Bonus depreciation proposed regulations: previously-owned property | Norton Rose Fulbright

This is the third post in a series examining effects of the updated proposed regulations under section 168(k) on various types of taxpayers and transactions. The first two posts discussed effects of the proposed regulations on transactions related to (1) property leased to regulated utilities and (2) floor plan financing. This post discusses the proposed regulations and their effect on taxpayers’ ability to claim bonus depreciation on used property.

The previous iteration of the bonus depreciation rules generally did not allow taxpayers to claim bonus depreciation on used property.^[1] The prior bonus depreciation rules intended to spur manufacturing and the acquisition of used equipment was not viewed as consistent with that goal. The Tax Cuts and Jobs Act (the “TCJA”) eliminated the used property prohibition in most scenarios.^[2] The policy goal of the TCJA bonus depreciation provision was to encourage investment in equipment by reducing the income tax liability of newly manufactured or used equipment buyers, in most instances.

The proposed section 168(k) regulations published on September 24, 2019 address an interesting partnership issue. Under section 168(k), a taxpayer is not permitted to claim bonus depreciation on used property it acquires to the extent the taxpayer previously owned an interest in that property.^[3] Until the proposed regulations were issued, tax advisors were puzzled to quantify previous ownership interest when the taxpayer was a partner in a partnership that owned a particular item of equipment. Estimating previous ownership interest was especially challenging when a partner’s allocation of the partnership tax attributes changed over time. For instance, a two-partners partnership acquired a railcar with a seven-year tax depreciation recovery period. Three years later, an allocation of the partnership’s profit and loss between the two partners changed from being 50/50 to 90/10. Then, in the sixth year, one of the partners purchased the railcar from the partnership. What is the acquiring partner’s previous ownership interest in the equipment?

The proposed regulations adopt a clear and administrable standard to address this fact pattern. Under the proposed regulations, “a partner is considered to have a depreciable interest in a portion of property equal to the partner’s total share of depreciation deductions with respect to the property as a percentage of the total depreciation deductions allocated to all partners with respect to that property during the current calendar year and five calendar years immediately prior to the partnership’s current placed-in-service year of the property” (the “Partnership Lookthrough Rule”).^[4]

The New York Bar Association proposed in November 2019 a different approach to the partner’s previous ownership issue.^[5] It recommended the Partnership Lookthrough Rule regulations to be withdrawn and a rule to be adopted whereby

a taxpayer would be treated as having a prior depreciable interest in an item of property if the taxpayer was a controlling partner in a partnership at any time the partnership owned the property (subject to the applicable lookback period), and in such case, the taxpayer would be treated as the prior user of all of the property represented by the partnership’s interest therein. For this purpose, a taxpayer would be a “controlling partner” if the taxpayer, together with any related persons under the rules of Section 267(b) and Section 707(b), owns, directly or indirectly, more than 50% of the capital interest, or the profits interest, in the partnership.^[6]

Alternatively, the New York Bar Association recommended additional guidance be issued detailing application of the Partnership Lookthrough Rule to certain situations.^[7]

Another issue raised by the prior ownership bonus depreciation limitation under section 168(k) is whether previous short-term ownership disqualifies property from bonus depreciation eligibility. For instance, a leasing company acquires a crane leased to a construction company. After a short period of ownership, the leasing company sells the crane, subject to the lease, to another leasing company. In a subsequent year, the construction company buys the crane from the second leasing company and asks the first leasing company to finance it through a sale-leaseback. Can the first leasing company claim the bonus depreciation deduction for the crane? This example sounds narrow but was causing angst for certain leasing companies. The proposed regulations conclude previous short-term ownership does not constitute “ownership” for purposes of calculating bonus depreciation if the taxpayer owned property for 90 days or less.^[8] Thus, with prior ownership of 90 days or less the first leasing company may subsequently acquire the crane and claim bonus depreciation.

There is an odd inconsistency in the way the proposed regulations and the underlying statute refer to a quarter of a year (i.e., the short-term ownership period described above).. Specifically, 168(k)(2)(E)(iii)(III), addressing certain lease syndications,[9] refers to “three months” as did prior section 168(k)(2)(E)(ii)(II), addressing the sale-leaseback exception to used property, but the proposed regulations adopt the convention of 90 days.  It is not clear why the proposed regulations use a different convention than the statute, but it does create more minutiae for tax advisors to add value to their clients by remembering. 

