The final regulations retain the rules contained in the temporary regulations providing that depreciable property must meet four requirements to be qualified property under section 168(k)(2) (property for which the 30-percent additional first year depreciation deduction is allowable) or 50-percent bonus depreciation property under section 168(k)(4) (property for which the 50-percent additional first year depreciation deduction is allowable). These requirements are: (1) the depreciable property must be of a specified type; (2) the original use of the depreciable property must commence with the taxpayer after September 10, 2001, for qualified property or after May 5, 2003, for 50-percent bonus depreciation property; (3) the depreciable property must be acquired by the taxpayer within a specified time period; and (4) the depreciable property must be placed in service by a specified date.

Several commentators questioned whether these requirements must be met in the year in which the depreciable property is placed in service by the taxpayer. The statute is clear that additional first year depreciation is allowed in the taxable year in which qualified property or 50 percent bonus depreciation property is placed in service by the taxpayer for use in its trade or business or for production of income. Therefore, only property that meets all of these requirements in the year in which placed in service by the taxpayer for use in its trade or business or for production of income is allowed additional first year depreciation in the year the property is placed in service by the taxpayer for use in its trade or business or for production of income. In response to this comment, the final regulations state more explicitly that all of the requirements must be met in the first taxable year in which the property is subject to depreciation by the taxpayer whether or not depreciation deductions are allowable.

The final regulations retain the rules contained in the temporary regulations providing that qualified property or 50-percent bonus depreciation property must be one of the following: (1) MACRS property that has a recovery period of 20 years or less; (2) computer software as defined in, and depreciated under, section 167(f)(1); (3) water utility property as defined in section 168(e)(5) and depreciated under section 168; or (4) qualified leasehold improvement property depreciated under section 168.

The final regulations also retain the rules contained in the temporary regulations providing that qualified property or 50-percent bonus depreciation property does not include: (1) property excluded from the application of section 168 as a result of section 168(f); (2) property that is required to be depreciated under the alternative depreciation system of section 168(g) (ADS); (3) any class of property for which the taxpayer elects not to deduct the 30-percent or 50-percent additional first year depreciation; or (4) qualified New York Liberty Zone leasehold improvement property as defined in section 1400L(c).

Property is required to be depreciated under the ADS if the property is described under section 168(g)(1)(A) through (D) or if other provisions of the Code require depreciation for the property to be determined under the ADS (for example, section 263A(e)(2)(A) or section 280F(b)(1)). A commentator questioned whether depreciable property held by taxpayers that made the election under section 263A(d)(3) should be excluded from eligibility for the additional first year depreciation deduction. Section 263A(e)(2)(A) provides that if a taxpayer (or a related person) makes an election under section 263A(d)(3) (relating to an election not to apply section 263A to any plant produced in any farming business carried on by the taxpayer), the ADS applies to all property of the taxpayer used predominantly in the farming business and placed in service in any taxable year during which any such election is in effect. Section 168(k) does not exclude property for which the section 263A(d)(3) election was made from the application of section 168(k)(2)(D)(i), which provides that property required to be depreciated under the ADS is not qualified property and 50-percent bonus depreciation property. For this reason, the final regulations do not adopt the suggestion that depreciable property held by taxpayers that made the election under section 263A(d)(3) is eligible for the additional first year depreciation deduction. Another commentator requested clarification as to whether the reference to “property described in section 263A(e)(2)(A)” in §1.168(k)-1T(b)(2)(ii)(A)(2) includes only property held by a taxpayer that has made an election under section 263A(d)(3). In response to this comment, the final regulations clarify that if the taxpayer (or a related person) has made the election under section 263A(d)(3), the property described in section 263A(e)(2)(A) is not eligible for the additional first year depreciation deduction.

The final regulations clarify and make conforming changes to the original use rules in the temporary regulations in several respects. First, a commentator inquired whether the rule providing that the cost of reconditioned or rebuilt property acquired by the taxpayer does not satisfy the original use requirement also applies to self-constructed property. A few commentators inquired whether the 20-percent test for determining whether property is reconditioned or rebuilt applies to self-constructed property. The IRS and Treasury Department intended that these rules apply to the cost of any reconditioned or rebuilt property, whether the taxpayer originally acquired the property or self-constructed the property. Accordingly, the final regulations clarify that the cost of reconditioned or rebuilt property does not satisfy the original use requirement and that the 20-percent test applies to acquired or self-constructed property.

Second, Example 2 of §1.168(k)-1T(b)(3)(v) provides that property held primarily for sale to customers in the ordinary course of a person’s business (inventory) does not constitute a use for purposes of the original use requirement. A commentator noted that this rule is not in the operative rules of the temporary regulations. In response to this comment, the final regulations make the rule explicit and provide that if a person initially acquires new property and holds the property as inventory and a taxpayer subsequently acquires the property from the person for use primarily in the taxpayer’s trade or business or primarily for the taxpayer’s production of income, the taxpayer is considered the original user of the property. The final regulations also provide that if a taxpayer initially acquires new property and holds the property as inventory and then subsequently withdraws the property from inventory and uses the property primarily in the taxpayer’s trade or business or primarily for the taxpayer’s production of income, the taxpayer is considered the original user of the property. In both situations, the final regulations provide that the original use of the property by the taxpayer commences on the date on which the taxpayer uses the property primarily in the taxpayer’s trade or business or primarily for the taxpayer’s production of income.

A commentator questioned whether Example 2 in §1.168(k)-1T(b)(3)(v) is the appropriate place to resolve the issue of the tax treatment of demonstrator automobiles for depreciation and other purposes when the issue may have a potential broader scope and significance that may continue to arise long after the additional first year depreciation under section 168(k) has ceased to be available. The IRS and Treasury Department believe that this example illustrates only the concept that if property is held by a person as inventory and then sold to a taxpayer for use in the taxpayer’s trade or business, the taxpayer is the original user of the property, and, therefore, that this example is in the appropriate place.

