What Is Bonus Depreciation?
Bonus depreciation is a tax incentive that allows a business to immediately deduct a large percentage of the purchase price of eligible assets, such as machinery, rather than write them off over the "useful life" of that asset. Bonus depreciation is also known as the additional first-year depreciation deduction.
- Bonus depreciation allows businesses to deduct a large percentage of the cost of eligible purchases the year they acquire them, rather than depreciating them over a period of years.
- It was created as a way to encourage investment by small businesses and stimulate the economy.
- Businesses should use IRS Form 4562 to record bonus depreciation as well as other types of depreciation and amortization.
- The rules and limits for bonus depreciation have changed over the years, and the latest ones are scheduled to expire in 2023.
- In 2022, bonus depreciation allows for 100% upfront deductibility of depreciation; this depreciates 20% in each subsequent year until its final year in 2026.
Understanding Bonus Depreciation
When a business buys or develops an asset, the tax treatment for that asset is traditionally to spread the cost of the asset over its useful life. This process is known as depreciation, and depreciation expense reduces a company's net earnings. With net earnings smaller, companies often incur smaller tax liabilities.
Bonus depreciation is an accelerated business tax deduction that lower's a company's taxable net income and thus reduces its tax liability. Instead of allocating the cost over the life of an asset, Congress enacted rules that allow businesses to deduct a fixed percentage of an eligible asset's cost upfront.
Although a company may ultimately expense the same total amount over the asset's life, bonus depreciation is more likely to assist a company in reducing its tax liability, especially when considering potential impacts to tax brackets. For example, deducting $10,000 over 10 years may not materially impact each year's taxable income, but deducting $100,000 in a single year may reduce a company's highest marginal tax rate.
The Tax Cuts and Jobs Act, passed in 2017, made major changes to the rules on bonus depreciation. Most significantly, it doubled the bonus depreciation deduction for qualified property, as defined by the IRS, from 50% to 100%. The 2017 law also extended the bonus to cover used property under certain conditions.
History of Bonus Depreciation
Bonus depreciation recently celebrated its 20th year in existence. Over time, the criteria for eligible property as well as the bonus depreciation rate has changed, and the legislation for the tax benefit has been extended several times. Below is a very high-level summary of the legislation associated with bonus depreciation.
|Bonus Depreciation, A Brief History|
|Job Creation and Worker Assistance Act (2002)||- Introduced bonus depreciation
- Let companies deduct 30% of the cost of eligible assets before the standard depreciation method was applied
|Jobs and Growth Tax Relief Reconciliation Act (2003)||- Increased the bonus depreciation rate to 50%|
|Economic Stimulus Act (2008)||- Maintained the bonus depreciation rate to 50%, extended the program|
|Protecting Americans from Tax Hikes (2015)||- Extended the program through 2019
- Included a phase-out of the bonus depreciation rate after 2017
|Tax Cuts and Jobs Act (2017)||- Raised the bonus depreciate rate to 100%
- Extended the program through 2026
Qualifying Assets for Bonus Depreciation
Bonus depreciation is only applicable to certain business assets that meet qualification requirements. Property must have a maximum useful life of 20 years, and it can be used for either business or personal use.
Under the Tax Cuts and Jobs Act, the taxpayer revisions to the eligibility also stipulate that:
- The asset was not used by the taxpayer prior to acquisition.
- The asset was not acquired by a related party to the taxpayer.
- The asset was not formerly owned by a component member of a controlled group of corporations.
- The asset's basis is not figured in reference to the adjusted basis of the property when under ownership of the seller.
- The asset's basis is not figured in reference to a basis acquired from a decedent.
Recent revisions also explicitly call out assets previously not eligible for bonus depreciation but now allowable. For example, the IRS explicitly calls out qualified film, television, or theater property acquired and placed in service after Sept. 27, 2017.
The IRS explicitly disqualifies certain types of assets from being able to claim bonus depreciation. Under new bonus depreciation rules, assets are not eligible if they are:
- Primarily used in the trade of furnishing or sale of electrical energy, water, or sewage disposal services.
- Primarily used in the trade of furnishing or the sale of gas or steam through distributed systems.
- Primarily used in the trade of furnishing or the sale of gas or steam by pipeline.
- Used in a trade or business that has had floor-plan financing indebtedness under certain circumstances.
- Qualified improvement property such as leasehold improvements acquired after Dec. 31, 2017.
There are specific tax consultants specialized in bonus depreciation (or other depreciation-related tax deductions). For the most up-to-date and relevant information, consult one of these advisors.
