Bonus Depreciation Eligibility Computation Rules

The Job Creation and Worker Assistance Act of 2002 (Act) provides an additional "bonus" depreciation allowance of 30% of the adjusted basis of qualified property, for the year in which the property is placed in service. This 30% is in addition to the usual annual depreciation allowance that applies to the remaining 70% of the property's adjusted basis (e.g., the first-year depreciation under Sec. 168, subject to the half-year convention (see Notices 2001-70 and 2001-74 for electing out of the mid-quarter convention)). The new bonus depreciation provision is retroactive (i.e., it affects certain returns filed for tax years ending in 2001).

Eligible Property

Four categories of property are eligible for bonus depreciation:

• Tangible personal property, subject under Sec. 168 to MACRS depreciation, with recovery periods of three, five, seven, 10, 15 or 20 years;
• Software depreciable over 36 months under Sec. 167(f)(1)(A);
• The Sec. 1250 property portion of certain leasehold improvements; and
• Water-utility property (as defined in Sec. 168(e)(5)).

"Qualified leasehold improvement property" is any improvement to a building's interior that is nonresidential real property, provided certain requirements are met:

1. The improvement must be made under (or pursuant to) a lease, either by the lessee (or sublessee) or lessor of that portion of the building.

2. That portion of the building must be occupied exclusively by the lessee (or any sublessee).

3. The improvement must be placed in service more than three years after the date the building was first placed in service.

Qualified leasehold improvement property does not include any im-provement attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area or the building's internal structural framework.

A binding commitment to enter into a lease is in fact a lease, and the parties are a lessor and a lessee. A lease between related persons is not a lease.

New York "Liberty Zone" qualified leasehold improvement property, which qualifies for special treatment under the New York City tax relief provisions of the Act, is not eligible for bonus depreciation.

Property subject to the alternative depreciation system of Sec. 168(g) on a mandatory basis (as opposed to an elective basis) does not qualify for bonus depreciation.

Only New Property Eligible

The Act provides that the property's "original use" must commence with the taxpayer on or after Sept. 11, 2001. "Original use" is defined in Regs. Sec. 1.48-2; that term is generally interpreted to mean new (but not used) property. For example, if a company buys all the assets of another business in a transaction to which Sec. 1060 applies, bonus depreciation would not apply to any of the property acquired, because the property's original use does not commence with the buyer. However, capital expenditures (that relate to used property) may satisfy the original-use requirement, even though the cost of the used property itself would not.

Example 1: On Feb. 1, 2002, taxpayer N buys from X for $20,000 a machine that X had used previously. Prior to Sept. 11, 2004, N makes a $5,000 property expenditure that must be capitalized. Regardless of whether N adds the $5,000 to the property's basis or capitalizes it as a separate asset, N treats that amount as qualified property, satisfying the original-use requirement (assuming all other conditions are met). No part of the $20,000 purchase price qualifies for bonus depreciation.

Eligibility Dates

Generally, the property must be acquired by the taxpayer during a three-year period, beginning on or after Sept. 11, 2001 and ending before Sept. 11, 2004. The property must be placed in service before Jan. 1, 2005 (Jan. 1, 2006 for certain property).

The property must not have been subject to a written binding contract before Sept. 11, 2001, a term not defined in the Act. As a result, there will probably be questions about the definition. For example, if a written purchase order was submitted on Sept. 7, 2001, for property delivered on Sept. 14, 2001, would the property qualify for bonus depreciation? The purchase order may be a written binding contract depending on the facts. Relevant factors could include whether the purchase order was cancelable at any time before delivery without penalty.

For property manufactured, constructed or produced by a taxpayer for the taxpayer's use, the taxpayer must begin the manufacture, construction or production of the property after Sept. 10, 2001 and before Sept. 11, 2004.

AMT Provisions

The 30% bonus depreciation al-lowance applies for both regular and alternative minimum tax (AMT) purposes. There is no adjustment under Sec. 56 for bonus depreciation for AMT purposes. The Act also eliminates the AMT adjustment for the remaining 70% portion of the basis. Stated another way, in addition to the 30% bonus depreciation amount being the same for regular and AMT purposes, depreciation deductions for the remaining 70% of the basis are also the same for regular and AMT purposes.

Computation

Example 2: On March 1, 2002, calendar-year taxpayer L acquires and places in service qualified five-year property that costs $1 million. L takes an additional first-year depreciation deduction of $300,000, recovering the remaining $700,000 of adjusted basis in 2002 and subsequent years, pursuant to the usual depreciation rules for regular tax purposes. In contrast, for AMT purposes, the usual rules are modified, which eliminates any adjustment under Sec. 56.

