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How does bonus depreciation work?

How does bonus depreciation work? For taxpayers looking for how to minimize short-term tax liabilities, electing to take bonus depreciation is usually favorable. Though future-year liabilities may be higher as a result of having a lower amount of bonus depreciation to claim. Also, electing for this may create a net business loss that may be rolled over and carried to future years.

There are some situations that make more sense to elect out of the program rather than claim it. Therefore, it is best to consult your advisor to see whether it strategically makes sense to claim a bonus depreciation and whether you qualify for it. In this article, we will be discussing how bonus depreciation works and what you need to know about claiming it.

Related: Is Accumulated Depreciation an Expense?

Bonus depreciation explained

When a business develops or buys an asset, usually, the tax treatment for that asset is to spread the cost of the asset over its useful life. This is known as depreciation expense which in turn reduces a company’s net earnings. However, bonus depreciation is an accelerated business tax deduction that permits businesses to deduct a large percentage of an eligible asset’s purchase price upfront. This tends to reduce the income tax of a company and in turn, reduces the company’s tax liability.

How does bonus depreciation work?
How does bonus depreciation work?

The Congress’ Job Creation and Worker Assistance Act of 2002 enacted bonus depreciation as a temporary deduction to encourage businesses to invest and stimulate the economy after the 9/11 terrorist attacks. This is an additional first-year depreciation allowance that is intended to spur capital purchases by all business taxpayers. According to the Internal Revenue Service (IRS), bonus depreciation permits business taxpayers to deduct additional depreciation for the cost of qualifying business assets, beyond normal depreciation allowances.

This just simply means that businesses are allowed to write off a large percentage of the eligible asset’s cost in the first year that the asset was purchased. Then, over multiple years, the remaining cost can be deducted using regular depreciation until it phases out. Before the Tax Cuts and Jobs Act (TCJA), passed in 2017, the IRS limited bonus depreciation to new equipment. However, the 2017 TCJA made major changes to the rules on bonus depreciation as the law now permits depreciation on used equipment, though it must be ‘first use’ by the purchasing business.

Most significantly, the 2017 law doubled the bonus depreciation deduction for qualified property, as defined by the IRS, from 50% to 100%. It allows bonus depreciation to 100% for all qualified purchases made between September 27, 2017, and January 1, 2023. However, starting in 2023, bonus depreciation now ramps down to 80%, and will continue to ramp down for ensuing years; 2024 (60%), 2025 (40%), 2026 (20%), and 2027 (0%).

See also: Is accumulated depreciation a fixed asset?

How does bonus depreciation work?

Bonus depreciation works as an accelerated business tax deduction that reduces the taxable net income of a company and thus reduces its tax liability. That is, instead of allocating the cost over the life of an asset, Congress enacted rules that allow business taxpayers to deduct a fixed percentage of an eligible asset’s cost upfront. This works by first purchasing qualified business assets and then putting the asset into service prior to year-end, then bonus depreciation is reported to the IRS.

Bonus depreciation has been in existence for 20 years and over this time, the criteria for the eligible property and the bonus depreciation rate have changed. The legislation for the tax benefit has been extended several times and bonus depreciation is only applicable to certain business assets that meet the qualifying requirements. For instance, the property must have a maximum useful life of 20 years, to qualify and it can be used for either personal or business use.

So let’s take this example of how bonus depreciation works. Take for instance, you purchased new computer software in December 2022 for your business but didn’t put that software into service until January 2023. You would be required to wait until you filed your 2023 tax return to claim bonus depreciation on the software. Since the bonus depreciation phase-out begins in January 2023, your business would then be eligible for 80% bonus depreciation (and not 100%).

Bonus depreciation is more likely to assist a business in reducing its tax liability (especially when considering potential impacts on tax brackets), even though a business may eventually expense the same total amount over the asset’s life. For instance, deducting $10,000 over 10 years may not materially impact a business’s taxable income for each year, but deducting $100,000 in a single year may reduce the business’s highest marginal tax rate.

Nonetheless, if a taxpayer decides that it would be more advantageous to recognize depreciation over the life of the asset instead of using an accelerated method, he/she can elect not to deduct any special depreciation allowance. In order to make this election, the taxpayer must attach a statement to their tax return pointing out which class of property they wish to not make the election for. It is important to note that once this election has been made, the decision can not be revoked with the IRS’s consent.

