Bonus Depreciation

What is a 'Bonus Depreciation'

A bonus depreciation is a tax incentive that allows a business to immediately deduct a large percentage of the purchase price of eligible business assets. This type of incentive is offered either as an additional incentive or as a measure of relief for small- to medium-sized businesses that want to buy additional equipment.

BREAKING DOWN 'Bonus Depreciation'

When individuals make purchases, the cost of the transaction is usually reflected immediately on their financial statements. Business purchases, however, are recorded differently on their financial transactions. When a business makes an acquisition, such as the purchase of machinery, the transaction cost is spread out across the useful life of that asset. This process is known as depreciation, and works in company’s favor. If depreciation is not applied, a company’s financial statement would show large losses for the period during which it made purchases and acquisitions.

To allow businesses to recover the cost of capital acquisitions more quickly in order to stimulate the economy, Congress introduced the bonus depreciation in 2002 through the Job Creation and Worker Assistance Act. The bonus depreciation allowed companies to deduct 30% of the cost of eligible assets before standard depreciation method is applied. To be eligible for this bonus depreciation, assets had to be purchased between September 10, 2001 and September 11, 2004, although most depreciable assets were eligible.

The 2003 Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) increased the bonus depreciation rate to 50% for property originally used after May 3, 2003 and placed in service before January 1, 2005. Placing an asset in service means that the asset is functionally and actively used in the operations of a business. The 50% depreciation incentive was introduced again through the 2008 Economic Stimulus Act for property acquired after December 31, 2007. The 2015 Protecting Americans from Tax Hikes (PATH) Act extended this program through 2019 for business owners, but included a phase-out of the bonus depreciation rate after 2017.

Under PATH, businesses are allowed to deduct their capital expenses by 50% for 2015, 2016, and 2017. The rate is then scheduled to drop to 40% in 2018 and 30% in 2019. After 2019, the tax incentive is expected to expire unless Congress approves another extension.

A business can claim bonus depreciation on only assets that are new and originally used by the company. This means that an asset that has been used previously but newly acquired by a company would not be eligible for the bonus depreciation since it is not new and a previous user most likely already claimed depreciation on the equipment. In addition, property used mostly outside the United States or tax-exempt property would not qualify for the extra depreciation.

The bonus depreciation is applied to capital expenses by multiplying the bonus depreciation rate by the cost basis of the acquired asset. The resulting figure is the business’ accelerated first year bonus depreciation deductible. The remaining portion of the cost basis is then depreciated normally. If the company is eligible for a Section 179 deduction, it must be claimed before applying the bonus and standard depreciation rate. Similar to the bonus depreciation, Section 179 of the IRS Code was enacted to allow small businesses take a depreciation deduction for capital assets in one year up to a maximum limit of $500,000.

Bonus Depreciation Example

A business who purchased machinery for $1.2 million and placed it in service during the year will apply the bonus depreciation in the following manner (assuming a 35% corporate tax rate):

Total Cost of Machinery

$1,200,000

Less Section 179 Deductible

     500,000 (maximum)

Subtotal

$   700,000

Less Bonus Depreciation (50% x 700,000)

     350,000

Depreciable Basis

$   350,000

Standard Depreciation (20% x 350,000)

       70,000

 

 

Total First Year Depreciation Expense (500,000 + 350,000 + 70,000)

$   920,000

Less Tax Expense (35% x 920,000)

     322,000

After-Tax Cost of Machinery (1,200,000 – 322,000)

$   878,000

Bonus depreciation is always taken right away, in the first year that the depreciable item is placed in service. The actual amount of bonus depreciation varies from year to year. The bonus depreciation cannot be taken on property that is required to use the Alternative Depreciation Schedule (ADS), but it is exempt from alternative minimum tax (AMT) adjustments. Bonus depreciation is classified as a Section 1245 depreciation deduction when disposing of an asset, and is subject to recapture as ordinary income.

IRS Form 4562 is used to record bonus depreciation and other forms of depreciation and amortization applied by a company.