Third, the final regulations retain the special rules contained in the temporary regulations for certain sale-leaseback transactions and syndication transactions. A commentator suggested that the title of §1.168(k)-1T(b)(3)(iii)(B), “Syndication transaction,” should be changed in the final regulations to reflect that this rule, by its terms, can apply to any sale of property within three months after the date on which it is placed in service, regardless of whether that sale constitutes a syndication. The final regulations adopt this suggestion and modify the titles of, and make conforming changes to, the applicable paragraphs. Similar changes also are made to the paragraphs relating to the placed-in-service date requirement.

Fourth, the final regulations modify the provision in the temporary regulations to implement section 403(a) of the Working Families Tax Relief Act of 2004, (Public Law 108-311, 118 Stat. 1166) (October 4, 2004) (WFTRA) and section 337 of the American Jobs Creation Act of 2004 (Public Law 108-357, 118 Stat. 1418) (October 22, 2004) (AJCA). Section 403(a) of the WFTRA amended section 168(k) by adding the provision in section 168(k)(2)(E)(iii). Section 403(f) of the WFTRA provides that this amendment is effective as if included in the provisions of the Job Creation and Worker Assistance Act of 2002 (Public Law 107-147, 116 Stat. 21) (March 9, 2002) (JCWAA). Section 337(a) of the AJCA amended the syndication transaction provision in section 168(k)(2)(E)(iii)(II) by adding at the end the following: “(or, in the case of multiple units of property subject to the same lease, within 3 months after the date the final unit is placed in service, so long as the period between the time the first unit is placed in service and the time the last unit is placed in service does not exceed 12 months).” Section 337(b) of the AJCA provides that this amendment is effective for property sold after June 4, 2004.

Fifth, if property placed in service by a person is sold and leased back within three months, and a syndication transaction occurs within three months after the sale-leaseback, a commentator questioned whether the purchaser of the property in the syndication transaction is considered the original user of the property and whether the property is treated as having been placed in service by the purchaser in the syndication transaction. Pursuant to §§1.168(k)-1T(b)(3)(iii)(C) and (5)(ii)(C), the purchaser of the property in the syndication transaction is considered the original user of the property and the property is treated as having been placed in service by the purchaser in the syndication transaction. The final regulations retain this rule and provide an example illustrating both the original use and the placed in service aspects of this situation.

Finally, the final regulations retain the rule contained in the temporary regulations providing that if, in the ordinary course of its business, a taxpayer sells fractional interests in qualified property or 50-percent bonus depreciation property to unrelated third parties, each first fractional owner of the property is considered as the original user of its proportionate share of the property. A commentator questioned whether the rule requiring the sale to be to unrelated third parties means that the purchasers must be unrelated to the seller, the purchasers must be unrelated to each other, or both. The IRS and Treasury Department intended that the purchasers be unrelated to the seller. Accordingly, the final regulations clarify this point.

A commentator questioned whether there are circumstances when the placed-in-service year of property is before the taxable year of original use. Pursuant to §1.46-3(d)(1)(ii), property is considered placed in service in the taxable year in which the property is placed in a condition or state of readiness and availability for a specifically assigned function, whether in a trade or business, in the production of income, in a tax-exempt activity, or in a personal activity. Original use begins when new property is placed in service. Consequently, the placed-in-service year of new property cannot be before the taxable year in which original use of the property occurs.

The final regulations modify the acquisition dates in the temporary regulations to reflect section 405 of the Gulf Opportunity Zone Act of 2005 (Public Law 109-135, 119 Stat. 2577) (December 21, 2005) (GOZA). Section 405(a)(1) of the GOZA amended section 168(k)(4)(B)(ii) to provide that 50-percent bonus depreciation property is property (I) acquired by the taxpayer after May 5, 2003, and before January 1, 2005, but only if no written binding contract for the acquisition of the property was in effect before May 6, 2003, or (II) acquired by the taxpayer pursuant to a written binding contract which was entered into after May 5, 2003, and before January 1, 2005. Section 405(b) provides that this amendment is effective as if included in section 201 of the Jobs and Growth Tax Relief and Reconciliation Act of 2003 (Public Law 108-27, 117 Stat. 752) (May 28, 2003).

The final regulations also modify in three respects the rules contained in the temporary regulations defining a binding contract. First, the temporary regulations provide that if a contract provides for a full refund of the purchase price in lieu of any damages allowable by law in the event of breach or cancellation by the seller, the contract is not considered binding. A commentator suggested that this rule should apply to a breach or cancellation by the buyer, not the seller. However, the IRS and Treasury Department believe that this rule relates to a breach or cancellation by either party. Accordingly, the final regulations provide that if a contract provides for a full refund of the purchase price in lieu of any damages allowable by law in the event of breach or cancellation, the contract is not considered binding.

Second, with respect to a contract subject to a condition, the temporary regulations provide that a contract that imposes significant obligations on the taxpayer or a predecessor will be treated as binding notwithstanding the fact that insubstantial terms remain to be negotiated by the parties to the contract. A commentator questioned whether this rule implies that a contract that imposes significant obligations will not be treated as binding if substantial terms remain to be negotiated. The IRS and Treasury Department believe that this implication was not intended. As a consequence, the final regulations clarify this rule by providing that a contract that imposes significant obligations on the taxpayer or a predecessor will be treated as binding notwithstanding the fact that certain terms remain to be negotiated by the parties to the contract.

Third, with respect to a supply agreement, a commentator suggested that the existence of agreed pricing terms should not be relevant in determining whether or not a supply agreement is a binding contract, except to the extent that their absence causes the contract not to be enforceable under local law. The commentator further suggested that if the existence of pricing terms is considered relevant to the result in the example of the operative rule and in some of the examples that illustrate the application of the rule, that requirement should be stated in the operative rule, and if not relevant, the references to pricing terms should be deleted. Pricing terms are not relevant in determining whether a supply agreement is a binding contract for purposes of these regulations. Accordingly, the final regulations adopt the suggestion by eliminating the reference to agreed pricing terms in the example of the operative rule. While the examples that illustrate the application of the rule continue to contain the agreed price as a fact, the conclusions in these examples depend upon only whether or not the quantity and the design specification of the property to be purchased are specified.

