Bonus depreciation, or a 168(k) allowance, is a tax incentive for businesses that accelerates asset depreciation. That way, you don’t need to write off assets over their useful life.
It was previously announced that bonus depreciation would be phased out by 2027. However, a recent bipartisan bill called the Tax Relief Act for American Families and Workers Act of 2024 announced the possible extension of 100% bonus depreciation. This would be effective retroactively from 1 January 2023, and extend until December 31, 2025.
Despite this, bonus depreciation for the 2023 tax year is set at 80% and is dropping by 20% for 2024.
That’s why businesses making use of the incentive must carefully plan their asset purchases, and work the phase-out into tax planning strategies.
Understanding Bonus Depreciation
Bonus depreciation is sometimes called the additional first-year depreciation deduction of assets, and was introduced under the Tax Cuts and Jobs Act (TCJA) in 2017. In a nutshell, it allows you to write off a percentage of an asset’s cost in the year it was purchased, while the remaining cost is deducted over several years until the scheme is phased out. This helps you to reduce your company’s income tax and tax liability.
Qualifying assets include:
- Modified Accelerated Cost Recovery System (MACRS) property with a recovery period of 20 years or less, including office furniture and computer equipment.
- Depreciable computer software.
- Some improvements to the property.
- Certain film, television, and theater costs.
- Vacation property used as a short-term rental, such as an Airbnb.
- Residential rental estate (if you’ve conducted a cost-segregation study).
- Vehicles with a useful life of 20 years or less.
- Used equipment that you did not use before purchase.
How bonus depreciation works
There are three main steps to take for bonus depreciation.
- Purchase a qualifying asset.
- Place the property in service (start using your asset).
- Claim bonus depreciation on your tax return, on Form 4562.
While it was possible to write off 100% of these asset costs in 2022, from 2023 onwards, this amount will be reduced by 20% annually. As such, the schedule is as follows:
- 2023: 80%
- 2024: 60%
- 2025: 40%
- 2026: 20%
- 2027: 0%
However, this may change if Congress enacts new tax law amendments before then, such as the bipartisan bill mentioned earlier.
It’s also worth noting that the qualifying amount of depreciation also depends on the rules in place for that tax year.
There are also certain restrictions around eligible assets. For example, qualified property does not include providing utility services whose rates are controlled by a government entity or public utility commission. Property used in a property trade is also not eligible. Additionally, assets must be owned and not leased to be eligible.
How bonus depreciation compares to Section 179 deductions
Like bonus depreciation, Section 179 also allows for immediate expense deductions. However, there are several differences between the two schemes, especially with regard to limitations.
Bonus depreciation allows you to deduct a percentage of an asset’s cost, with no annual limits on the amount. There are also no income limits for using the scheme, meaning that you can use it to create a net loss.
Section 179, on the other hand, only allows for deductions of a set dollar amount. These deductions also have annual limitations. In 2022, the maximum limit was $1 080 000. In 2023, the limit is $1 160 000. Importantly, such deductions are also limited to your annual taxable income, so you can’t deduct more than you’ve made.
The Role of Bonus Depreciation in Tax Planning
By allowing your company to make immediate deductions, bonus depreciation helps you pay less tax. By reducing taxable income, the scheme also lowers your corporate tax liability.
For example, if your company purchased a $50 000 piece of machinery that it will use over a decade, standard depreciation would enable you to deduct $5000 a year. With the current corporate tax rate of 21%, that deduction would be 21% of $5000, or $1050 over ten years.
Under bonus depreciation, depending on the year of purchase and the current state of the phase-out plan, you would be able to deduct a much higher percentage, in a single deduction. By lowering your taxable income, you can free up more cash to reinvest in your business and grow.
Timing your asset purchases is crucial here. The incentive’s phase-out provides an incentive to invest in property and expand operations before 2027. When planning your budgets and tax strategy, you can therefore focus on larger purchases to make the most of budget depreciation before it is phased out.
By making a provision for depreciation during tax planning, you can also ensure more accurate financial statements and planning.
Strategic Asset Management and Depreciation
While the value of fixed assets depreciates over time, they should still deliver a return on investment (ROI). With bonus depreciation, you can boost the ROI on your assets. After all, calculating ROI on fixed assets involves dividing the net profit generated by the asset by the total cost of the asset.
For that reason, bonus depreciation is an attractive option for businesses that want to make capital investments. However, you’ll need to make sure that you know exactly which assets qualify, as well as how to calculate the deduction to make the most of its benefits.
As mentioned above, the phase-out of bonus depreciation means that timing your purchases correctly is essential. If you know you’ll have a year of good profits, consider making significant asset acquisitions in that year to offset the increased tax liability.
To use this incentive for property, it’s vital to conduct cost-segregation studies. Segregating and classifying your costs will help you to identify components of a building that could be depreciated even faster.
Potential pitfalls that could affect your planning
Bonus depreciation can limit your ability to make future deductions. It is also subject to recapture. If you sell the asset, you may be required to recapture any benefits you received. This can affect your long-term planning and acquisitions, as well as future tax liability.
Also, depending on the type of asset you need to purchase, you may get a better tax result by claiming a Section 179 deduction rather than under bonus depreciation.
Finally, bonus depreciation may have an impact on your state taxes. While many states follow the federal bonus depreciation rules, some do not, while others disallow the scheme altogether.
Before deciding on whether to expense under bonus depreciation, speak to a CPA about best practices for your business.
Balancing Bonus Depreciation with Other Tax Deductions and Credits
Bonus depreciation does not have to be used in isolation. It can be used with other strategies, including Section 179 expensing, in the same year. Despite the limitations of Section 179, this scheme can offer greater flexibility, as you can choose which assets you want to deduct, and how much of those assets to cover.
For example, your business could use Section 179 up to its annual limit, and apply Bonus Depreciation to remaining asset costs.
However, the size of your business can affect which option is best for you. Because Section 179 has an investment limit and is tied to taxable income, it is an attractive option for many small businesses. Alternatively, bonus depreciation is often more appealing to large corporations with significant asset purchases or investments.
When it comes to using bonus depreciation with other deductions or credits, it’s a simple matter of what’s best for your company. Despite Section 179’s flexibility, its limitations can impact your planning. On the other hand, bonus depreciation may force you to “waste” depreciation that you could have benefited from in the future.
Future-Proofing Tax Strategies
Tax laws change constantly. For example, in the future, there may be future amendments that could extend bonus depreciation, or new schemes to offer other benefits. For this reason, it’s important to make the most of such incentives while you can. But your tax planning should also be flexible and adaptable.
One of the best ways to do this is through financial forecasting. By using historical data and trends to try and predict what could happen in the future, your business can plan for potential changes and uncertainty.
Ideally, your financial forecast should include:
- Historical results weighed against conditions at the time.
- A projected outlook.
- Consideration for any external risks.
- A list of possible internal risks.
- A best-case revenue scenario.
- A worst-case revenue scenario.
Seeking Professional Advice
With the help of an accountant or tax attorney, you can undertake tax planning that not only accounts for aspects like bonus depreciation and how best to use it, but ensures compliance with any tax regulations.
Such professionals come with extensive expertise and experience, allowing you to maximize any benefits while minimizing potential penalties and oversights. By identifying opportunities and risks, tax professionals can help your business save money, and establish efficient financial management.
For assistance with your tax planning, and to maximize the benefits of tax incentives like bonus depreciation, schedule a Discovery Call with one of our CPAs.
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