Bonus Depreciation: What It Is, How It Works, and When It Starts to Phase Out
Bonus depreciation is a valuable tax break designed to encourage businesses to make capital purchases. The Tax Cuts and Jobs Act of 2017 (TCJA) increased the value of bonus depreciation, but only temporarily. To make the most of it, you need to act quickly. Here’s what you need to know to do that.
Is bonus depreciation new?
Sec. 168(k) depreciation, commonly known as “bonus depreciation,” wasn’t created by the TCJA; it’s been available in different degrees for a while. Before the TCJA, for example, eligible businesses could claim a depreciation deduction equal to 50% of the purchase price of qualified property in its first year of service.
Without bonus depreciation, you generally would be limited to deducting smaller amounts over the property’s useful life for tax purposes under the modified accelerated cost recovery system (MACRS). The useful life for most business assets is three to 20 years. (The useful life is longer for residential rental property and nonresidential real estate)
How did the TCJA change bonus depreciation?
The TCJA expanded the deduction to 100% in the year qualified property is placed in service through 2022. The percentage amount falls by 20% each year after 2022, zeroing out in 2027 unless Congress takes action to extend it.
What types of property qualify?
You can claim the deduction for property with a useful life of 20 years or less—including certain vehicles, machinery, equipment, office furniture, computer systems, and software. The deduction is also available for “qualified improvement property” (QIP), meaning interior improvements to nonresidential property. QIP does not include elevators, escalators, interior structural framework, or building expansion.
Note: A text error in the TCJA seemed to suggest that QIP wasn’t eligible for bonus depreciation, but the Coronavirus Aid, Relief, and Economic Security (CARES) Act passed in 2020 made clear that it is indeed eligible. If you placed QIP in service in 2018 or 2019, you might qualify for a tax refund for bonus depreciation you didn’t claim in those years.
Does used property qualify?
Yes. You generally can claim bonus depreciation on used property that wasn’t:
- Used by you or a predecessor any time before acquiring it,
- Acquired from a related party, or
- Acquired as part of a tax-free transaction.
Can I claim bonus depreciation on a building?
Buildings have useful lives of 27.5 (residential) or 39 (commercial) years, so they aren’t eligible.
Note: While a building as a whole is ineligible, it could contain multiple components that do qualify for bonus depreciation. If you purchase a new or used building, you may want to have a cost segregation study done to determine the components of the building that are eligible for bonus depreciation in the year placed in service. Otherwise, you’ll have to depreciate them over a much longer period.
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Why do I need to act promptly to maximize bonus depreciation?
The maximum 100 percent bonus depreciation is only available for eligible property placed in service before 2023. According to the Internal Revenue Code, property is placed in service when it’s first put in a condition or state of readiness and availability for a specifically assigned function.
Let’s say you buy a used vehicle for your business on November 1, 2022, but it needs a repair before you can use it. If the repair isn’t completed until January 2, 2023, you can’t claim the bonus depreciation deduction until the 2023 tax year. At that point, you can deduct only 80 percent of the cost.
Normally, you might be able to wait until later in the year to purchase eligible property and still have time to place it in service before the new year. But, depending on the type of property, you could face shortages and shipping delays these days, so it’s best to get those orders in now.
What about Sec. 179 depreciation? Is that the same thing?
No. They’re similar, but technically, Sec. 179 isn’t a depreciation deduction. It allows you to treat qualified depreciable property as a deductible expense rather than a capital purchase that is depreciated over time.
Like bonus depreciation, Sec. 179 lets you deduct 100 percent of the purchase price of new and used eligible assets. Eligible assets include software, computer and office equipment, certain vehicles and machinery, and QIP. But there are some big differences.
- Sec. 179 is subject to some limits that don’t apply to bonus depreciation. The maximum allowable deduction for 2022 is $1.08 million, for example.
- The IRS limits Sec. 179 to small and medium businesses. The deduction begins phasing out on a dollar-for-dollar basis when your qualifying property purchases exceed $2.7 million. That means you can’t claim the Sec. 179 deduction at all once you place property that costs $3.78 million or more in service in a tax year.
- The Sec. 179 deduction is limited by the amount of your taxable income You can’t claim a deduction if it results in a loss for the business. Any cost not deductible in the first year can be carried over to the next year for an unlimited number of years, though. Or you could claim the excess as bonus depreciation in the first year. For example, a new business might spend $50,000 on qualifying property but only have $40,000 in income for the year it’s placed in service. It could deduct $40,000 under Sec. 179 and the remaining $10,000 as bonus depreciation. It also could deduct that $10,000 under MACRS.
- The Sec. 179 deduction isn’t automatic. It has to be claimed for each piece of qualifying property.
How do I claim bonus depreciation?
By contrast, the IRS automatically applies bonus depreciation to eligible property unless you elect out. If you elect out, the election will apply to all qualified assets in the same class of property placed in service in the same tax year (for example, all seven-year MACRS property).
Why might I want to elect out of bonus depreciation?
Bonus depreciation seems like a great deal, but it can have consequences that might mean it’s not the best choice for your circumstances.
For example, do you claim the qualified business income deduction (QBI, also known as the pass-through or Sec. 199A deduction)? If so, bear in mind that the amount of your deduction is limited by your taxable income—and bonus depreciation will reduce your taxable income. With the QBI scheduled to expire after 2026 (again, absent congressional action), it might make more sense to maximize it in the meantime.
You also need to think about your tax bracket when you consider accelerating deductions—do you expect to be in a higher tax bracket in the future? Tax deductions are worth more when you’re at a higher tax rate.
If you’re in the 24 percent tax bracket, for example, a $1,000 deduction is worth $240 ($1,000 x 24 percent). But, if you’re in the 32 percent tax bracket, the same deduction is worth $320 ($1,000 x 32 percent).
You’d be wise to consult with a CPA—but do so quickly if you’re mulling purchases that would qualify for bonus depreciation.