The Tax Cuts and Jobs Act (TCJA) significantly boosted the potential value of bonus depreciation for taxpayers — but only for a limited duration. The amount of first-year depreciation available as a so-called bonus will begin to drop from 100% after 2022 and businesses should plan accordingly.
Bonus depreciation in a nutshell
Bonus depreciation has been available in varying amounts for some time. For example, immediately prior to the passage of the TCJA, taxpayers generally could claim a depreciation deduction for 50% of the purchase price of qualified property in the first year — as opposed to deducting smaller amounts over the useful life of the property under the modified accelerated cost recovery system (MACRS).
The TCJA expanded the deduction to 100% in the year qualified property is placed in service through 2022, with the amount dropping each subsequent year by 20%, until bonus depreciation sunsets in 2027, unless Congress acts to extend it. Special rules apply to property with longer recovery periods.
Businesses can take advantage of the deduction by purchasing, among other things, property with a useful life of 20 years or less. That includes computer systems, software, certain vehicles, machinery, equipment and office furniture.
Both new and used property can qualify. Used property generally qualifies if it was not:
- Used by the taxpayer or a predecessor before acquiring it;
- Acquired from a related party; and
- Acquired as part of a tax-free transaction.
Qualified improvement property (generally, interior improvements to nonresidential property, excluding elevators, escalators, interior structural framework and building expansion) also qualify for bonus depreciation. A drafting error in the TCJA indicated otherwise, but the CARES Act, enacted in 2020, retroactively made such property eligible for bonus depreciation. Taxpayers that placed qualified improvement property in service in 2018, 2019 or 2020 may, generally, now claim any related deductions not claimed then — subject to certain restrictions.
Buildings themselves are not eligible for bonus depreciation, with their useful life of 27.5 (residential) or 39 (commercial) years — but cost segregation studies can help businesses identify components that might be. These studies identify parts of real property that are actually tangible personal property. Such property has shorter depreciation recovery periods and therefore qualifies for bonus depreciation in the year placed in service.
The placed-in-service requirement is particularly critical for those wishing to claim 100% bonus depreciation before the maximum deduction amount falls to 80% in 2023. With the continuing shipping delays and shortages in labor, materials and supplies, taxpayers should place their orders promptly to increase the odds of being able to deploy qualifying property in their businesses before year-end.
Note, too, that bonus depreciation is automatically applied by the IRS unless a taxpayer opts out. Elections apply to all qualified property in the same class of property that is placed in service in the same tax year (for example, all five-year MACRS property).
Bonus depreciation versus Section 179 expensing
Taxpayers sometimes confuse bonus depreciation with Sec. 179 expensing. The two tax breaks are similar, but distinct.
Like bonus deprecation, Sec. 179 allows a taxpayer to deduct 100% of the purchase price of new and used eligible assets. Eligible assets include software, computer and office equipment, certain vehicles and machinery, as well as qualified improvement property.
But Sec. 179 is subject to some limits that do not apply to bonus depreciation. For example, the maximum allowable deduction for 2022 is $1.08 million.
In addition, the deduction is intended to benefit small- and medium-sized businesses so it begins phasing out on a dollar-for-dollar basis when qualifying property purchases exceed $2.7 million. In other words, the deduction is not available if the cost of Sec. 179 property placed in service this year is $3.78 million or more.
The Sec. 179 deduction is also limited by the amount of a business’ taxable income; applying the deduction cannot create 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.
Also in contrast to bonus depreciation, the Sec. 179 deduction is not automatic. You must claim it on a property-by-property basis.
At first glance, bonus depreciation can seem like a no-brainer. However, it is not necessarily advisable in every situation.
For example, taxpayers who claim the qualified business income (QBI) deduction for pass-through businesses could find that bonus depreciation backfires. The amount of your QBI deduction is limited by your taxable income and bonus depreciation will reduce this income. Like bonus depreciation, the QBI deduction is scheduled to expire in 2026, so you might want to maximize it before then.
The QBI deduction is not the only tax break that depends on taxable income. Increasing your depreciation deduction could also affect the value of expiring net operating losses and charitable contribution and credit carryforwards.
And deduction acceleration strategies should always take into account tax bracket expectations going forward. The value of any deduction is higher when you are subject to higher tax rates. For example, newer businesses that currently have relatively low incomes might prefer to spread out depreciation. With bonus depreciation, though, you will also need to account for the coming declines in the maximum deduction amounts.
Buy now, decide later
If you plan on purchasing bonus depreciation qualifying property, it may be wise to do so and place it in service before year end to maximize your options. ORBA can help you chart the most advantageous course of action based on your specific circumstances and the upcoming changes in tax law.