The historical practice in granting leniencies to lessors appears to be “three months,” rather than 90 days. For instance, section 50(d)(4) allows the investment tax credit to a lessor (1) when a lessee initially owned the property and originally placed it in service and (2) enters a sale-leaseback transaction within three months after the property was placed in service.^[10] This is an exception to the general rule that only a party that originally places the property in service is entitled to claim any associated investment tax credit.[11] Subsequent users or buyers of property do not qualify for the credit. Further, under regulations section 467, tax avoidance will not be considered a principal purpose for providing increasing or decreasing rent in the context of disqualified leaseback or long-term agreements even if the uneven rent test is not satisfied when the increase or decrease in rent is wholly attributable to a single rent holiday provision. ^[12] The rent holiday is for a period of three months or less at the beginning of the lease term.^[13]

It is not clear if the use of a 90-days period in the proposed bonus depreciation regulations reflects a new-found preference by the IRS and Treasury for “90 days” rather than “three months” or if the lawyer who drafted the proposed bonus depreciation provision was not focused on this distinction.   

Special thanks to law clerk Natalia Muzlayev, who works under the supervision of David Burton, for her assistance in the preparation of this content.

[1] See prior I.R.C. § 168(k)(2)(A)(ii) (amended by the Tax Cuts and Jobs Act, P.L. 115-97). An exception to the general rule of disallowing bonus depreciation on used property was granted for certain leasing transactions at the outset of the equipment’s life. See prior I.R.C. §168(k)(2)(E)(ii) (amended by the Tax Cuts and Jobs Act, P.L. 115-97).

[2] See I.R.C. § 168(k)(2)(A)(ii), (E)(ii).

[3] I.R.C. § 168(k)(2)(E)(ii).

[4] Prop. Reg. § 1.168(k)-2(b)(3)(iii)(B)(5).

[5] See generally, N.Y. State Bar Ass’n, Report No. 1428 (2019).

[6] Id. at 2.

[7] Id.

[8] Prop. Reg. § 1.168(k)-2(b)(3)(iii)(B)(4) (“the taxpayer disposes of the property to an unrelated party within 90 calendar days after the date the property was originally placed in service by the taxpayer … and the taxpayer reacquires and again places in service the property, the taxpayer’s depreciable interest in the property during that 90-day period is not taken into account for determining whether the property was used by the taxpayer … at any time prior to its reacquisition by the taxpayer”).

[9] The reason for the retention of this lease syndication rule in the statute is not clear in light of the change of the statute to allow bonus depreciation for used property generally.  The preamble to the proposed regulations provides: “These proposed regulations introduce an exception, providing that a taxpayer does not have a depreciable interest in a given property if the taxpayer disposed of the property within 90 days of the initial date when the property was placed in service (so long as the asset is not repurchased and placed in service again within the same taxable year). The Treasury Department and the IRS primarily instituted this rule in order to coordinate with the syndication transaction rules of section 168(k)(E)(2)(iii)” (emphasis added).  Rather than coordinating with the syndication rule, it appears the short-term ownership exception in the proposed regulation has nullified the lease syndication rule as the syndication rule serves no purpose if an acquirer is permitted to claim bonus depreciation with respect to property acquired within 90 days of when a related party placed the property in service.

[10] I.R.C. § 50(d)(4) (referencing paragraphs (2) and (3)  I.R.C. § 48(b) (amended by the Revenue Reconciliation Act of 1990, P.L. 101-508) (prior I.R.C. § 48(b)(2)(B) provides “sold and leased back by such person, or is leased to such person, within 3 months after the date such property was originally placed in service, such property shall be treated as originally placed in service not earlier than the date on which such property is used under the leaseback (or lease)”).

[11] See I.R.C. 48(a)(3)(B)(ii) (“the original use of such property comments with the taxpayer”).

[12] Treas. Reg. § 1.467-3(c)(3)(ii)(B). The rent holiday can be longer for real estate.

[13] Id.