The Treasury and the Internal Revenue Service have released the latest round of final regulations for additional first year (bonus) depreciation. As part of TCJA, the rules governing bonus depreciation were modified so that property that is placed in service after September 27, 2017, and before January 1, 2023, is eligible for 100% bonus depreciation (decreasing by 20% every year after 2022), regardless of whether the taxpayer is the original user of the property, so long as the property’s cost recovery period is 20 years or less under MACRS, the taxpayer did not have a previous prior depreciable interest in the property, and it was not acquired from a related party. The release was highly anticipated as Treasury had previously indicated that it was attempting to release all TCJA-related guidance by October 1st. The final regulations generally adopt the September 24, 2019 proposed regulations. This alert highlights some of the more notable changes to the proposed regulations.

Series of Related Transactions

If a taxpayer acquires depreciable property as a part of a “series of related transactions,” then the bonus depreciation regulations provide rules to determine whether the transferee acquired the property from a related person, which would render it ineligible for bonus depreciation. The most recent final regulations expand the scope of the relatedness testing by requiring that testing must occur both before the initial transfer from the original transferor and immediately before the transferee's acquisition of the property.

Example: As part of a series of related transactions, A sells depreciable property to B (who is unrelated to both A and C), who in turn sells it to C. At the time A sold the property to B, A and C were related. However, at the time B sold the property to C, A and C were not related. Under the proposed regulations, C would test for relatedness at the time it acquired the property and therefore would be treated as acquiring the property from a related person. However, under the final regulations, at the time of the initial transfer, A and C were related and as a result, C would be treated as acquiring the property from a related person and therefore would be ineligible for bonus depreciation.

Additionally, a transferee must test whether it is related to the transferor from whom it obtained the property and the original transferor.

Example: As part of a series of related transactions, A sells depreciable property to B, who in turn sells it to C, who in turn sells it to D. Under the proposed regulations, B would test relatedness with respect to A, C would test relatedness with respect to B, and D would test relatedness with respect to both A and C. Under the final regulations, B would test relatedness with respect to A, C would test relatedness with respect to both A and B, and D would test relatedness with respect to both A and C. Therefore, if A and C were related, then C would be ineligible for bonus depreciation under the final regulations.

A&M Insight: As highlighted in the examples, the modification of the “series of related transactions” rule can ensnare taxpayers that planned to claim bonus depreciation. In addition, due to the expanded relationships that must be tested and the times at which those relationships must be tested, claiming bonus depreciation has become more complex. A&M is happy to discuss your transaction to help ascertain whether bonus depreciation is available for the acquired assets.

Partnership Look-Through Rule

The 2019 proposed regulations included a “look-through” rule under which a partner was deemed to have a depreciable interest in the property of a partnership in which it was a partner. That proposed look-through rule limited the ability to obtain bonus depreciation in transactions involving partnerships (e.g., a partner that purchased property from a partnership was treated as having a prior depreciable interest irrespective of the extent of the partner’s interest in the partnership), and imposed significant administrative and compliance burdens. The final regulations removed this “look-through” rule and, as a result, a partner is not treated as having a prior depreciable interest in property solely because it was a partner in a partnership that owned the property.

A&M Insight: The final regulations provide that for taxable years that begin before January 1, 2021, taxpayers can rely on the 2019 proposed regulations (ignoring the look-through rule). As a result, taxpayers that did not claim bonus depreciation should determine whether they need to amend their previously filed returns or previously did not plan to claim bonus depreciation because of the look-through rule should reconsider whether to claim this benefit.

Consolidated Group Rules

The final regulations generally retain the consolidated group rules in the proposed regulations, with one notable exception. Under the final regulations, a member of a group can acquire property from another member of the group and still qualify for the bonus depreciation deduction with respect to the property, if it meets the following criteria:

1. The acquired property must otherwise satisfy the used acquisition requirements (but for the prohibitions on acquisitions from related parties and the prior use of the asset within a consolidated group).
2. As part of the same series of related transactions that includes the acquisition of the acquired property, the transferee (or the target, if a 338 or 336(e) election is made) must leave the consolidated group and cease to be related to the transferor member.
3. The acquired property must be eligible for bonus depreciation on the deconsolidation date and the next day.

If those criteria are met, then for all Federal income tax purposes:

• The transferee member (or the target) is treated as selling the acquired property to an unrelated third party one day after the deconsolidation date for cash equal to its basis.
• Immediately after the deemed sale, the transferee member (or the target) is treated as purchasing identical (but distinct) used property from another unrelated third party for an amount of cash equal to the property’s basis before the deemed sale.

As a result of the deemed purchase, the transferee member (or the target) will be eligible to take bonus depreciation on the remaining basis of the acquired property.

Example: P, B, and S are members of a consolidated group. As part of a series of related transactions, on May 1, Year 1, B acquires a machine (which would otherwise be eligible for bonus depreciation) from S for $1 million. During Year 1, B takes depreciation deductions of $200k. On January 1, Year 2, P sells the stock of B to an unrelated third party. On these facts, B could elect to take a bonus depreciation deduction of $800K in Year 2.

A&M Insight: Taxpayers can elect out of the deemed sale and purchase approach contained in the final regulations. Taxpayers may want to consider doing so, because the ability to claim bonus depreciation may be offset by the cost of the deemed sale and purchase model that applies for all Federal income tax purposes.  For example, a taxpayer will have a new holding period for the asset and the approach can eliminate certain gains that otherwise might have increased its section 382 limitation. 

Qualified Improvement Property

As a result of the CARES Act Retail Glitch Fix (discussed in detail here), the final regulations reflect the new treatment of Qualified Improvement Property (QIP), including its eligibility for bonus depreciation. The regulations do clarify, however, that QIP cannot be purchased and retain its character as QIP. In other words, if a buyer acquires both real estate and QIP from the same seller, that former QIP is no longer characterized as QIP in the hands of the buyer and therefore is ineligible for bonus depreciation, because it was neither placed in service nor constructed by the taxpayer. In these situations, the assets would automatically default back to a real property life with the availability of accelerating portions of the basis through a cost segregation analysis.

A&M Taxand Says

In general, the new final regulations are helpful. However, there are still uncertainties as to their application, as well as to whether certain assets are eligible for bonus depreciation. Additionally, there are traps for the unwary of which taxpayers should be cognizant before deciding to claim bonus depreciation. A&M is happy to discuss your situation and to assist with cost segregation studies to help identify acquired assets that could qualify for bonus depreciation.