With respect to self-constructed property, the final regulations clarify the rules in the temporary regulations in several respects. First, with respect to property described in section 168(k)(2)(B) (longer production period property) or section 168(k)(2)(C) (certain aircraft), the final regulations clarify that if a taxpayer enters into a written binding contract after September 10, 2001, and before January 1, 2005, with another person to manufacture, construct, or produce such property and the manufacture, construction, or production begins after December 31, 2004, the taxpayer has acquired the property pursuant to a written binding contract entered into after September 10, 2001, and before January 1, 2005 (for qualified property) or after May 5, 2003, and before January 1, 2005 (for 50-percent bonus depreciation property).

Second, a commentator asked whether the rules in the temporary regulations providing for when construction begins are intended also to apply to manufacture and production because self-constructed property can be manufactured, constructed, or produced for purposes of the additional first year depreciation deduction. The IRS and Treasury Department intended these rules to apply to manufacture, construction, or production. Accordingly, the final regulations make this clarification.

Third, the temporary regulations provide that construction of property begins when physical work of a significant nature begins and the determination of when physical work of a significant nature begins depends on the facts and circumstances. The temporary regulations also provide that physical work of a significant nature will not be considered to begin before the taxpayer incurs or pays more than 10 percent of the total cost of the property (excluding the cost of any land and preliminary activities). Several commentators questioned whether this 10-percent test is a safe harbor. The preamble to the temporary regulations (68 FR 52987) states that the 10-percent test is a safe harbor. Consequently, the final regulations are clarified to provide that the 10-percent test is a safe harbor. Further, when another party manufactures, constructs, or produces property for the taxpayer, the final regulations clarify that the safe harbor test must be met by the taxpayer. Thus, under the final regulations, a taxpayer can determine when manufacture, construction, or production of the property begins either (1) by using the 10 percent safe harbor or (2) by using its own facts and circumstances.

Fourth, the final regulations retain the rules contained in the temporary regulations relating to components of self-constructed property. One of these rules is that if the binding contract to acquire a component is entered into, or the manufacture, construction, or production of a component begins, after September 10, 2001, for qualified property, or after May 5, 2003, for 50-percent bonus depreciation property, and before January 1, 2005, but the manufacture, construction, or production of the larger self-constructed property begins after December 31, 2004, the component qualifies for the additional first year depreciation deduction (assuming all other requirements are met) but the larger self-constructed property does not. In the case of a self-constructed component that is to be incorporated into a larger self-constructed property, some commentators noted that the applicability of this rule is limited. Specifically, one commentator stated that if the 10 percent test mentioned in the preceding paragraph is not a safe harbor test, then the only case in which self-constructed components could qualify for the additional first year depreciation deduction is one in which the taxpayer’s pre-January 1, 2005, costs are 10 percent or less of the total cost of the larger self-constructed property (but more than 10 percent of the total cost of the component). Another commentator stated that a self-constructed component that is to be incorporated into a larger self-constructed property may not be placed in service before the larger self-constructed property. The IRS and Treasury Department agree that the rule has limited applicability. The rule applies when the larger self-constructed property is property that is manufactured, constructed, or produced by the taxpayer for its own use and that is described in section 168(k)(2)(B) (longer production period property) or section 168(k)(2)(C) (certain aircraft) and, therefore, the property is eligible for the extended placed-in-service date of January 1, 2006.

The final regulations clarify the disqualified transaction rules in the temporary regulations to reflect section 403(a) of the WFTRA. This section amended section 168(k) by adding section 168(k)(2)(E)(iv), which provides limitations related to users and related parties (disqualified transactions). Section 168(k)(2)(E)(iv) provides that the term qualified property does not include any property if: (I) the user of such property (as of the date on which the property is originally placed in service) or a person that is related (within the meaning of section 267(b) or 707(b)) to such user or to the taxpayer had a written binding contract in effect for the acquisition of the property at any time on or before September 10, 2001; or (II) in the case of property manufactured, constructed, or produced for such user’s or person’s own use, the manufacture, construction, or production of the property began at any time on or before September 10, 2001. Section 403(f) of the WFTRA provides that this amendment is effective as if included in the provisions of the JCWAA.

Finally, the IRS and Treasury Department decided to add new examples to illustrate the above rules. Further, in Example 10 of §1.168(k)-1T(b)(4)(v), a commentator inquired whether the taxpayer (S) is considered to be self-constructing the property, acquiring the property, or both. The IRS and Treasury Department intended to have the taxpayer both self-constructing and acquiring the property. The final regulations make this clarification.

A commentator questioned whether the result in Example 10 of §1.168(k)-1T(b)(4)(v) also would apply if before September 11, 2001, a partnership began construction of a power plant for its own use, then after September 10, 2001, and before completion of the plant, there is a technical termination of the partnership under section 708(b)(1)(B), and then subsequently the new partnership incurred additional expenditures to complete the construction of the power plant and placed the power plant in service before January 1, 2005. Assuming the terminated partnership and the new partnership are not related parties, the new partnership is considered to have acquired the uncompleted power plant and completed the construction of the power plant and, thus, the result in Example 10 of §1.168(k)-1T(b)(4)(v) will apply to the new partnership in this case. While the additional first year depreciation deduction for Liberty Zone property requires the property to be acquired by purchase, the same result would apply because for purposes of that requirement, §1.1400L(b)-1T(c)(5)(ii) treats the new partnership as acquiring the property by purchase and the final regulations retain this rule.

