On August 3, 2018, the IRS released proposed regulations (REG 104397-18) on the modifications made to additional first-year depreciation deductions as provided by the Tax Cuts and Jobs Act (“TCJA”). TCJA enacted 100 percent bonus depreciation on “qualifying property” with a life of 20 years or less and placed in service after September 27, 2017, and also expanded the definition of qualifying property to include “used” property purchased in an arms-length transaction. The proposed regulations contain several significant provisions for partnerships and real estate businesses.
Key Partnership Provisions in the Proposed Bonus Depreciation Regulations
Before the TCJA, bonus depreciation was not permitted for “used” property. This meant that taxpayers could not claim bonus depreciation on property basis in many common partnership transactions. The TCJA’s expansion of bonus depreciation to include “used” property opened the door for bonus depreciation in many of those transactions.
The Proposed Regulations specifically state that bonus depreciation may be available in §743(b) basis transactions and for the certain contributing partners in a Rev. Rul. 99-5 transaction. In contrast, the Proposed Regulations provide that bonus depreciation does not apply to §734(b) basis transactions, partnership property distributions, and §704(c) remedial allocations.
Section 743(b) Basis Transactions
A basis adjustment under §743(b) is allowed where there is a transfer of a partnership interest by sale or exchange or upon the death of a partner, and the partnership has made an election under §754. The §743 basis adjustment is made with respect to the transferee partner only and is considered a partner specific basis adjustment. Thus, §743 basis is not common basis inside of the partnership. Basis created under §743(b) is allocated among partnership property pursuant to specific rules in the Code and regulations.
In the case of an interest transferred by sale or exchange, assuming the transferee is not related (as defined by §267), not a member of a controlled group, and has not used the transferor’s portion of the partnership property prior to the acquisition, the incremental increase in basis from the §743(b) adjustment is generally eligible for additional first-year bonus depreciation. The Proposed Regulations apply the aggregate theory of partnerships, which means that the regulations deem each partner to own a ratable share of the partnership’s property. The preamble to the proposed regulations explains that because of this view, even if the transferee is already a partner in the partnership, the basis adjustment would still be eligible for additional first-year depreciation because the transferee had not used the transferor’s portion of the property.
Not all §743 basis adjustments are eligible for bonus depreciation. Significantly, a transferee partner may only claim bonus depreciation on §743 basis that is allocated to otherwise qualified property of the partnership (i.e., tangible property with a use life of 20 years or less). Under the Proposed Regulations, Section 743 basis that is allocable to goodwill or other intangible property of a partnership is not eligible for bonus depreciation. In addition, the statutory definition of used property excludes property acquired from a decedent. Because of this exclusion, the Proposed Regulations do not permit bonus depreciation on a §743(b) basis adjustment resulting from the death of a partner.
Finally, the proposed regulations provide that §743 basis is treated separately from other partnership property for purposes of electing out of bonus depreciation. This means that a transferee partner can claim bonus depreciation on otherwise eligible §743 basis even if the partnership otherwise chooses to elect out of bonus depreciation for a particular year.
Rev. Rul. 99-5 Transactions
Situation 1 of Rev. Rul. 99-5 considers a transaction in which a buyer purchases units in a single-member, disregarded entity from its sole owner. Under Rev. Rul. 99-5, the buyer is deemed to purchase assets from the seller and then both seller and buyer are deemed to contribute those assets to the new partnership. The Proposed Regulations provide a special rule for this type of transaction: The buyer is eligible to claim bonus depreciation on its purchased property and this bonus depreciation is deemed to occur before the buyer’s deemed contribution of the purchased property to the partnership.
Section 734 Transactions
A partnership that has made a Section 754 election generally makes a §734 basis adjustment to partnership property either (1) when a partner recognizes gain from a cash distribution in excess of its basis or (2) when distributed property has a basis in the hands of the recipient partner that differs from it basis immediately before the distribution. Section 734 basis is an adjustment to the basis of the assets that the partnership retains after the distribution and is a change in the common basis of the property with respect to all partners in the partnership.
