3. Claiming the Special Depreciation Allowance (or Liberty Zone Depreciation Allowance)

Introduction

You can take the special depreciation allowance to recover part of the cost of qualified property placed in service during the tax year. Similarly, you can take the special Liberty Zone depreciation allowance for qualified Liberty Zone property placed in service during the tax year. An allowance applies for the year you place the property in service. It is an additional 30% deduction you can take after any section 179 deduction and before you figure regular depreciation under MACRS for the year you place the property in service.

You cannot claim the special Liberty Zone depreciation allowance for property eligible for the special depreciation allowance explained later under What Is Qualified Property. Qualified property is eligible for only one special depreciation allowance.

This chapter explains what is qualified property and what is qualified Liberty Zone property. It also covers the rules common to both the special depreciation allowance and the special Liberty Zone depreciation allowance regarding how to figure an allowance, how to elect not to claim it, and when and how to recapture it.

Useful Items You may want to see:

Form (and Instructions)

• 4562   Depreciation and Amortization

See chapter 7 for information about getting publications and forms.

What Is Qualified Property?

• Business/investment use
• Improvement
• Nonresidential real property
• Placed in service
• Structural components

You can take the special depreciation allowance for qualified property. Your property is qualified property if it meets the following requirements.

1. It is new property of one of the following types.
   1. Property depreciated under the modified accelerated cost recovery system (MACRS) with a recovery period of 20 years or less. Generally, every type of property except real property has a recovery period of 20 years or less. In addition, MACRS is used to depreciate most property. However, the following property cannot be depreciated under MACRS.
      1. Property you placed in service before 1987.
      2. Certain property owned or used in 1986.
      3. Intangible property.
      4. Films, video tapes, and recordings.
      5. Certain corporate or partnership property acquired in a nontaxable transfer.
      6. Property you elected to exclude from MACRS.

      Each type of property listed above is described in chapter 1 under Can You Use MACRS To Depreciate Your Property.

   2. Water utility property, which is either of the following.
      1. Property that is an integral part of the gathering, treatment, or commercial distribution of water, and that, without regard to this provision, would be 20-year property.
      2. Any municipal sewer.
   3. Computer software that is not a section 197 intangible, which is software that is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified. (The cost of some computer software is treated as part of the cost of hardware and is depreciated under MACRS.)
   4. Qualified leasehold improvement property (defined later).
2. It is property that meets the following tests (explained later under Tests To Be Met).
   1. Acquisition date test.
   2. Placed in service date test.
   3. Original use test.
3. It is not excepted property (explained later under Excepted Property).

Qualified leasehold improvement property.   Generally, this is any improvement to an interior part of a building that is nonresidential real property, provided all the following requirements are met.

• The improvement is made under or pursuant to a lease by the lessee (or any sublessee) or the lessor of that part of the building.
• That part of the building is to be occupied exclusively by the lessee (or any sublessee) of that part.
• The improvement is placed in service more than 3 years after the date the building was first placed in service.

However, a qualified leasehold improvement does not include any improvement for which the expenditure is attributable to any of the following.

• The enlargement of the building.
• Any elevator or escalator.
• Any structural component benefiting a common area.
• The internal structural framework of the building.

Generally, a binding commitment to enter into a lease is treated as a lease and the parties to the commitment are treated as the lessor and lessee. However, a binding commitment between related persons is not treated as a lease.

Related persons.   For this purpose, the following are related persons.

1. Members of an affiliated group.
2. An individual and a member of his or her family, including only a spouse, child, parent, brother, sister, half-brother, half-sister, ancestor, and lineal descendant.
3. A corporation and an individual who directly or indirectly owns 80% or more of the value of the outstanding stock of that corporation.
4. Two corporations that are members of the same controlled group.
5. A trust fiduciary and a corporation if 80% or more of the value of the outstanding stock is directly or indirectly owned by or for the trust or grantor of the trust.
6. The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
7. The fiduciaries of two different trusts, and the fiduciaries and beneficiaries of two different trusts, if the same person is the grantor of both trusts.
8. Certain educational and charitable organizations and any person (or, if that person is an individual, a member of that person's family) who directly or indirectly controls the organization.
9. Two S corporations, and an S corporation and a regular corporation, if the same persons own 80% or more of the value of the outstanding stock of each corporation.
10. A corporation and a partnership if the same persons own both of the following.
    1. 80% or more of the value of the outstanding stock of the corporation.
    2. 80% or more of the capital or profits interest in the partnership.
11. The executor and beneficiary of any estate.