The final regulations retain the rule contained in the temporary regulations providing, pursuant to section 168(k)(2)(A)(iv) and section 168(k)(4)(B)(iii), that qualified property or 50-percent bonus depreciation property is property that is placed in service by the taxpayer before January 1, 2005. The temporary regulations also provide that property described in section 168(k)(2)(B) (longer production period property) must be placed in service before January 1, 2006. The final regulations modify this extended placed-in-service date requirement in two respects. First, the final regulations reflect that the extended placed-in-service date of before January 1, 2006, also applies to property described in section 168(k)(2)(C) (certain aircraft), which was added to section 168(k) by section 336 of the AJCA. Second, the final regulations reflect that the extended placed-in-service date of before January 1, 2006, is extended for one year to before January 1, 2007, for property to which Announcement 2006-29, 2006-19 I.R.B. 879 applies. Announcement 2006-29 applies to property described in section 168(k)(2)(B) or (C) that is either placed in service by the taxpayer or manufactured by a person in the Gulf Opportunity (GO) Zone, the Rita GO Zone, or the Wilma GO Zone, provided the taxpayer was unable to meet the December 31, 2005, placed-in-service date deadline for such property as a result of Hurricane Katrina, Hurricane Rita, or Hurricane Wilma.

The final regulations retain the rules contained in the temporary regulations relating to qualified leasehold improvement property. The temporary regulations provide that qualified leasehold improvement property means any improvement, which is section 1250 property, to an interior portion of a building that is nonresidential real property if, among other things, the improvement is made under or pursuant to a lease by the lessee (or any sublessee) of the interior portion, or by the lessor of that interior portion. A commentator questioned whether this rule means an improvement that is permitted or required by a lease. The IRS and Treasury Department believe that the improvement must be made under or pursuant to a lease, regardless of whether the improvement is permitted or required under the lease.

The final regulations retain the rules contained in the temporary regulations for determining the amount of the additional first year depreciation deduction and otherwise allowable depreciation deduction. In addition, the final regulations clarify that the additional first year depreciation deduction generally is allowable in the first taxable year in which the qualified property or 50-percent bonus depreciation property is placed in service by the taxpayer for use in its trade or business or for the production of income.

With respect to the election not to claim the additional first year depreciation deduction, the final regulations retain the rules contained in the temporary regulations for making this election and for defining what is a class of property for purposes of the election. For any class of property that is qualified property, a taxpayer may elect out of the 30-percent additional first year depreciation deduction for any class of qualified property. For any class of property that is 50-percent bonus depreciation property, a taxpayer may elect either to deduct the 30-percent, instead of the 50-percent, additional first year depreciation or to deduct no additional first year depreciation. A commentator asked whether a taxpayer with 50-percent bonus depreciation property must make two elections to elect not to deduct any additional first year depreciation. The final regulations clarify that only one election is needed to elect not to deduct both the 30-percent and 50-percent additional first year depreciation for 50-percent bonus depreciation property.

If a taxpayer elects not to deduct any additional first year depreciation for a class of property, another commentator asked whether the depreciation adjustments under section 56 apply to property included in such class for purposes of computing the taxpayer’s alternative minimum taxable income. The non-applicability of the depreciation adjustments under section 56 provided by section 168(k)(2)(G) applies only to qualified property or 50-percent bonus depreciation property. If a taxpayer elects not to deduct any additional first year depreciation for a class of property, the property included in such class is not qualified property or 50-percent bonus depreciation property. Accordingly, the final regulations provide that if a taxpayer elects not to deduct any additional first year depreciation for a class of property, the depreciation adjustments under section 56 apply to that property for purposes of computing the taxpayer’s alternative minimum taxable income.

The final regulations also include the procedures provided by section 3.04 of Rev. Proc. 2002-33, 2002-1 C.B. 963, for revoking an election not to deduct the additional first year depreciation for a class of property. These procedures provide that this election is revocable only with the prior written consent of the Commissioner of Internal Revenue and, to seek the Commissioner’s consent, the taxpayer must submit a request for a letter ruling. However, the final regulations also provide an automatic 6-month extension from the due date of the taxpayer’s Federal tax return (excluding extensions) for the placed-in-service year to revoke the election, provided the taxpayer timely filed its Federal tax return for the placed-in-service year.

Generally, the requirements for determining the eligibility of property for the additional first year depreciation deduction for Liberty Zone property provided by section 1400L(b) are similar to the requirements for the 30-percent additional first year depreciation deduction for qualified property provided by section 168(k)(1) in the final regulations. The final regulations made several changes to the temporary regulations with respect to the Liberty Zone property, which are discussed below.

The final regulations retain the rule contained in the temporary regulations providing that Liberty Zone property includes the same property that is described as qualified property or 50-percent bonus depreciation property for purposes of section 168(k). In addition, Liberty Zone property includes nonresidential real property or residential rental property to the extent such property rehabilitates real property damaged, or replaces real property destroyed or condemned, as a result of the terrorist attacks of September 11, 2001. Real property is considered to have been destroyed or condemned only if an entire building or structure was destroyed or condemned as a result of the terrorist attacks of September 11, 2001. Property is treated as replacing destroyed or condemned property if, as part of an integrated plan, the property replaces real property that is included in a continuous area that includes real property destroyed or condemned. A commentator noted that the temporary regulations simply reiterate the statute but do not define the word continuous. The IRS and Treasury Department believe that the common meaning of continuous applies.

The temporary regulations define real property as a building or its structural components, or other tangible real property except: (1) property described in section 1245(a)(3)(B) (relating to depreciable property used as an integral part of a specified activity or as a specified facility); (2) property described in section 1245(a)(3)(D) (relating to a single purpose agricultural or horticultural structure); and (3) property described in section 1245(a)(3)(E) (relating to storage facility used in connection with the distribution of petroleum or any primary product of petroleum). A commentator suggested that these exclusions to the definition of real property should be deleted in the final regulations. As a result of this definition, nonresidential real property or residential rental property that rehabilitates or replaces any of the excluded properties that were damaged, destroyed, or condemned, is not eligible for the Liberty Zone additional first year depreciation deduction. For this reason, the IRS and Treasury Department agree. Accordingly, the final regulations provide that real property is a building or its structural components, or other tangible real property.

