Now that the bonus depreciation rules have been liberalized to allow for 100% writeoffs, and expanded to cover used as well as new property, taxpayers that also are eligible for Code Sec. 179 expensing may be wondering why they need to bother with expensing at all. After all, Code Sec. 179 expensing faces dollar limits and other restrictions that don’t burden users of 100% bonus depreciation. However, as this Practice Alert illustrates, Code Sec. 179 has unique advantages. It can be used to fine-tune annual deductions, doesn’t cause UNICAP problems, and covers a number of realty improvements that are ineligible for 100% bonus depreciation.
Good times for capital cost recovery. Under the Tax Cuts and Jobs Act (TCJA), a 100% first-year deduction for the adjusted basis of depreciable property is allowed for qualified property acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023 (after Sept. 27, 2017, and before Jan. 1, 2024, for certain aircraft and property with longer production periods). (Code Sec. 168(k)) In later years, the first-year bonus depreciation deduction phases down (i.e., to 80% in 2023, to 60% in 2024, 40% in 2015, and 20% in 2026—a one-year date adjustment applies for certain aircraft and property with longer production periods). The additional first-year depreciation allowance for qualified property acquired before Sept. 28, 2017, and placed in service after Sept. 27, 2017 was 50%. Additionally, under the TCJA, for the first time ever, the additional first-year depreciation deduction is allowed for used as well as new property (although used property is ineligible in certain circumstances, such as where it was acquired from a related party or there was previous use by the taxpayer).
Under the TCJA, for tax years beginning in 2018, the dollar limitation on Code Sec. 179 expensing is $1 million (up from $510,000) and the investment-based reduction in the dollar limitation starts to take effect when expensing-eligible property placed in service in the tax year exceeds $2.5 million (up from $2,030,000). (Code Sec. 179(b)(1), Code Sec. 179(b)(2)) However, under long-standing rules that weren’t changed by the TCJA, the Code Sec. 179 expensing deduction is limited to taxable income from all of the taxpayer’s active trades or businesses. In general, any amount that cannot be deducted because of the taxable income limit can be carried forward to later years until it is fully deducted. (Code Sec. 179(b)(3))
Where Sec. 179 expensing may be the better choice. A business that is eligible for either Code Sec. 179 expensing or 100% bonus depreciation under Code Sec. 168(k) should consider using the expensing option to capture the following advantages.
More flexibility. Although taxpayers generally benefit by accelerating the timing of deductions, there are situations in which accelerating deductions is offset by other considerations. One of those situations is the expiration of net operating loss (NOL), charitable contribution, or credit carryforwards. That is, the use of NOLs (Code Sec. 172(a)(2)), charitable contributions (Code Sec. 170(b)), and many credits is limited by a taxpayer’s taxable income (see, e.g., Code Sec. 23(b)(2)), but the carryover of many of these benefits expires after a specified time (e.g., the carryover of unusable charitable contribution deductions is generally limited to five years under Code Sec. 170(d)(1)(A)).
By not claiming Code Sec. 179 expensing, or electing out of bonus depreciation, a taxpayer increases current-year taxable income, but can (1) offset the increase by use of the expiring tax benefit, and (2) receive the deferred depreciation deductions in future years.
Expensing comes out ahead under such circumstances because a taxpayer that uses Code Sec. 179 expensing makes an annual election to do so on a property-by-property basis and specifies the elected-for part of a property’s cost. (Code Sec. 179(c)) By contrast, bonus depreciation automatically applies to all eligible properties at their full costs (less any amounts expensed under Code Sec. 179). The taxpayer may elect out of bonus depreciation, but can do so only for one or more full classes of property, such as all five-year MACRS property. (Code Sec. 168(k)(7)) In other words, a taxpayer can’t pick and choose which properties it wants to write off via 100% bonus depreciation.
Illustration. In Year Y, Taxpayer A buys $2,000 of equipment that is 5-year MACRS property. This is its sole machinery/equipment purchase for the year. The equipment is eligible for Code Sec. 179 expensing and is qualified property eligible for 100% bonus depreciation. Before taking depreciation into account, A has $2,000 of taxable income and a $800 NOL that expires in Year Y.
If A claims 100% bonus depreciation for the equipment, it will reduce its Year Y taxable income to $0. However, this will also allow the $800 NOL to expire unused and reduce A’s future depreciation deductions by $2,000. A can’t elect out of bonus depreciation for part of its 5-year MACRS purchase.
By contrast, if A elects Code Sec. 179 expensing for only $1,000 of the equipment purchase, and elects out of bonus depreciation for the balance of its purchase, it will have $800 of taxable income ($2,000 minus the $1,000 of expensing minus $200 of regular MACRS depreciation (20% × $1,000) for the equipment) before the NOL. Thus, the full $800 NOL will be used, reducing taxable income to $0, while A preserves $800 of future depreciation deductions to be applied against taxable income in future tax years.