The usual first-year depreciation allowance for the property (for regular tax purposes) would be $140,000 (the first year of the double-declining-balance method for five-year property subject to a half-year convention). Thus, total depreciation for the property for L's 2002 return is $440,000, which is the allowance for both regular and AMT purposes.

For tax years after 2002, the remaining $560,000 of basis is depreciated for both regular and AMT purposes using the allowance computed for regular tax purposes.

Example 3: On March 1, 2002, calendar-year taxpayer J acquires and places in service $50,000 of qualified five-year property. In addition, the property qualifies for expensing under Sec. 179. Under the Act, J takes a $24,000 deduction under Sec. 179, then an additional first-year depreciation deduction of $7,800, which is 30% of $26,000 of adjusted basis ($50,000 original cost, less the $24,000 Sec. 179 deduction). Finally, J recovers the remaining $18,000 adjusted basis ($26,000 adjusted basis, less $7,800 additional first-year depreciation) in 2002 and subsequent years, pursuant to the usual depreciation rules for regular tax and the modified rules for AMT.

The usual first-year depreciation allowance for the property would be $3,640 (the first year of the double-declining-balance method for five-year property, subject to a half-year convention). Thus, Sec. 179 expensing for the property for the 2002 return is $24,000, and total depreciation for the 2002 return is $11,440, which is the same for regular and AMT purposes.

Luxury Automobiles

Sec. 280F limits the annual depreciation deductions for passenger automobiles to specified dollar amounts, indexed for inflation. The Act increases the limit in the first year by $4,600 for automobiles that qualify (with no election out of bonus depreciation). The $4,600 in-crease is not indexed for inflation.

Election Out

The 30% bonus depreciation allow-ance is required unless a taxpayer elects out of the bonus-depreciation provision. The IRS recently issued guidance on recouping missed bonus depreciation on 2001 returns, and electing out of bonus depreciation. Rev. Proc. 2002-33 provides "special rules" that address the procedural problems created by the Act's retroactive effective dates. Rev. Proc. 2002-33 also provides "general rules" that apply on a going-forward basis.

Special Rules--Recoupment

The special rules for recouping the missed bonus depreciation are generous. These rules address a situation in which a company filed its 2001 return, did not claim the 30% bonus-depreciation deduction, and did not elect out of the bonus-depreciation provision. This situation is problematic, as bonus depreciation is mandatory unless a company elects out.

A company may either amend its 2001 return and take the bonus depreciation into account, or make an automatic accounting-method change for its 2002 return (equivalent to deducting the 2001 30% bonus-depreciation amount in the 2002 return). The amended return must be filed by the extended due date of the return for the year following the year in which the bonus depreciation was not taken (e.g., for calendar-year companies, Sept. 15, 2003). If an amended return is not filed by such extended due date and an accounting-method change is not filed, the company will then be deemed to have made an election out of the bonus-depreciation provisions for the 2001 tax year.

Observation: If a company elected out of the bonus-depreciation provision on its 2001 return with an affirmative statement in its return, but only did so because of insufficient time to compute the bonus depreciation, it might want to revisit the election out, because the new guidance would allow it to recoup the 2001 bonus depreciation on its 2002 return. However, companies that want to pursue this route will have to file a ruling request under Rev. Proc. 2002-1, and receive IRS permission to revoke the election out.

General Rules for Electing Out

A taxpayer may elect not to deduct the bonus depreciation for any class of property placed in service during the tax year. The election applies to all property in the same class and placed in service in the same year. If the taxpayer makes the election, the depreciation adjustments under Sec. 56 apply to that property for purposes of computing alternative minimum taxable income.

Rev. Proc. 2002-33 provides that the election is made separately by each person owning such property (e.g., by each member of a consolidated group, or by a partnership or S corporation). Rev. Proc. 2002-33 defines "class of property" as:

• Each class of property described in Sec. 168(e) (e.g., all property in a particular recovery period (such as all five-year property));
• Water-utility property (as defined in Sec. 168(e)(5));
• Computer software depreciated under Sec. 167(f)(1); and
• Qualified leasehold-improvement property (as defined in Sec. 168(k)(3)).

Special Rules for Electing Out

Special rules for elections out of the bonus-depreciation provisions apply to 2001 returns filed before June 1, 2002.

For returns filed on or after June 1, 2002, the election out must be made with a timely filed return, by following the instructions to Form 4562, Depreciation and Amortization (which require a statement attached to the return specifying the classes of property for which the election out is made). The general rules also provide that both automatic and nonautomatic Regs. Sec. 301.9100 relief is potentially available.

From Vicki Howe Zenner, J.D., LL.M., Washington, DC