100% Bonus Depreciation for 2011: How Does it Impact Like Kind Exchange Programs for Lessors?By Jeff Nelson
On December 17, 2010, President Obama signed HR 4853, the “Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010″ (the “ACT”). Among other things, the ACT increased the “bonus” depreciation deduction from 50% to 100% for qualified property acquired and placed in service between September 8, 2010 and December 31, 2011and it extended 50% bonus depreciation for property acquired and placed in service in calendar year 2012.
With the enactment of 100% bonus depreciation in particular, many companies with active Like Kind Exchange (LKE) programs are wondering whether it makes sense to suspend their LKE programs for the balance of 2011. Their logic hinges on the federal income tax impact of LKE deferrals on the tax basis of replacement property available for a 100% bonus depreciation deduction. Since gain deferred by LKE reduces the depreciable basis of replacement property it also reduces the amount of basis that might otherwise be deducted using 100% bonus depreciation.
The impact LKE deferrals on 100% bonus depreciation is illustrated in the following example where property is sold for a $10,000 realized gain and 100% bonus qualified replacement property is acquired for $25,000.
With LKE, the $10,000 gain is not recognized. However, the unrecognized gain reduces the depreciable basis of the replacement property as well as the bonus depreciation deduction from $25,000 to $15,000. With LKE the interplay of LKE and 100% bonus depreciation results in a net reduction of federal taxable income of -$15,000.
Without LKE, the $10,000 is recognized and the replacement property basis as well as the 100% bonus depreciation deduction remains at $25,000. Without LKE the company ends up with the same amount of federal taxable income as they would with LKE, namely -$15,000.
As the above illustration indicates companies who choose to take advantage of 100% bonus depreciation end up with the same federal taxable income with or without an LKE program. For this reason, many companies with active LKE Programs are wondering if they should suspend their LKE programs for 2011, temporarily saving the expense of running the program during the suspension period and then restart their LKE programs on January 1, 2012 when the 100% bonus rules expire.
The answer to this question is not nearly as clear as the above illustration seems to indicate. The simple illustration only considers the impact on Federal income taxes. It does not address a number of other important factors including the following:
- State income tax considerations
- Federal Alternative Minimum Tax considerations for individual owners of S-Corporations and Partnerships
- LKE matching considerations
- The use of LKE program functionality for non-LKE purposes
- Other considerations in suspending an LKE program
State Tax Considerations
Impact of state decoupling from federal “bonus” depreciation rules
For budgetary reasons, many states are not adopting the federal bonus depreciation rules. For companies that do business in these states turning off a company’s LKE program could result in additional 2011 state taxes equal to the amount of forgone LKE deferral multiplied by the respective state’s highest marginal tax rate (note – for some states, this rate can be 11% or higher).
To illustrate, let’s assume the same $10,000 gain and $25,000 replacement property as in the previous example except in this instance let’s also assume that the state has not adopted 100% federal bonus depreciation.
The above example highlights the significance of LKE for state tax purposes even where federal LKE benefits are diminished by 100% bonus depreciation.
Note – as more fully explained below, LKE reductions of state income taxes can also reduce the federal Alternative Minimum Tax for individual owners of S-Corporation and partnerships that take advantage of LKE for state income tax purposes.
State Net Operating Loss considerations
Many states have more restrictive Net Operating Loss (NOL) carryback and carryforward provisions than the “2 years back and 20 years forward” provisions under federal law. In addition, some states have suspended or even eliminated NOL carrybacks and carryforwards for state income tax purposes. Where the use of State NOLs is restricted, taxpayers need to closely examine their own facts and circumstances as well as their respective state’s rules and determine whether bonus depreciation and/or an LKE program are the right choice.
Alternative Minimum Tax (AMT) for Individual Owners of S-Corporations & Partnerships
It is important to note that Individual taxpayers are not allowed a state income tax deduction in calculating their Federal AMT. In addition, AMT resulting from lost state tax deductions are not allowed in the calculation of AMT credits that are typically allowed to offset regular tax liabilities in future tax years. Accordingly, for those taxpayers who incur additional state income tax as a result of “turning off” their LKE program and who are also subject to AMT, “turning off” their LKE program may result in additional AMT that can’t be recouped in future years.
LKE matching considerations
LKE program safe harbor rules give taxpayers flexibility when matching old and new properties to formulate exchanges. This flexibility presents a planning opportunity for companies to complete exchanges with replacement property that does not qualify for bonus depreciation. In this way, companies can continue to defer gains into non-bonus qualified acquisitions while at the same time taking full advantage of 100% bonus depreciation on those assets that do qualify. This opportunity is available for the following two types of asset acquisitions:
- “Used” property acquisitions – Under the ACT, “used” property (or property where “first use” does not begin with the taxpayer) does not qualify for bonus depreciation. Accordingly, where companies have sufficient 2011 acquisitions of used property, they can choose to exchange their old assets for “used” assets without reducing their ability to take full advantage of 100% bonus depreciation on their “new” assets.
- 2012 property acquisitions – LKE rules give companies who “identify” potential replacement property up to 180 days to acquire the identified assets. Accordingly, where companies have sufficient 2012 acquisitions, they can choose to exchange old assets sold between July and December of 2011, for assets acquired between January and June of 2012. This exchange of old assets sold in 2011 for assets acquired up to 180 days later in 2012 enables companies to take full advantage of 100% bonus depreciation on assets acquired in 2011 while at the same time deferring 2011 gain into 2012 acquisitions.
The use of LKE program functionality for non-LKE purposes
Companies often enhance their LKE program functionality to assist them in areas unrelated to LKE including the following:
- State and federal energy tax credits and incentives (Ex: federal hybrid and plug-in vehicle tax credits).
- “Trade-in” credits for state sales and use tax purposes.
- Tax accounting, depreciation and compliance services for non-LKE fixed assets like furniture and fixtures.
For these companies, suspending an LKE programs might not result in a significant cost savings since they would need to develop and implement alternative processes to meet their needs in non-LKE areas.
Other Considerations in suspending an LKE Program
The technical requirements of Like Kind Exchange programs require that certain operational changes be made to business processes in order to institutionalize and automate LKE for asset dispositions and acquisitions. Designing and implementing these operational changes requires significant time and resources from company professionals in a variety of business areas including treasury, accounting, tax, procurement, remarketing, legal and customer and vendor communications.
Similarly, significant time and resources are also needed to stop and restart a company’s LKE program. Business processes implemented to automate like kind exchange as a “matter of course” are not easily turned off nor are they easily restarted. Turning an LKE program off and on may require amendments to the company’s exchange agreements as well as modifications of the company’s cash processes or changes to customer and vendor communications. All of these changes require time, effort and expense to modify and in the end, these additional costs must be considered in evaluating the cost of any changes to your LKE program.
While 100% bonus depreciation may reduce the Federal tax benefits of LKE in 2011, most state tax benefits will remain. In the long run LKE programs continue to represent an effective tool that companies can use to defer federal and state tax liabilities as well as to streamline many of their fixed asset processes. In addition, as companies take advantage of various forms of 30%, 50% and 100% bonus depreciation the tax bases of their assets will fall to historical lows. Eventually, reduced tax basis will lead to even larger taxable gains when assets are ultimately sold representing an even greater opportunity for LKE program deferrals in future years.
While the long term advantages of LKE are not in doubt, the short term benefits, especially in periods of 100% bonus depreciation may be less obvious. In the short term, companies considering modifications to their LKE programs, whether by temporary program suspension or otherwise, should carefully evaluate and weigh all relevant factors to ensure they achieve their desired results.