an automatic extension of 6 months from the due date (excluding extensions) of the taxpayer’s tax return for the placed-in-service year of the class of property during which the taxpayer may file an amended tax return to revoke the election out of bonus depreciation for that class of property.

If the election to forego the bonus depreciation deduction is made, all property in the same class of property and placed in service in the same taxable year is deemed to be non-qualifying property, and no bonus depreciation is allowable for any property of the same property class placed in service during the taxable year. Accordingly, if a taxpayer identifies tangible personal property in a cost segregation study that would otherwise qualify for bonus depreciation, but that property was placed in service in the same tax year and is in the same class of property as a property for which the taxpayer elected out of bonus depreciation, then the tangible personal property identified in the study is deemed to be non-qualifying property.