Bonus depreciation and Internal Revenue Code (IRC) Section 179 expensing are tools that allow certain businesses to deduct at least a portion of an asset’s cost in the year placed in service. There is considerable overlap between the property eligible for bonus depreciation and Section 179 allowances, so businesses should understand the similarities and differences between the two capital cost recovery opportunities. That said, while available to a wide range of taxpayers and applicable to various assets, the full benefits of both opportunities are only available for a limited duration and will be scaled back starting Jan. 1, 2023.
Breaking Down Bonus Depreciation Under IRC Section 168
Bonus depreciation generally allows an additional first-year depreciation deduction with respect to qualifying property acquired and placed in service during the tax year. For some time now, bonus depreciation has been available to business taxpayers in varying amounts. Before the 2017 passage of the Tax Cuts and Jobs Act (TCJA), business owners could claim a depreciation deduction for 50% of the purchase price of qualified property in the first year placed in service rather than deducting the qualified property’s cost over its useful life. Following the passage of the TCJA, the bonus depreciation deduction expanded to 100% in the year qualified property is placed in service through 2022, with the deduction percentage decreasing by 20% each year through 2026 (e.g., 80% for property placed in service in 2023, 60% for property placed in service in 2024, etc.). Unless Congress acts to extend this depreciation benefit, bonus depreciation is set to expire on Jan. 1, 2027.
Businesses can claim the bonus depreciation deduction when purchasing certain qualified property, which generally includes property with a useful life of 20 years or less, such as computer systems, software, certain vehicles, machinery, equipment, and office furniture. Qualified improvement property — interior improvements to the nonresidential property, excluding elevators, escalators, interior structural framework, and building expansion — is also eligible for bonus depreciation. Buildings themselves are not eligible for bonus depreciation, but qualifying property within a purchased building that is identified as tangible personal property would qualify for bonus depreciation in the year the property is placed in service. Detailed cost segregation studies can be completed to help identify the qualified property as part of an improvement project or acquisition. Certain exclusions from the qualified property include listed property used 50% or less for business purposes, certain intangibles, and any property primarily used in the trade or business of a rate-regulated utility.
With the maximum deduction amount phasing down to 80% in 2023, the placed-in-service requirement is crucial for business owners seeking to claim 100% bonus depreciation. With continued supply chain issues, shipping delays, and shortages in labor, materials, and supplies, business owners should place their orders promptly to increase the odds of deploying qualifying property in their businesses before year-end. It is important to note that bonus depreciation is automatically applied by the Internal Revenue Service unless a business owner opts out of the deduction.
Demystifying IRC Section 179 Expensing
Business owners commonly confuse bonus depreciation with IRC Section 179 expensing. IRC Section 179 allows a taxpayer to deduct currently, rather than depreciate, the total cost of new and used qualified depreciable assets bought and placed in service during the year. However, an important distinction between the two tools is the annual deduction limit placed on IRC Section 179 expensing.
Because the deduction is intended to benefit small to mid-sized businesses, the maximum allowable deduction for 2022 is $1.08 million. Further, once the business spends more than $2,700,000 on equipment, the available deduction begins to decrease. Essentially, the deduction is unavailable if the cost of eligible IRC Section 179 property placed in service is greater than $3.78 million. These deduction limits are adjusted annually.
Eligible assets for IRC Section 179 expensing are generally similar to those eligible for bonus depreciation, and include, amongst other items, software, computer equipment, office furniture, office equipment, vehicles, machinery, and qualified improvement property. However, IRC Section 179 allows a taxpayer to identify specific assets to deduct in this manner, while bonus depreciation must be claimed uniformly for all assets in a particular asset class.
Choosing Between Bonus Depreciation and IRC Section 179 Expensing
Often, the same business property qualifies for bonus depreciation and IRC Section 179 expensing. In such cases, a business owner may choose one over the other, or may in some circumstances claim both to maximize their deductions.
In addition to the annual deduction limitation and asset flexibility discussed previously, bonus depreciation differs from IRC Section 179 expensing in other notable ways. First, bonus depreciation is not limited to the extent a taxpayer has business income and therefore can create a net loss for a given year, whereas IRC Section 179 expensing is limited to the extent of a taxpayer’s income and any unclaimed deduction may still be carried forward to future tax years. Second, while most property is qualified for purposes of either provision, certain property may qualify for bonus depreciation but not IRC Section 179 expensing, and vice versa.
Buy Now, Deduct Later
Bonus depreciation and IRC Section 179 expensing provide business owners opportunities to manage their tax burden following the purchase of qualified assets. With certain of these benefits scaling back in the near term, a takeaway for business owners is to invest now to provide the option and ability to maximize their deductions. Additionally, in certain circumstances, taxpayers may benefit from electing to forego 100% first-year bonus depreciation and depreciate qualifying assets under a longer period of time (e.g., to avoid a net operating loss carryforward that could be subject to additional limitations on use in a future year).
Business owners should consult with their accountants and tax counsel when analyzing whether assets purchased qualify for these deduction tools and when electing which — if any — deduction to take on their upcoming tax returns.