Ready, set, depreciate: Highlights from the 2002 tax act.

On March 9, President Bush signed the 2002 Job Creation and Worker Assistance Act into law. Following are selected highlights:

Special Depreciation Allowance for Certain Property

The new law allows an additional depreciation deduction for both the regular tax and AMT, equal to 30 percent of the adjusted basis of "qualified property," for the tax year in which the property is placed in service.

The property's basis and depreciation allowances for the year of purchase and subsequent years are reduced to reflect this new deduction. There is no AMT depreciation adjustment throughout the entire recovery period of qualified property. A taxpayer can elect out of this new deduction for any class of property for any tax year.

Example of New Rules in Action

On March 1, 2002, a calendar year taxpayer acquired and placed in service a five-year MACRS asset, that is qualified property, costing $100,000. Under the existing law, using the half-year convention, the asset's 2002 depreciation is $20,000.

Under the new law, the taxpayer is allowed a $30,000 special depreciation allowance. The remaining $70,000 of adjusted basis is recovered under the existing depreciation rules. Hence, the taxpayer's 2002 depreciation deduction for this asset is $44,000 [$30,000 plus $14,000 ($70,000 x .20)].

If the taxpayer elects to expense $24,000 of this asset's cost (under Sec. 179), the 2002 depreciation for the asset is computed as follows:

Special allowance
($100,000 less $24,000
 or $76,000 x .30)                  $22,800
Regular depreciation ($76,000 less
 $22,800 or $53,200 x .20)           10,640

Total depreciation                  $33,440
Sec. 179 expense                     24,000

Total deduction                     $57,440

Luxury Passenger Automobiles

Under existing Sec. 280F, the annual depreciation deduction for a passenger automobile cannot exceed a specified dollar amount (indexed for inflation). For autos placed in service in 2001 or 2002, the first-year depreciation cannot exceed $3,060.

For autos that are qualified property, and for which there is no election out of the new increased first-year depreciation deduction, the new law increases the maximum deduction by $4,600 (not indexed for inflation). Thus, the first year depreciation deduction on a new auto purchased after Sept. 10, 2001, and before Jan. 1, 2003, cannot exceed $7,660 ($3,060 plus $4,600).

Qualified Property

Qualified property must be:

* Property to which the general rules of MACRS apply with a recovery period of 20 years or less;

* Property that is not required to be depreciated under MACRS' alternative depreciation system (such as tangible property used predominantly outside the U.S.);

* Computer software that is not amortized under Sec. 197;

* Water utility property; or

* Qualified leasehold improvement property.

Also, the property must be acquired after Sept. 10, 2001 and before Sept. 11, 2004 (and no binding written contract for this acquisition was in effect before Sept. 11, 2001) or acquired under a binding written contract entered into after Sept. 10, 2001 and before Sept. 11, 2004. In addition, the property's original use must commence with the taxpayer after Sept. 10, 2001.

In the case of property originally placed in service by a person that is then sold to the taxpayer and leased back to this person by the taxpayer within three months after the property was placed in service, the property is treated as originally placed in service by the taxpayer not earlier than the date that the property is used under the leaseback.

Further, the property must be placed in service before Jan. 1, 2005 (or Jan. 1, 2006 for property with a recovery period of 10 years or longer and transportation property--if their estimated production period exceeds two years, or one year and their cost exceeds $1 million).

Qualified Leasehold Improvement Property

This type of property is any improvement to an interior portion of a building that is nonresidential real property if:

* The improvement is made under a lease by either the lessee (or sublessee) or lessor of that portion of the building;

* Such portion is to be occupied exclusively by the lessee (or any sublessee); and

* The improvement is placed in service more than three years after the building was first placed in service.

A lease between related persons is not considered a lease for this purpose. A binding commitment to enter into a lease is treated as a lease and the commitment's parties are treated as lessor and lessee.

Improvements do not qualify if they are attributable to:

* The building's enlargement or internal structural framework;

* Elevators or escalators; or

* Any structural components benefiting a common area.

Original Use

This means the first use to which the property is put, whether or not such use corresponds to the taxpayer's use of the property. It is intended that the factors used (in Regs. Sec. 1.48-2) to determine whether property qualified as "new Sec. 38 property" under the repealed investment credit should apply.

Consequently, additional capital expenditures to recondition or rebuild acquired (or owned) property should satisfy the "original use" requirement. However, the cost of such property would not satisfy this requirement.

Example: On Feb. 1, 2002, a taxpayer buys from X a $20,000 machine previously used by X. Before Sept. 11, 2004, the taxpayer makes a $5,000 capital expenditure on this machine. Regardless of whether this $5,000 is added to the machine's basis or capitalized as a separate asset, it is treated as being "originally used" and would be qualified property (if all other conditions are met). No part of the $20,000 purchase price would qualify for the special 30 percent additional first-year depreciation deduction

Effective Date

These new rules apply to property placed in service after Sept. 10, 2001, in tax years ending after that date. Therefore, where appropriate, they should be reflected in relevant income tax returns. If such returns have already been filed, amended returns should be considered--if advisable.

Carryback of NOLs

Under the existing law, an NOL generally may be carried back two years and forward 20 years. Different rules apply to NOLs arising in specified circumstances. For instance, a three-year carryback applies to NOLs:

* Arising from individuals' casualty or theft losses; or

* Attributable to presidentially declared disasters for taxpayers engaged in a farming or small business.

For AMT purposes, an NOL cannot reduce the taxpayer's AMT income by more than 90 percent of the AMTI.

The new law temporarily extends the general NOL carryback period from two to five years for NOLs arising in tax years ending in 2001 and 2002. The five-year carryback period also applies to NOLs from these years that qualify for the three-year carryback period under existing law.

A taxpayer can irrevocably elect to waive the five-year carryback period, in the manner prescribed by the IRS, by the loss year return's due date (including extensions). If this election is made, the existing rules apply to the NOL.

Moreover, the new law allows an NOL deduction attributable to NOL carrybacks arising in tax years ending in 2001 and 2002, as well as NOL carryforwards to these years, to offset 100 percent of AMTI.

Effective Date

The five-year carryback rules apply to NOLs generated in tax years ending after 2000. The new AMT rule is effective for tax years ending before 2003.

If a carryback is desirable, an Application for Tentative Refund should be filed within one year after the loss year ends. Otherwise, an amended return must be filed to claim the carryback.

Stuart R. Josephs, CPA, has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].