Caution. The TCJA changed the rules for NOLs. Effective for losses arising in tax years beginning after 2017, the NOL deduction is limited to 80% of taxable income, determined without regard to the NOL deduction itself. (Code Sec. 172(a)) And, for NOLs arising in tax years ending after 2017, the general 2-year NOL carryback and prior law’s special carryback provisions are repealed (except that certain losses incurred in a farming trade or business may be carried back two years, and insurance companies other than life insurance companies get a 2-year carryback and 20-year carryforward); and NOLs may be carried forward indefinitely. (Code Sec. 172(b)(1)(A))
Built-in expensing advantage for those subject to UNICAP rules. Under the Code Sec. 263A UNICAP rules, a taxpayer must include in inventory costs the “allocable costs” of “property” that is inventory (Code Sec. 263A(a)(1)(A)) and capitalize the allocable costs of any other property. (Code Sec. 263A(a)(2)(B)) The allocable costs are: the direct costs of the property (Code Sec. 263A(a)(2)(A)); and the indirect costs, to the extent of the property’s proper share of that part (or all) of the costs allocable to that property. (Code Sec. 263A(a)(2)(B))
Under Reg. § 1.263A-1(e)(3)(ii)(I), amounts claimed for depreciation are required to be capitalized under Code Sec. 263A. By contrast, under Reg. § 1.263A-1(e)(3)(iii), amounts expensed under Code Sec. 179 are indirect costs that are not required to be capitalized under Code Sec. 263A. Thus, for those subject to the Code Sec. 263A UNICAP rules, Code Sec. 179 expensing is a clear winner for those eligible to use it.
Observation. Under the TCJA, fewer taxpayers are subject to Code Sec. 263A. Under Code Sec. 263A(i), taxpayers (other than tax shelters prohibited from using the cash receipts and disbursements method of accounting under Code Sec. 448(a)(3)) that meet the Code Sec. 448(c) gross receipts test are exempt from the application of the UNICAP rules. This gross receipts test is met if average annual gross receipts for the 3-taxable-year period ending with the taxable year which precedes such taxable year does not exceed $25 million (adjusted for inflation after 2018). This new exemption, which applies to both producers and resellers of both real and personal property, is effective for tax years beginning after Dec. 31, 2017.
Earnings and profits calculation. Code Sec. 179 expensing has a small edge when calculating corporate earnings and profits. An amount expensed under Code Sec. 179 is deducted for earnings and profits purposes ratably over a period of five years, beginning with the year the amount is deductible under Code Sec. 179. (Code Sec. 312(k)(3)(B)) By contrast, the additional first year depreciation deduction under Code Sec. 168(k) is not allowable at all for purposes of computing earnings and profits. (Prop Reg § 1.168(k)-1(f)(7), on which taxpayers may rely, Reg § 1.168(k)-1(f), Reg § 1.312-15(a)(1))
Nonresidential realty improvements are eligible for Sec. 179 expensing only. Under the TCJA, a category of improvements related to nonresidential realty may be expensed under Code Sec. 179, but is not, under current law, eligible for 100% bonus depreciation, although the category may become eligible if technical corrections are made. Another category of nonresidential realty improvements is newly eligible for Code Sec. 179expensing under the TCJA, but there is no parallel provision that would allow property in this category to become eligible for bonus depreciation even if technical corrections are enacted.
Qualified real property acquired by purchase for use in the active conduct of a trade business is eligible for Code Sec. 179 expensing. (Code Sec. 179(d)(1)) Effective for property placed in service in tax years beginning after Dec. 31, 2017, qualified real property consists of two categories: (1) qualified improvement property; and (2) a grab-bag of specific property improvements.
(1) Qualified improvement property. This is any improvement to an interior portion of a building which is nonresidential real property if the improvement is placed in service after the date the building was first placed in service. Qualified improvement property does not include the enlargement of the building, any elevator or escalator, or the internal structural framework of the building. Code Sec. 179(f)(1) defines qualified improvement property by reference to its definition in the depreciation rules (i.e., Code Sec. 168(e)(6))
Observation. The qualified improvement property category eligible for expensing under the TCJA replaces, and is generally broader in application than, prior law’s Sec. 179-eligible nonresidential realty improvement category which consisted of qualified leasehold improvement property, qualified restaurant property, or qualified retail improvement property, each of which had its own narrowly defined definition.
Under current law’s Code Sec. 168(e), qualified improvement property (as defined above) is 39-year property under MACRS, and therefore ineligible for 100% bonus depreciation which applies only to property with a MACRS recovery period of 20 years or less.
Observation. Congress intended—but failed—to give qualified improvement property a 15-year MACRS recovery period, which would have qualified this asset category for 100% bonus depreciation. Thus, absent a technical correction, which many commentators have called for, qualified improvement property does not qualify for 100% bonus depreciation.
(2) Specific property improvements. Under the TCJA, these Code Sec. 179 expensing-eligible specific property improvements consist of any of the following improvements to nonresidential real property placed in service after the date that the underlying property was placed in service: roofs; heating, ventilation, and air-conditioning (HVAC) property; fire protection and alarm systems; and security systems. (Code Sec. 179(f)(2)) This category of property improvements is unique to Code Sec. 179 and has no parallel in the depreciation provisions of Code Sec. 168.
Observation. Under Code Sec. 168(i)(6)(A), these specific types of property improvements are 39-year property for MACRS purposes and thus are automatically ineligible for 100% bonus depreciation.