The temporary regulations provide that Liberty Zone property does not include property that is described as qualified property or 50-percent bonus depreciation property for purposes of section 168(k), or property that is described in §1.168(k)-1T(b)(2)(ii). The property described in §1.168(k)-1T(b)(2)(ii) is property that is: (1) described in section 168(f); (2) required to be depreciated under the alternative depreciation system; (3) included in any class of property for which the taxpayer elects out of the additional first year depreciation deduction under section 168(k); or (4) qualified Liberty Zone leasehold improvement property. Instead of providing a cross-reference to §1.168(k)-1(b)(2)(ii), the final regulations list the property that is described in §1.168(k)-1(b)(2)(ii) with one modification to the exclusion for property that is included in any class of property for which the taxpayer elects out of the additional first year depreciation deduction under section 168(k). In this regard, a commentator stated that while section 1400L(b)(2)(C)(iv) provides that the election out rules for purposes of section 1400L(b) are to be similar to the election out rules under section 168(k), section 1400L(b)(2)(C)(iv) does not mean that the same election must be made with respect to both sections 168(k) and 1400L(b). Accordingly, the commentator suggested that a taxpayer be permitted to elect not to apply section 168(k) to its property of a particular class of property to the extent that such property is not located within the Liberty Zone, while still being entitled to the benefits of section 1400L(b) for its property of the same class that is located within the Liberty Zone. The IRS and Treasury Department agree with this suggestion. Accordingly, the final regulations make clear that Liberty Zone property is not property included in any class of property for which the taxpayer elects out of the additional first year depreciation deduction under section 1400L(b).

The final regulations retain the rule contained in the temporary regulations providing that Liberty Zone property is property that is acquired by the taxpayer by purchase after September 10, 2001, but only if no written binding contract for the acquisition of the property was in effect before September 10, 2001. The term by purchase is defined in section 179(d) and §1.179-4(c). The final regulations also retain the rule contained in the temporary regulations providing that the new partnership resulting from a technical termination under section 708(b)(1)(B) or a transferee in section 168(i)(7) transactions is deemed to acquire the depreciable property by purchase. A commentator suggested that the rule should apply only if the old transferor partnership had itself acquired the property by purchase, as the mere existence of a technical termination does not provide sufficient reason to deem the statutory purchase requirement to have been met. The final regulations do not adopt this suggestion. The rule is the result of the rules provided in the temporary regulations regarding the additional first year depreciation deduction under sections 168(k) and 1400L(b) that allow the new partnership resulting from a technical termination to be entitled to the additional first year depreciation deduction for eligible property that was placed in service by the terminated partnership during the taxable year of termination. As a result, the IRS and Treasury Department determined that the rule should not be changed.

The final regulations also retain the rules contained in the temporary regulations for electing not to deduct the Liberty Zone additional first year depreciation deduction for a class of property. In addition, the final regulations for this election include provisions similar to those previously discussed relating to the alternative minimum tax and the revocation of the election with respect to the election not to deduct the additional first year depreciation deduction under section 168(k).

Similar to the temporary regulations, the final regulations provide special rules for the following situations: (1) qualified property, 50-percent bonus depreciation property, or Liberty Zone property placed in service and disposed of in the same taxable year; (2) redetermination of basis of qualified property, 50-percent bonus depreciation property, or Liberty Zone property; (3) recapture of additional first year depreciation for purposes of section 1245 and section 1250; (4) a certified pollution control facility that is qualified property, 50-percent bonus depreciation property, or Liberty Zone property; (5) like-kind exchanges and involuntary conversions of qualified property, 50-percent bonus depreciation property, or Liberty Zone property; (6) a change in use of qualified property, 50-percent bonus depreciation property, or Liberty Zone property; (7) the computation of earnings and profits; (8) the increase in the limitation of the amount of depreciation for passenger automobiles; and (9) the step-up in basis due to a section 754 election. For some of these situations, the final regulations modify or clarify the rules contained in the temporary regulations. In addition, the final regulations provide rules for two new situations: the rehabilitation credit under section 47 and the computation of depreciation for purposes of section 514(a)(3).

With respect to qualified property, 50-percent bonus depreciation property, or Liberty Zone property placed in service and disposed of in the same taxable year, the final regulations retain the rules contained in the temporary regulations. In general, the regulations provide that the additional first year depreciation deduction is not allowed. If qualified property or 50-percent bonus depreciation property is placed in service and disposed of by a taxpayer in the same taxable year and then, in a subsequent taxable year, is reacquired and again placed in service by the taxpayer, a commentator inquired whether the additional first year depreciation deduction is allowable in the subsequent taxable year. Because the property is used property in the subsequent taxable year, the additional first year depreciation deduction is not allowable for the property in the subsequent taxable year. Accordingly, in this situation, the final regulations clarify that the additional first year depreciation deduction is not allowable for the property in the subsequent taxable year.

The temporary regulations provide two exceptions to the general rule. First, the additional first year depreciation deduction is allowable for qualified property, 50-percent bonus depreciation property, or Liberty Zone property placed in service by a terminated partnership in the same taxable year in which a technical termination of the partnership occurs. In this case, the new partnership, and not the terminated partnership, claims the additional first year depreciation deduction. Second, the additional first year depreciation deduction is allowable for qualified property, 50-percent bonus depreciation property, or Liberty Zone property placed in service by a transferor in the same taxable year in which the property is transferred in a transaction described in section 168(i)(7). In this case, the additional first year depreciation deduction for the transferor’s taxable year in which the property is placed in service is allocated between the transferor and the transferee on a monthly basis. The allocation shall be made in accordance with the rules in §1.168(d)-1(b)(7)(ii) for allocating the depreciation deduction between the transferor and the transferee. If the transferee has a different taxable year than the transferor, a commentator questioned whether the allocation of the additional first year depreciation deduction would be made between the transferor and the transferee in accordance with the above rules. Because the allocation rules in §1.168(d)-1(b)(7)(ii) cover this situation, the IRS and Treasury Department did not modify the rule in the final regulations.