The Proposed Regulations do not permit bonus depreciation for §734 basis adjustments. The Preamble to the Proposed Regulations explains that bonus depreciation is not allowed for §734 basis adjustments because they affect the basis of partnership property that belongs to all partners and thus fails the original use test for used property under the TCJA.
Partnerships commonly distribute property to their partners. The basis of the distributed property in the hands of the recipient partners -- regardless of whether the distribution completely liquidated the partner’s interest in the partnership – is determined under Section 732. The Proposed Regulations specifically address partnership property distributions and state that bonus depreciation is not allowed for property for which basis is determined under §732. Thus, a partner who receives a property distribution from a partnership cannot claim bonus depreciation on that distributed property.
Section 704(c) Remedial Allocations
When a partner contributes appreciated property to a partnership, the difference between the market value of the property and its tax basis at the time of contribution is referred to as forward §704(c). The regulations for §704(c) provide that under the remedial allocation method, any excess value of property contributed over its adjusted tax basis is recovered using any recovery period and depreciation method available to the partnership. To the extent depreciation calculated under the remedial allocation method exceeded depreciation calculated using actual tax basis, the contributing partners have to recognize an offsetting amount of income. The potential application of bonus depreciation to §704(c) remedial allocations was a significant concern because allowing 100 percent bonus depreciation for remedial allocations would force contributing partners to recognize gain on its contributed property to the extent of bonus depreciation allocated to a non-contributing partner.
The Proposed Regulations eliminate this concern by providing that bonus depreciation is not allowed for remedial allocations.
Key Real Estate Aspects of the Proposed Bonus Depreciation Regulations
The Proposed Regulations also address two key issues for real estate businesses: the treatment of qualified improvement property and like-kind exchanges
Qualified Improvement Property
Before the TCJA, several types of building improvements were classified as 15-year property and eligible for 50 percent bonus depreciation. The TCJA consolidated all of those classes into a new class of property called Qualified Improvement Property, effective as of January 1, 2018. The committee reports that accompanied the TCJA described this new Qualified Improvement Property as also having a 15-year life, which would have made this property eligible for bonus depreciation. However, in what is commonly assumed to be an oversight when drafting the bill, the TCJA did not give Qualified Improvement Property a 15-year life (generally causing such property to revert back to a 39-year life prescribed under prior law). There had been some speculation that this oversight might be addressed in the regulations.
The Proposed Regulations did not correct for the assumed mistake in the text of the TCJA. Instead, the Proposed Regulations provide that improvements made between September 27, 2017, and December 31, 2017, are eligible for the new 100 percent bonus depreciation because such property had a 15-year life during that time. But starting on January 1, 2018, Qualified Improvement Property is no longer eligible for bonus depreciation since the depreciable life is no longer 20 years or less. A binding contract entered into for Qualified Improvement Property prior to September 27, 2017, but placed in service during the time frame is specifically excluded from being eligible for 100 percent bonus depreciation under the statute and proposed regulations.
The TCJA preserved like-kind exchanges for real property, even though the TCJA eliminated like-kind exchanges for other property. A taxpayer potentially has two types of basis in replacement property that it receives in a like-kind exchange: (a) exchanged basis and (b) excess basis. The exchanged basis is the basis associated with the property that the taxpayer relinquished in the like-kind exchange. The excess basis is cash or property that the taxpayer paid to acquire the replacement property in addition to the like-kind property that it relinquished in the transaction.
The Proposed Regulations provide that excess basis is generally eligible for bonus depreciation regardless of whether the replacement property is new or used property. But if exchanged basis is eligible for bonus depreciation only if the replacement property is new; exchanged basis is not eligible for bonus depreciation if a taxpayer receives used replacement property.
A&M Taxand Says:
The potential for bonus depreciation increases the importance of proper structuring when acquiring a partnership interest. When acquiring a partnership interest, the buyer can achieve a time value benefit from bonus depreciation to the extent it acquires eligible property in a §743 basis transaction or a Rev. Rul. 99-5 transaction. In contrast, bonus depreciation is not available for a transaction that results in §734 basis. Close attention should be paid to the manner in which partnerships are acquired to maximize tax benefits while the taxpayer-favorable bonus depreciation rules apply to used property.