Tests To Be Met

To be qualified property, the property must meet all of the following tests.

Acquisition date test.   Generally, you must have acquired the property either:

• After September 10, 2001, and before September 11, 2004, but only if no written binding contract for the acquisition was in effect before September 11, 2001, or
• Pursuant to a written binding contract entered into after September 10, 2001, and before September 11, 2004.

Property you manufacture, construct, or produce for your own use meets this test if you began the manufacture, construction, or production of the property after September 10, 2001, and before September 11, 2004.

Placed in service date test.   Generally, the property must be placed in service for use in your trade or business or for the production of income after September 10, 2001, and before January 1, 2005.

If you sold property you placed in service after September 10, 2001, and you leased it back within 3 months after the property was originally placed in service, the property is treated as placed in service no earlier than the date it is used under the leaseback.

Original use test.   The original use of the property must have begun with you after September 10, 2001. Original use means the first use to which the property is put, whether or not by you. Additional capital expenditures you incurred after September 10, 2001, to recondition or rebuild your property meet the original use test.

Excepted Property

Qualified property does not include any of the following.

• Property used by any person before September 11, 2001.
• Property required to be depreciated using ADS. This includes listed property used 50% or less in a qualified business use.
• Qualified New York Liberty Zone leasehold improvement property (defined next).

Qualified New York Liberty Zone leasehold improvement property.   This is any qualified leasehold improvement property (as defined earlier) if all the following requirements are met.

• The improvement is to a building located in the New York Liberty Zone (Liberty Zone).
• The improvement is placed in service after September 10, 2001, and before January 1, 2007.
• No written binding contract for the improvement was in effect before September 11, 2001.

Area defined.   The New York Liberty Zone is the area located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with East Broadway) in the Borough of Manhattan in the City of New York, New York.

What Is Qualified Liberty Zone Property?

• Business/investment use
• Nonresidential real property
• Placed in service
• Residential rental property
• Structural components

You can take the special Liberty Zone depreciation allowance for qualified Liberty Zone property. Your property is qualified Liberty Zone property if it meets the following requirements.

1. It is one of the following types of property.
   1. Used property depreciated under the modified accelerated cost recovery system (MACRS) with a recovery period of 20 years or less. Generally, every type of property except real property has a recovery period of 20 years or less. In addition, MACRS is used to depreciate most property. However, the following property cannot be depreciated under MACRS.
      1. Property you placed in service before 1987.
      2. Certain property owned or used in 1986.
      3. Intangible property.
      4. Films, video tapes, and recordings.
      5. Certain corporate or partnership property acquired in a nontaxable transfer.
      6. Property you elected to exclude from MACRS.

      Each type of property listed above is described in chapter 1 under Can You Use MACRS To Depreciate Your Property.

   2. Used water utility property, which is either of the following.
      1. Property that is an integral part of the gathering, treatment, or commercial distribution of water, and that, without regard to this provision, would be 20-year property.
      2. Any municipal sewer.
   3. Used computer software that is not a section 197 intangible, which is software that is readily available for purchase by the general public, is subject to a nonexclusive license, and has not been substantially modified. (The cost of some computer software is treated as part of the cost of hardware and is depreciated under MACRS.)
   4. Certain nonresidential real property and residential rental property (defined next).
2. It is property that meets the following tests (explained later under Tests To Be Met).
   1. Acquisition date test.
   2. Placed in service date test.
   3. Substantial use test.
   4. Original use test.
3. It is not excepted property (explained later under Excepted Property).

Nonresidential real property and residential rental property.   This property is qualifying Liberty Zone property only to the extent it rehabilitates real property damaged, or replaces real property destroyed or condemned, as a result of the terrorist attack of September 11, 2001. Property is treated as replacing destroyed or condemned property if, as part of an integrated plan, such property replaces real property included in a continuous area that includes real property destroyed or condemned.