The final regulations also retain the rules contained in the temporary regulations with respect to a redetermination of basis of qualified property, 50-percent bonus depreciation property, or Liberty Zone property (for example, due to a contingent purchase price or a discharge of indebtedness). These rules apply to a redetermination of the unadjusted depreciable basis of the property occurring before January 1, 2005 (January 1, 2006, for the extended placed-in-service date property) for qualified property or 50-percent bonus depreciation property, or before January 1, 2007 (January 1, 2010, in the case of nonresidential real property and residential rental property) for Liberty Zone property. A commentator suggested that the rules should be expanded to include redeterminations of basis occurring on or after these dates. The commentator pointed out that the rule results in additional first year depreciation not being allowable for additional purchase price paid on or after January 1, 2005, with respect to qualified property or 50-percent bonus depreciation property acquired before 2005. The final regulations do not adopt this suggestion. While the current rule may be unfavorable when, for example, a redetermination of basis results in an increase of basis on or after January 1, 2005, for qualified property or 50-percent bonus depreciation property acquired before 2005, the current rule may be favorable when, for example, a redetermination of basis results in a decrease of basis on or after January 1, 2005, with respect to qualified property or 50-percent bonus depreciation property acquired before 2005. Further, the IRS and Treasury Department limited the rules to redeterminations occurring before the dates mentioned above to be consistent with the dates on which property must be placed in service to be eligible for the additional first year depreciation deduction. For this reason, the IRS and Treasury Department determined not to change the rule in the final regulations.

In the case of a redetermination of basis that results in a decrease in basis, a commentator noted that the operative rule provides that the taxpayer includes in the taxpayer’s income the excess additional first year depreciation deduction previously claimed for the qualified property, the 50-percent bonus depreciation property, or the Liberty Zone property but the example illustrating the application of this rule allows the taxpayer to reduce current year depreciation deductions by the amount of the excess additional first year depreciation deduction previously claimed for the qualified property, the 50-percent bonus depreciation property, or Liberty Zone property. Because the IRS and Treasury Department recognize that the lump-sum inclusion in income approach provided in the operative rule of the temporary regulation may adversely affect real estate investment trusts and similar entities, the final regulations provide that the excess additional first year depreciation deduction offsets the amount otherwise allowable for depreciation for the taxable year. Even if the amount of the offset exceeds the amount otherwise allowable for depreciation for the taxable year, the taxpayer takes into account a negative depreciation deduction in computing taxable income.

The final regulations retain the rule contained in the temporary regulations providing that, for purposes of the redetermination of basis rules: (1) an increase in basis occurs in the taxable year an amount is taken into account under section 461; and (2) a decrease in basis occurs in the taxable year an amount is taken into account under section 451. A commentator questioned whether because the event in question is giving rise to a basis adjustment, rather than to an item of income or deduction, it is appropriate for the rule to tie the timing of the adjustment to accounting method rules concerning the timing of income and deductions. The commentator also noted that one apparent effect of applying the accounting method rules is to override the basis reduction rule of section 1017(a) as illustrated in Example 2 of §1.168(k)-1T(f)(2)(iv). The IRS and Treasury Department did not intend to change the section 1017(a) rules. While the IRS and Treasury Department continue to believe that the current rule is appropriate, the final regulations have been modified for cases in which the Code, the regulations under the Code, or other published guidance expressly provides an exception to such rule (for example, section 1017(a)). Therefore, Example 2 of §1.168(k)-1(f)(2)(iv) in the final regulations reflects the basis adjustment rules of section 1017(a).

With respect to MACRS property or computer software acquired in a like-kind exchange under section 1031 or as a result of an involuntary conversion under section 1033, the final regulations change the rules contained in the temporary regulations (T.D. 9091 as amended by T.D. 9115) in several respects. First, the final regulations modify the scope of this provision to include property described in section 168(k)(2)(C) (certain aircraft), which was added to section 168(k) by section 336 of the AJCA, and to include property to which Announcement 2006-29, 2006-19 I.R.B. 879, applies if the time of replacement is after September 10, 2001, and before January 1, 2007. As previously noted, Announcement 2006-29 applies to property described in section 168(k)(2)(B) or (C) that is either placed in service by the taxpayer or manufactured by a person in the Gulf Opportunity (GO) Zone, the Rita GO Zone, or the Wilma GO Zone, provided the taxpayer was unable to meet the December 31, 2005, placed-in-service date deadline for such property as a result of Hurricane Katrina, Hurricane Rita, or Hurricane Wilma. Similar changes also are made to the paragraph relating to the computation of the additional first year depreciation deduction for MACRS property or computer software acquired in a like-kind exchange or as a result of an involuntary conversion.

A commentator inquired whether the rules should be expanded to include exchanged or involuntarily converted property that is subject to former section 168 (the accelerated cost recovery system or ACRS) or that is pre-1981 depreciation property. The current rules apply only to exchanged or involuntarily converted property that is MACRS property in order to conform with §1.168(i)-6T (relating to depreciation of property acquired in like-kind exchanges or as a result of involuntary conversions). Accordingly, the IRS and Treasury Department believe that this issue is outside the scope of these regulations and should be addressed when the temporary regulations under §1.168(i)-6T are finalized.

