Bonus depreciation was enacted by Congress’ Job Creation and Worker Assistance Act of 2002 as an additional first-year depreciation allowance that allows business taxpayers to deduct additional depreciation for the cost of qualifying business assets. According to the rules for bonus depreciation, by claiming this special depreciation allowance, businesses are allowed to write off a large percentage of the cost of a qualifying asset in the first year that the asset was purchased while the remaining cost of the asset is deducted over multiple years using regular depreciation until it phases out.
Electing to claim bonus depreciation is usually favorable for business owners seeking ways to minimize short-term tax liabilities. In 2017, the Tax Cuts and Jobs Act (TCJA) was passed, which made significant changes to the rules for bonus depreciation. In this article, we will discuss bonus depreciation rules and how this additional first-year depreciation allowance works.
What is bonus depreciation?
Bonus depreciation is an accelerated tax deduction that allows the deduction of a large percentage of the cost price of an eligible asset upfront in the first year that the asset was purchased. Claiming this special depreciation deduction reduces the taxable net income of a company which, in turn, reduces its tax liability.
Instead of allocating the cost of an asset over the depreciable life of the asset, Congress enacted bonus depreciation that allows the deduction of a large percentage of an eligible asset’s cost (or the entire cost) upfront. In order to claim this accelerated business tax deduction one has to purchase an eligible asset first and then put it into service prior to year-end. Then the calculated bonus depreciation is reported to the Internal Revenue Service on a Federal tax return through Form 4562.
The percentage of the cost of the asset is written off on Form 4562, which gets filed together with the business tax return. The taxpayer must calculate the amount of bonus depreciation and then report it under Part II, Line 14 on Form 4562. How to calculate the bonus depreciation is to first figure out the depreciable base of the property, which is gotten by subtracting any credits or deductions allocated to the property from the basis of the property. Then, to calculate bonus depreciation, multiply the bonus depreciation rate (e.g 50%, 100%, or 80%) by the cost of the business property and deduct the tax of the property from the cost of the property.
Rules for bonus depreciation
According to the bonus depreciation rules, not all properties are eligible for this tax incentive and the percentage of the cost of the eligible asset that can be deducted upfront varies by year. Before the 2017 Tax Cuts and Jobs Act (TCJA), the bonus depreciation percentage was 50% and the IRS limited it to a new property. However, with the passage of TCJA in 2017, the rules for bonus depreciation were amended as the law increased the bonus depreciation deduction for qualified property, from 50% to 100%. Also, the law now allows depreciation on used property, though the property must be ‘first use’ by the purchasing business.
According to the rules for bonus depreciation, for an asset to be eligible for any bonus depreciation percentage, the asset must be placed in service prior to the deadline. Placing an asset in service means making use of the asset in the business. This means that simply purchasing a qualified property prior to the deadline is not enough to claim bonus depreciation on the property; the property must be placed in service before the end of the tax year.
If the property is not placed in service before the end of the year, it will only qualify for the next year’s bonus percentage amount. For example, if a taxpayer purchases a property in December 2022, but doesn’t start using it until January 2023, before he can claim bonus depreciation on the property, he would have to wait until he files his 2023 tax return.
Bonus depreciation phase-out schedule
The new bonus depreciation rules for 100% deduction apply to property acquired and placed in service between Sept. 27, 2017, and Jan. 1, 2023. That is, under the current law, businesses can deduct 100% of the cost of a qualified property that is acquired and placed in service after September 27, 2017, and before January 1, 2023. However, starting January 1, 2023, this full bonus depreciation will decrease by 20% each year until it phases out. That is, in January 2023, the 100% bonus depreciation will expire and the current phase-out schedule extends to 2026 as shown in the bonus depreciation phase-out schedule chart below:
|Placed-in-service year||Bonus depreciation percentage for Qualified property in general/specified classes||Bonus depreciation percentage for Longer production period property and certain aircraft|
|Sept 28, 2017 – Dec 31, 2022||100%||100%|
|2028 and thereafter||None||None|
Bonus depreciation rules for qualifying assets
According to the rules for bonus depreciation, only certain business assets qualify for the tax incentive. They include depreciable assets with a recovery period of 20 years or less, such as furniture, computer software, vehicles, heavy machinery, water utility property, manufacturing equipment, and qualified film, television, or live theatrical productions. Also, ‘qualified improvement property’ which involves interior upgrades to buildings is likewise eligible for bonus depreciation.
The new bonus depreciation rules under the 2017 TCJA stipulate that:
- For an asset to be eligible for bonus depreciation, the taxpayer must not use the asset prior to acquisition.
- The asset must not be acquired by the taxpayer from a related party
- The asset should not be formerly owned by a component member of a controlled group of corporations.
- The taxpayer’s basis of the used property should not be figured in part or whole by reference to the adjusted basis of the property in the hands of the transferor or seller.
- The taxpayer’s basis of the used property should not be figured under the provision for deciding the basis of property acquired from a decedent.
Bonus depreciation rules for real property
When it comes to real estate, you can not take bonus depreciation on the actual rental property because they have a minimum depreciation period of 27.5 years. Hence, in real estate, this special depreciation deduction applies only to the improvements and personal property used within the property that has a useful life of fewer than 20 years.
Hence, one major way to utilize the value of bonus depreciation for rental property is to use a cost segregation study. This study is used by real estate investors to accurately categorize the components of the buildings into asset classes that have recovery periods of 20 years or less. Hence, making the assets eligible for bonus depreciation rather than the uneligible building. During a cost segregation study, teams of engineers, accountants, and building construction professionals identify and assign costs to the building elements that are eligible for cost recovery over shorter asset lives than that of real property.
Bonus depreciation rules for vehicles
In as much as vehicles qualify for this tax incentive, there are certain bonus depreciation rules for vehicles. Generally, business fleets or work vehicles with limited potential for personal use will qualify for bonus depreciation such as delivery vehicles, cargo vans, specialty vehicles like an ambulance or a hearse, and box trucks without passenger seats. The vehicles that are not considered business vehicles are those operated for hire (e.g taxis or transport vans) or those operated as equipment (e.g tractors).
For a vehicle to be eligible, it must be driven for at least 50% of business purposes. Vehicles eligible for bonus depreciation can be new or used and can be financed by the dealership or bank. or the first year, $10,200, plus an additional $8,000 in bonus depreciation is the maximum write-off for new and pre-owned (used) vehicles. The full 100% of the cost of a vehicle can be depreciated for SUVs with weights over 6,000 lbs but not heavier than 14,000 lbs, purchased after September 27, 2017. Nonetheless, the 100% will be phased down beginning in 2023.
Bonus depreciation rules on disqualified assets
According to the rules for bonus depreciation, there are certain kinds of assets that the IRS explicitly disqualifies from being able to claim bonus depreciation. That is, assets are not eligible for bonus depreciation if they are mainly used in the trade of the furnishing or sale of:
- Water, electrical energy, or sewage disposal services
- Gas or steam through a local distribution system
- Transportation of gas or steam by pipeline.
Such assets are excluded from qualifying assets if the rates for the furnishing or sale have to be approved by a local government, state or federal agency; an electric cooperative; or a public service or public utility commission. Also, any asset used in a trade that has had floor-plan financing indebtedness is not eligible for bonus depreciation under certain circumstances.