For these purposes, real property is considered destroyed (or condemned) only if an entire building or structure was destroyed (or condemned) as a result of the terrorist attack. Otherwise, the property is considered damaged real property. For example, if certain structural components of a building (such as walls, floors, or plumbing fixtures) are damaged or destroyed as a result of the terrorist attack, but the building is not destroyed (or condemned), then only costs related to replacing the damaged or destroyed structural components qualify for the special Liberty Zone depreciation allowance.

Tests To Be Met

To be qualified Liberty Zone property, the property must meet all of the following tests.

Acquisition date test.   You must have acquired the property by purchase after September 10, 2001, and there must not have been a binding written contract for the acquisition in effect before September 11, 2001.

For information on the acquisition of property by purchase, see Property Acquired by Purchase in chapter 2.

Property you manufacture, construct, or produce for your own use meets this test if you began the manufacture, construction, or production of the property after September 10, 2001.

Placed in service date test.   Generally, the property must be placed in service for use in your trade or business or for the production of income before January 1, 2007 (January 1, 2010, in the case of qualifying nonresidential real property and residential rental property).

If you sold property you placed in service after September 10, 2001, and you leased it back within 3 months after the property was originally placed in service, the property is treated as placed in service no earlier than the date it is used under the leaseback.

Substantial use test.   Substantially all use of the property must be in the Liberty Zone and in the active conduct of your trade or business in the Liberty Zone.

Original use test.   The original use of the property in the Liberty Zone must have begun with you after September 10, 2001.

Used property can be qualified Liberty Zone property if it has not previously been used within the Liberty Zone. Also, additional capital expenditures you incurred after September 10, 2001, to recondition or rebuild your property meet the original use test if the original use of the property in the Liberty Zone began with you.

Excepted Property

Qualified Liberty Zone property does not include any of the following.

• Any other property that also qualifies for the special depreciation allowance, explained earlier under What Is Qualified Property.
• Property required to be depreciated using ADS. This includes listed property used 50% or less in a qualified business use.
• Qualified New York Liberty Zone leasehold improvement property (see Qualified New York Liberty Zone leasehold improvement property, earlier, in the discussion on excepted property under What Is Qualified Property?).

How Much Can You Deduct?

• Adjusted basis
• Basis
• Placed in service

The special depreciation allowance (or Liberty Zone depreciation allowance) for qualified property (or Liberty Zone property) is an additional deduction of 30% of the property's depreciable basis.

You can take the full amount of a special depreciation allowance (or Liberty Zone depreciation allowance) if you place qualified property (or Liberty Zone property) in service in a short tax year.

Depreciable basis.   This is the property's cost or other basis multiplied by the percentage of business/investment use and then reduced by the following items.

• Any section 179 deduction taken with respect to the property.
• Any deduction for removal of barriers to the disabled and the elderly with respect to the property.
• Any investment credit, disabled access credit, or enhanced oil recovery credit with respect to the property.

For information about how to determine the cost or other basis of property, see What Is the Basis of Your Depreciable Property? in chapter 1. For a discussion of business/investment use, see Partial business or investment use under Property Used in Your Business or Income-Producing Activity in chapter 1.

Depreciating the remaining cost.   After you figure your special depreciation allowance (or Liberty Zone depreciation allowance) for your qualified property (or Liberty Zone property), you can use the remaining cost to figure your regular MACRS depreciation deduction (discussed in chapter 4). In the year you claim the allowance (generally the year you place the property in service), you must reduce the depreciable basis of the property by the allowance before figuring your regular MACRS depreciation deduction.

Example 1.   On November 1, 2002, Tom Brown bought and placed in service in his business qualified property that cost $100,000. He did not elect to claim a section 179 deduction. He can deduct 30% of the cost ($30,000) as a special depreciation allowance for 2002. He uses the remaining $70,000 of cost to figure his regular MACRS depreciation deduction for 2002 and later years.

Example 2.   The facts are the same as in Example 1, except that Tom chooses to deduct $24,000 of the property's cost as a section 179 deduction. He uses the remaining $76,000 of cost to figure his special depreciation allowance of $22,800 ($76,000 × 30%). He uses the remaining $53,200 of cost to figure his regular MACRS depreciation deduction for 2002 and later years.

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