Second, the temporary regulations define the time of replacement as the later of when the acquired MACRS property or acquired computer software is placed in service, or the time of disposition of the exchanged or involuntarily converted property. A commentator expressed concern that in the case of an involuntary conversion under section 1033, the final regulations may confer an unintended benefit in the case of taxpayers who acquired property prior to September 11, 2001, in order to replace property that was ultimately requisitioned or condemned after September 10, 2001, but as to which the threat or imminence of condemnation existed prior to that date. The IRS and Treasury Department acknowledge that the rule confers a benefit under such circumstances, but continue to believe that the rule is appropriate. Additionally, the IRS and Treasury Department decided to provide rules in the final regulations to address how the additional first year depreciation deduction is treated when §1.168(i)-6T(d)(4) applies. Section 1.168(i)-6T(d)(4) applies when, in an involuntary conversion, a taxpayer acquires and places in service acquired MACRS property before the time of disposition of the involuntarily converted MACRS property. If the time of disposition of the involuntarily converted MACRS property is after December 31, 2004, or, in the case of property described in section 168(k)(2)(B) or (C), after December 31, 2005 (or after December 31, 2006, in the case of property described in section 168(k)(2)(B) or (C) to which Announcement 2006-29 applies), the final regulations provide that the time of replacement is when the acquired MACRS property is placed in service, provided the threat or imminence of requisition or condemnation of the converted property existed prior to January 1, 2005, or, in the case of property described in section 168(k)(2)(B) or (C), existed before January 1, 2006 (or existed before January 1, 2007, in the case of property described in section 168(k)(2)(B) or (C) to which Announcement 2006-29 applies). In this case, the final regulations also modify the income inclusion rule in §1.168(i)-6T(d)(4) to allow the additional first year depreciation deduction on the remaining carryover basis of the acquired MACRS property that is qualified property, 50-percent bonus depreciation property, or Liberty Zone property.

Third, the final regulations clarify the rules contained in the temporary regulations relating to the computation of the additional first year depreciation deduction for property described in section 168(k)(2)(B) (longer production period property) and for alternative minimum tax purposes. In both cases, the temporary regulations provide a cross-reference to §1.168(k)-1T(d) (computation of depreciation deduction for qualified property or 50-percent bonus depreciation property). A commentator suggested that the purpose of the reference to §1.168(k)-1T(d) should be clarified. The final regulations adopt this suggestion by deleting the cross-reference and providing rules for computing the additional first year depreciation deduction for property described in section 168(k)(2)(B) (longer production period property) and for alternative minimum tax purposes.

Also, a commentator questioned whether the rule that the additional first year depreciation is calculated separately with respect to the carryover basis and the excess basis is appropriate, and suggested that the rule should be simplified by eliminating the requirement of separate calculations. The IRS and Treasury Department believe that the rule is appropriate because it conforms with §1.168(i)-6T, which requires separate calculations of depreciation for the carryover basis and the excess basis.

Fourth, the final regulations clarify the rules contained in the temporary regulations relating to exchanged or involuntarily converted MACRS property or exchanged or involuntarily converted computer software that is placed in service and disposed of in an exchange or involuntary conversion in the same taxable year. In this case, the temporary regulations provide that the additional first year depreciation deduction is not allowable for the exchanged or involuntarily converted MACRS property or the exchanged or involuntarily converted computer software if the MACRS property or computer software is placed in service and disposed of in an exchange or involuntary conversion in the same taxable year. A commentator suggested that the final regulations clarify that the reference in the above rule to the MACRS property or computer software that is placed in service and disposed of in the same taxable year is the exchanged or involuntarily converted MACRS property or exchanged or involuntarily converted computer software. The final regulations adopt this suggestion.

Finally, a new example is added and the facts in several of the examples are clarified to reflect that the acquired property must be new property in order to meet the original use requirement and, therefore, qualify for the additional first year depreciation deduction.

The final regulations retain the rules contained in the temporary regulations providing when the use of qualified property, 50-percent bonus depreciation property, or Liberty Zone property changes in the hands of the same taxpayer during the placed-in-service year or a subsequent taxable year. One of these rules provide that if property is acquired by a taxpayer for personal use and, during a subsequent taxable year, is converted by the taxpayer from personal use to business or income-producing use, the additional first year depreciation deduction is allowable for the property in the taxable year the property is converted to business or income-producing use (assuming all the requirements for the additional first year depreciation deduction are met). Another rule provides that if depreciable property is not qualified property, 50-percent bonus depreciation property, or Liberty Zone property in the placed-in-service year, the additional first year depreciation deduction is not allowable for the property even if a change in the use of the property subsequent to the placed-in-service year results in the property being qualified property, 50-percent bonus depreciation property, or Liberty Zone property in the taxable year of the change in use. A commentator questioned whether these two rules are inconsistent. The commentator further noted that under §1.167(a)-11(e)(1)(i), property that is ready for use in a personal activity is considered to be placed in service. The IRS and Treasury Department do not believe that the two rules are inconsistent. Property is eligible for the additional first year depreciation deduction if in the first year in which the property is subject to depreciation, the property meets all the requirements to qualify for the additional first year depreciation deduction. In the case of property that changes from personal use to a business or income-producing use, the first year such property is subject to depreciation is the year of conversion to business or income-producing use. But in the case of property that changes from a depreciable use not eligible for the additional first year depreciation deduction to a depreciable use that is eligible for the additional first year depreciation deduction, such property did not meet the requirements to qualify for the additional first year depreciation deduction in the first year in which the property is subject to depreciation.

The final regulations retain the rule contained in the temporary regulations providing that the additional first year depreciation deduction is not allowable for purposes of computing earnings and profits. A commentator suggested that because this provision interprets section 312(k), the regulations under section 312 should include a cross-reference to the regulations under section 168(k). The IRS and Treasury Department agree and, accordingly, the final regulations adopt this suggestion.

