Bonus Depreciation

Bonus depreciation is a significant tax incentive that allows businesses to immediately deduct a substantial percentage of the purchase price of qualified assets, like machinery and equipment. Unlike traditional depreciation, which spreads out the deduction over the asset’s useful life, bonus depreciation accelerates the benefit, giving businesses a larger deduction in the first year. This glossary item will delve into bonus depreciation—how it works, what qualifies, and how it stacks up against Section 179 deductions.

What Is Bonus Depreciation?

Bonus depreciation, also known as the additional first-year depreciation deduction, was designed to encourage investment in business assets. The tax benefit allows businesses to deduct a large percentage of the asset’s cost in the year it is placed in service, instead of writing off the value gradually over several years through standard depreciation methods.

Originally introduced in 2002, bonus depreciation has evolved through various tax reforms. The most significant changes occurred with the Tax Cuts and Jobs Act (TCJA) in 2017, which allowed businesses to immediately deduct 100% of the cost of qualifying assets acquired and placed in service between September 27, 2017, and December 31, 2022. Following 2022, the bonus depreciation phase out commenced, with the allowable deduction percentage decreasing incrementally each year.

How Does Bonus Depreciation Work?

Bonus depreciation works by allowing businesses to deduct a large portion of the cost of qualified assets in the year they are placed into service, instead of spreading the deduction over the asset’s useful life. For example, if a business purchases equipment worth $1,000,000, it can deduct a significant percentage of that amount as bonus depreciation in the first year, depending on the applicable bonus depreciation rate.

In the context of the bonus depreciation phaseout, the percentage of the deduction decreases each year. For assets placed in service after 2022, businesses can expect the following phaseout schedule:

• 2022: 100%
• 2023: 80%
• 2024: 60%
• 2025: 40%
• 2026: 20%
• 2027: 0%

This allows businesses to benefit from larger immediate deductions in the earlier years, thus providing substantial tax relief in the short term. As the bonus depreciation rate declines over time, businesses may need to rely more on traditional depreciation or other tax incentives like Section 179.

What Qualifies for Bonus Depreciation?

To qualify for bonus depreciation, an asset must meet specific eligibility criteria, including the following:

• Tangible Property: Assets such as machinery, equipment, and furniture that are depreciated under the Modified Accelerated Cost Recovery System (MACRS) with a useful life of 20 years or less.
• Computer Software: Certain types of computer software can also qualify for bonus depreciation.
• Water Utility Property: This includes assets used by water utilities.
• Qualified Leasehold Improvement Property: Improvements made to nonresidential buildings after a certain date.
• Vehicles: Vehicles with a useful life of 20 years or less can also be eligible for bonus depreciation, but there are limits on the amount that can be deducted for certain types of vehicles.

In addition, the asset must be new to the taxpayer, meaning it cannot have been used by the business before its acquisition. For used property to qualify, it must meet certain conditions outlined by the IRS.

One example of an asset that qualifies for bonus depreciation real estate is a commercial property used for business purposes. If the business conducts a cost-segregation study, certain components of the property, such as specialized equipment or certain improvements, can qualify for accelerated depreciation under the bonus depreciation rules.

Bonus Depreciation vs. Section 179 Deduction

While both bonus depreciation and the Section 179 deduction allow businesses to deduct the cost of qualifying property in the year it is placed in service, they differ in several important ways.

• Section 179 Deduction: Section 179 allows businesses to deduct the cost of qualifying assets up to a set annual limit. For tax years starting in 2023, businesses can deduct up to $1,160,000 for the purchase of qualifying property. However, this deduction phases out once the total cost of eligible property purchased exceeds $2,890,000.
• Bonus Depreciation: Bonus depreciation, on the other hand, allows businesses to deduct a larger percentage of the asset’s cost in the first year with no dollar cap. Unlike Section 179, which is limited by the business’s taxable income, bonus depreciation can create a net operating loss (NOL) that may be carried forward to future years.

In practice, businesses may use both Section 179 and bonus depreciation in the same tax year to maximize their tax savings. For example, a business could take a Section 179 deduction on equipment up to the annual limit and then use bonus depreciation to write off the remaining cost of the asset.

Bonus Depreciation Extension: Will It Happen Again?

The bonus depreciation extension is a topic of ongoing discussion, particularly as the bonus depreciation phaseout continues. The TCJA initially allowed businesses to deduct 100% of qualifying assets placed in service through 2022. However, as the phaseout begins, many are wondering whether lawmakers will extend this benefit.

In 2022, the bonus depreciation deduction was 100%, but for assets placed in service after December 31, 2022, the deduction dropped to 80% and will continue to decrease each year through 2027. With this planned phaseout, some businesses and industry groups are lobbying for an extension or even a return to 100% deductions.

Given the current political landscape and the impact of bonus depreciation on stimulating business investment, there is a possibility that lawmakers could pass a new extension or make further adjustments to the current rules. However, as of now, the phaseout is expected to proceed as planned, with the full elimination of the bonus depreciation deduction set for 2027.