How to Report Bonus Depreciation
Bonus depreciation is reported on a Federal tax return through Form 4562 (Depreciation and Amortization (Including Information on Listed Property). This form is also used to report or claim other types of depreciation such as the Section 179 deduction. Taxpayers must calculate their own amount of bonus depreciation to recognize and report their "special depreciation allowance" under Part II, Line 14.
To figure the depreciable base of the asset, the taxpayer should subtract any credits or deductions allocated to the property from the basis of the asset. Special treatment exists for assets acquired in a like-kind exchange or involuntary conversion.
If taxpayers decide it would be more advantageous to recognize depreciation over the life of the asset instead of using an accelerated method, the taxpayer can elect not to deduct any special depreciation allowance. To make this election, the taxpayer must attach a statement to their tax return indicating which class of property they wish to not make the election for. Once the election has been made, the decision can not be revoked with the IRS's consent.
If a taxpayer disposes of property in which they claimed a special depreciation deduction for, the taxpayer if often required to recognized as ordinary income a recaptured amount.
Bonus Depreciation Schedule and Phase Out
The new bonus depreciation rules apply to property acquired and placed in service after Sept. 27, 2017 and before Jan. 1, 2023. In January 2023, the current provision will expire. However, the current bonus depreciation phase out schedule extends to 2026.
|Bonus Depreciation, Phase-Out Schedule|
|Year the Asset was Placed In Service||Bonus Depreciation Rate|
Bonus Depreciation vs. Section 179
Two common tax benefits regarding depreciation are bonus depreciation and Section 179 deductions. Section 179 allows taxpayers to recognize depreciation expense on qualifying property when its used more than 50% of the time for business. It allows business owners to deduct a set dollar amount of new business assets that have been put in place during the current tax year.
Broadly speaking, Section 179 rules are often more flexible with timing than bonus depreciation rules. Under Section 179, the taxpayer can elect to save certain assets for future tax breaks or claim only a portion of the cost and defer the other portion for a future tax year. With bonus depreciation, the amount of depreciation allowable is strictly defined.
However, bonus depreciation may apply to higher spending amounts. Bonus depreciation is not capped in regards to dollars; an entire multi-million deduction for the entire cost of a single may be recognized in a single year. On the other hand, Section 179 deductions were limited to $1,080,000 for 2022 (based on $2,700,000 capital equipment spend).
Each program has specific criteria that make it more or less appealing to certain taxpayers. Some real estate improvements do not qualify for bonus depreciation but do quality for Section 179 treatment. On the other hand, bonus depreciation can exceed business income, while Section 179 deductions are limited to annual business income. It is also possible to claim both bonus depreciation and Section 179 deductions in the same tax year.
What Are the Benefits of Bonus Depreciation?
Bonus depreciation allows a taxpayer to reduce their short-term taxable income by the cost of depreciable assets. Bonus depreciation allows a taxpayer to deduct 100% of depreciation upfront on their Federal tax return. This accelerated depreciation method means a company may pay substantially fewer taxes in the tax year in which they claim bonus depreciation.
Do Vehicles Qualify for Bonus Depreciation?
Yes, businesses can deduct and depreciate 100% of the cost of vehicle or truck under bonus depreciation rules. Note that this will be different than Section 179 rules; though a vehicle or truck is often a qualifying asset, it will be subject to a deduction up to a specific dollar amount.
Should I Take Bonus Depreciation?
Electing to take bonus depreciation is often favorable for taxpayers seeking to minimize short-term tax liabilities. Though future year liabilities may be higher due to having a lower amount of bonus depreciation to claim, this may also create a net business loss that may be rolled over and carried to future years. There may be situations that make more sense to elect out of the program; for more information, consult your advisor to see whether you qualify for bonus depreciation and whether it strategically makes sense to claim.
What Assets Qualify for Bonus Depreciation?
To be eligible for bonus depreciation, eligible property must be MACRS property with a useful life of 20 years or less, certain depreciable computer software, or qualifying leasehold improvement property. In addition, new criteria limits how the asset was acquired or how the basis is to be calculated.
The Bottom Line
Bonus depreciation is a tax incentive for taxpayers who incur capital expenditures or spend money on certain depreciable assets. These taxpayers can elect to deduct 100% of the asset's depreciation in the current tax year, although the allowable amount of depreciation is scheduled to decrease each of the next five years. Bonus depreciation allows a higher but less controllable depreciable tax strategy compared to Section 179 deductions.
Internal Revenue Service. "New Rules and Limitations for Depreciation and Expensing Under the Tax Cuts and Jobs Act."
Internal Revenue Service. "Instructions for Form 4562."
United States Congress. "Public Law 115-97 - Dec. 22, 2017," Page 53.