The final regulations also retain the rules contained in the temporary regulations providing the increase in the limitation under section 280F(a)(1) of the amount of depreciation for certain passenger automobiles that are qualified property or 50-percent bonus depreciation property. A commentator had three inquiries about this increase in the limitation under section 280F(a)(1). First, the commentator asked whether the increase in the limitation can be taken as a section 179 expense. The increase in the limitation under section 280F(a)(1) that is provided in the final regulations may be taken as a section 179 expense. Second, the commentator asked whether the increase in the limitation of amount of depreciation for certain passenger automobiles needs to be prorated in a short taxable year. Because the additional first year depreciation deduction is not prorated for a short taxable year, the increase in the limitation under section 280F(a)(1) that is provided in the final regulations also is not prorated. Third, when calculating depreciation for an asset with less than 100 percent business use, the commentator asked whether the business use percentage is applied to the increase in the limitation of amount of depreciation for certain passenger automobiles. If a taxpayer’s business use of the automobile is less than 100 percent, the business use percentage is applied to the automobile’s depreciation deduction, including the additional first year depreciation deduction, for the taxable year. The IRS and Treasury Department believe that these issues are outside the scope of these regulations and, accordingly, the final regulations do not address these issues.

Finally, the final regulations retain the rules contained in the temporary regulations relating to any increase in basis of qualified property, 50-percent bonus depreciation property, or Liberty Zone property due to a section 754 election. Under these rules, such increase in basis generally is not eligible for the additional first year depreciation deduction. However, if qualified property, 50-percent bonus depreciation property, or Liberty Zone property is placed in service by a partnership in the taxable year the partnership terminates under section 708(b)(1)(B), any increase of basis of the qualified property, 50-percent bonus depreciation property, or Liberty Zone property due to a section 754 election is eligible for the additional first year depreciation deduction. A commentator requested that we expand this terminating partnership rule to any increase in basis due to a section 754 election that arises before or during the placed-in-service year of the property. The IRS and Treasury Department decided not to do so. The rule for a termination of a partnership under section 708(b)(1)(B) was made to be consistent with the special rule allowing the new partnership, instead of the terminated partnership, to claim the additional first year depreciation deduction for property placed in service during the taxable year of termination and contributed by the terminated partnership to a new partnership. The IRS and Treasury Department believe that these rules should not be expanded to cover any other situations.

A commentator also suggested that we clarify the regulation to provide that any increase in basis due to a section 754 election that arises before or during the year in which the qualified property, 50-percent bonus depreciation property, or Liberty Zone property is placed in service will be taken into account for the additional first year depreciation deduction. The IRS and Treasury Department did not adopt this suggestion in the final regulations. The additional first year depreciation deduction rules provide for the accelerated recovery of a taxpayer’s cost of qualified property, 50-percent bonus depreciation property, or Liberty Zone property. Many basis increases resulting from a section 754 election bear no relation whatsoever to the cost of qualified property, 50-percent bonus depreciation property, or Liberty Zone property. For example, if a partnership with a section 754 election in effect made a liquidating distribution of high-basis property to a partner with low basis in his partnership interest, the basis of the partnership’s undistributed property would be increased under section 734(b) by an amount equal to the decrease in basis to the distributed property under section 732(b). The amount of the section 734(b) basis increase allocable to qualified property under section 755 would have no correlation to the taxpayer’s cost of the property. The IRS and Treasury Department believe that the rules regarding any basis increase due to a section 754 election should remain limited to those provided in the temporary regulations.

Several commentators asked whether property that is qualified property, 50-percent bonus depreciation property, or Liberty Zone property qualifies for the rehabilitation credit under section 47. Section 47 allows a rehabilitation credit for qualified rehabilitation expenditures for certain buildings. Section 47(c)(2) defines the term qualified rehabilitation expenditure as meaning, in general, any amount properly chargeable to capital account for property for which depreciation is allowable under section 168 and that is nonresidential real property, residential rental property, real property that has a class life of more than 12.5 years, or an addition or improvement thereof. However, a qualified rehabilitation expenditure does not include any expenditure with respect to which the taxpayer does not use the straight line method over a recovery period determined under section 168(c) or (g). Because the additional first year depreciation deduction is not a straight line method, the IRS and Treasury Department have decided to provide in the final regulations that if qualified rehabilitation expenditures (as defined in section 47(c)(2) and §1.48-12(c)) are qualified property, 50-percent bonus depreciation property, or Liberty Zone property, the taxpayer may claim the additional first year depreciation deduction for the unadjusted depreciable basis of the qualified rehabilitation expenditures and may claim the rehabilitation credit (provided the requirements of section 47 are met) for the remaining basis of the qualified rehabilitation expenditures (unadjusted depreciable basis less the additional first year depreciation deduction allowed or allowable, whichever is greater) provided the taxpayer depreciates the remaining adjusted depreciable basis of such expenditures using the straight line method over a recovery period determined under section 168(c) or (g). The taxpayer may also claim the rehabilitation credit for the portion of the basis of the qualified rehabilitated building that is attributable to the qualified rehabilitation expenditures if the taxpayer elects not to deduct the additional first year depreciation for the class of property that includes the qualified rehabilitated expenditures.

Finally, a few commentators questioned whether a tax-exempt partner in a partnership that has debt-financed property may take advantage of the additional first year depreciation deduction. In computing under section 512 the unrelated business taxable income for any taxable year, section 514 provides the rules for determining the amount of unrelated business taxable income related to debt-financed property. Under section 514(a)(3), the deductions allowable with respect to each debt-financed property is the sum of the deductions under chapter 1 of the Code that are directly connected with the debt-financed property or the income therefrom, except that if the debt-financed property is depreciable property, the allowance must be computed only by use of the straight-line method. The final regulations provide that the additional first year depreciation deduction is not allowable for purposes of section 514(a)(3).

The IRS and Treasury Department intend to issue administrative guidance providing procedures for automatic consent for taxpayers that wish to seek a change in method of accounting to comply with these final regulations.

In general, the final regulations apply to qualified property or Liberty Zone property acquired by a taxpayer after September 10, 2001, and for 50-percent bonus depreciation property acquired by a taxpayer after May 5, 2003. Modifications to §1.168(k)-1(b)(3)(iii)(B) and (5)(ii)(B) relating to syndication and other lease transactions that provide a special rule for multiple units of property subject to the same lease apply to property sold after June 4, 2004.

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