Bonus Depreciation: A Definitive Guide
Taxes can be taxing, but there are certain tax incentives that can allow business owners to deduct certain things from their overall taxable income. That’s where bonus depreciation comes into play.
What exactly is bonus depreciation, and how does it work? Read on as we take a closer look at this tax incentive and how it can help your business.
Table of Contents
- Bonus depreciation is a useful tax-saving measure for businesses.
- It was created as a way to encourage investment by small businesses and to stimulate the economy.
- Businesses need to use IRS Form 4562 to record bonus depreciation.
What Is Bonus Depreciation?
Bonus depreciation is a tax incentive. It allows a business to segregate cost and identify portions of real property that are separate tangible personal properties subject to shorter depreciable recovery periods. Some of these properties may also qualify for additional first-year depreciation, which is known as “bonus” depreciation.
In order to qualify for bonus depreciation, the original use of the property must begin with the taxpayer and the property must be:
- MACRS property with a recovery period of 20 years or less
- Depreciable computer software
- Water utility property, or
- Qualified leasehold improvement property.
Certain acquisition requirements and placed in service dates must also be met in order to qualify for bonus depreciation.
Businesses can use IRS Form 4562 in order to record bonus depreciation. This form is also used to record other types of depreciation and amortization.
How Does Bonus Depreciation Work?
When a business makes a purchase, for tax accounting purposes, the cost is normally spread out over the useful life of the asset. This is a process known as depreciation which can tend to work in favor of the company. Bonus depreciation can be calculated by taking the bonus depreciation rate and multiplying it by the cost basis of the acquired asset. This would be the initial cost.
An example is when a business acquires machinery, the cost is not normally recognized in the year it’s been purchased, but instead spread across its useful life (e.g. 5 years). So a portion of the purchase price is expensed in each year of its useful life.
From an accounting perspective, that makes sense as it represents a company’s real financial situation. However, from a tax perspective, businesses would prefer to not use depreciation. That’s because if depreciation is not applied, then the company’s taxable income could be reduced more in the year of purchase, and it can harvest immediate financial benefit by paying less tax.
In 2017, the Tax Cuts and Jobs Act was passed. This made large changes to the rules regarding bonus depreciation. One of the significant changes was that the bonus depreciation deduction for qualified property doubled (50% to 100%). This law also extended the bonus in order to cover used property, though this had to be under certain conditions. This was mainly applied to property that was bought new instead of used.
The new rules for bonus depreciation apply to property acquired and placed in service after September 27, 2017, and before January 1, 2023. At this time, the provision will expire unless Congress renews it.
In 2023, the rate for bonus depreciation will stand at 80%. This will continue to go down by 20% until 2026 when it will reach 20%. This is under the assumption that Congress doesn’t change the law before 2026. Any property that was acquired before September 27, 2017, remained subject to the previous rules.
Qualifications and Restrictions to Use Bonus Depreciation
In order to be qualified to use bonus depreciation, the asset must be first used in the year in which the first depreciation deduction was claimed. Only certain types of assets can be eligible for bonus depreciation. These types are as follows:
- Modified accelerated cost recovery system (MACRS) property with a recovery period of 20 years or less
- Depreciable computer software
- Water utility property
- Qualified leasehold improvement property
Certain assets are specifically excluded from being eligible for a bonus depreciation deduction. This includes equipment that is used to build capital improvements, certain intangible assets, and assets that are disposed of in the year they were purchased.
Some assets must be used for business use 50%+ of the time in order to qualify for bonus depreciation. These assets are known as listed property. This includes autos and other properties that can be used for both business and personal use. Although things such as computers or laptops are no longer considered listed property.
Bonus depreciation is a useful tax incentive and a valuable tax-saving tool that businesses can use to reduce their pre-tax income. It was created to allow small businesses to invest and then claim a bonus depreciation expense. This, therefore, stimulates the economy. The rules and limits for bonus depreciation are ever-evolving and changing, with the latest set of rules due to expire in 2023.
Bonus Depreciation FAQs
Under depreciation laws, the standard taxpayer must claim bonus depreciation. This is unless an election is made. Commonly, any taxpayer that fails to claim bonus depreciation has to file an accounting method change.
It is possible to deduct any amount of bonus depreciation. If the deduction creates a net operating loss, then you can carry that amount back. This would be in order to offset the previous year’s income. You can either claim regular depreciation, or you can also carry any unused loss forward to deduct against any future income.
Special depreciation is an extra allowance. With this, you can deduct 100% of the depreciation in the first year an asset has depreciated under the MACRS method. This rule can be applied to property with a useful life of up to 20 years, if it was placed in service before January 1, 2023.
Section 179 allows business owners to deduct a set dollar of new business assets, while bonus depreciation allows you to deduct a percentage of the cost. So while these two terms are similar, they in fact mean separate things.
Bonus depreciation can be taken whether or not you are profitable or not. This allows bonus depreciation to be used to create a larger taxable loss for your business tax return. This is in direct contrast to Section 179 which doesn’t allow you to create a larger loss.
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