How bonus depreciation works

  1. First, purchase qualified business property
  2. Put the property into service
  3. Then, claim bonus depreciation on your tax return

Purchase qualified business property

A taxpayer cannot claim bonus depreciation for a nonqualified business property. This means that if the business property is not qualified, claiming bonus depreciation does not work. A qualified business property would be a property that has a useful life of 20 years or less such as vehicles, machinery, equipment, furniture, and fixtures; land and buildings are excluded. In order to qualify for bonus depreciation, the asset has to be used for business at least 50% of the time.

The new rules and limitations for depreciation and expensing under the Tax Cuts and Jobs Act gave certain criteria that must be met in order to qualify for a bonus depreciation deduction. According to these rules, qualifying properties can include:

  • Depreciable computer software
  • MACRS (Modified Accelerated Cost Recovery System) property with a recovery period of 20 years or less such as office furniture and computer equipment
  • Water utility property
  • Used equipment that was not used by the taxpayer at any time prior to the acquisition
  • Qualified leasehold improvement property such as any improvement to the interior portion of a nonresidential building
  • Vacation property if being used by the taxpayer as a short-term rental
  • Costs of certain television, film, and live theatrical productions
  • Residential rental estate if the taxpayer conducts a cost segregation study
  • Vehicles with a useful life of 20 years or less.

Put the property into service

Placing a property in service means you have to start making use of the asset in your business. For instance, if you purchase a piece of equipment in December of 2022, but don’t start using it until January 2023, before you can claim bonus depreciation on the equipment, you would have to wait until you file your 2023 tax return.

The passage of the Tax Cuts and Jobs Act in 2017 enacted 100% bonus depreciation, thus, allowing businesses to immediately write off 100% of the cost of eligible property purchased and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Before the TCJA, it was usually 50%. Therefore, the new bonus depreciation rules apply to properties purchased and placed in service after Sept. 27, 2017, and before Jan. 1, 2023.

Thus, the 100% write-off of eligible property expired Jan 2023 and the current bonus depreciation phase-out schedule extends to 2026. Unless this changes, after Dec. 31, 2022, and before Jan. 1, 2027, the bonus percentage will decrease by 20 points each year for property placed in service. That is the phase-out schedule for subsequent years will be as:

The year the asset was placed In serviceBonus depreciation rate
2025 40%
2026 20%
2027 0%
Phase-out schedule of bonus depreciation

Claim bonus depreciation on your tax return

Bonus depreciation is reported on a Federal tax return through Form 4562 which is also used to report or claim other types of depreciation such as the Section 179 deduction. Hence, to claim bonus depreciation, you write off a percentage of the cost of an asset on Form 4562, which gets filed along with your business tax return. That is, make an election by filing a statement with IRS Form 4562, by the due date of the Federal tax return for the taxable year that the qualified property is put into service.

A taxpayer must calculate his or her own amount of bonus depreciation to recognize and report their special depreciation allowance under Part II, Line 14. In order to figure out the depreciable base of the asset, subtract any credits or deductions allocated to the property from the basis of the asset. There is special treatment for assets acquired in an involuntary conversion or like-kind exchange.

In order to calculate bonus depreciation, multiply the bonus depreciation rate (that is prevailing in the market) by the cost of the business asset. Then deduct the tax of the property from the cost of the asset. In order to understand how bonus depreciation works let’s look at an example:

Assume Jotscroll media company purchased $500,000 of office furniture on January 15, 2022, and placed them in service. This is qualified property because it has a recovery period of 20 years or less. To calculate the bonus depreciation:

Cost of asset $500,000 X 100% tax rate = $500,000

This means that, for 2022, Jotscroll media company is allowed a depreciation deduction of the entire $500,000. Furthermore, using the same facts and figures as the preceding example, let’s assume Jotscroll media company purchases and places the property in service on January 15, 2023. The bonus depreciation that can be claimed for this will differ from the first example because of the 80% bonus depreciation rate for the year 2023. Hence, calculating the bonus depreciation would be:

Cost of asset $500,000 X 80% tax rate = $400,000

This means a $400,000 bonus depreciation can be claimed.

Cost of asset $500,000 – $400,000 bonus depreciation = $100,000 depreciated value of the asset

Hence, the remaining $100,000 is depreciated under the general depreciation system, beginning in 2023 using the 200-percent declining balance method.

Read also: Adjusting Entry for Depreciation