The bonus or special depreciation allowance is one of several business tax breaks introduced or expanded under recent tax bills. Normally, you write off the cost of a business asset by depreciating it over several years. Currently, the special depreciation allowance lets businesses deduct the entire purchase price of some assets in the first year of use.
TL;DR (Too Long; Didn't Read)
The special depreciation allowance allows you to claim 50% or 100% of the cost of buying a qualifying asset in the first year you use it for business. The allowance for bonus depreciation is set to shrink to 20% by 2026.
Depreciation and Taxes
You can write off some purchases, such as printer paper or gas for your truck, as a business expense. That doesn't apply to fixed assets such as buildings, computer equipment and vehicles. Instead, you deduct the cost of your business property by depreciating it over time.
To claim depreciation, the asset must be one your business owns and uses to help produce income. It must have a measurable useful life greater than one year. It can't be any type of property the IRS excludes from claiming depreciation. The exclusions include land, assets you sell within a year of buying them and some intangible assets such as goodwill.
You also use depreciation in your accounting to write down the initial value of assets as they age. The two depreciation systems work differently, though: You deduct depreciation quicker for taxes than you do in your ledger.
The Useful Life of Assets
The useful life of an asset is based on accounting concepts, not reality. An automobile's useful life is five years, even if you stretch it out and use it for a decade.
Depreciation is based on an asset's useful life. If you buy a $7,000 piece of equipment with a seven-year useful life, you'd deduct $1,000 a year using the straight-line depreciation method. Even if you use the equipment longer, you don't get to depreciate it.
You base useful life on the asset class, such as furniture, vehicles or buildings, so you don't have to calculate it for each individual purchase. If the item has salvage value, you factor that. If, say, the IRS sets the salvage value of the $7,000 equipment at $1,000, you depreciate $6,000 over seven years.
Depreciation in your everyday bookkeeping is usually straight line, with the same amount depreciated each year. Tax depreciation includes this option, but you can also use an accelerated depreciation method to claim a larger deduction up front and less in later years.
No matter what method you use, you can't depreciate more than your basis in the asset. The basis is the purchase price plus related expenses, such as sales tax, shipping and installation fees. Accelerating deprecation doesn't increase your write-off, but it lets you take it quicker.
Accelerating depreciation is a choice. If you buy a $20,000 vehicle and your tax bill for the year is small, you might want to take regular depreciation so you can write off more of the cost in later years. Tax law gives you that flexibility.
Before the Allowance
You can't simply use the special depreciation allowance straight out of the gate. There are two other methods of claiming extra depreciation that you should apply first. The initial step is to use the de minimis rule for writing off your assets as an expense.
Figuring out whether an expense should be claimed on taxes immediately or capitalized over time is often a challenge, as the law isn't always clear. The de minimis rule establishes a safe harbor: minimal purchases get the benefit of the doubt.
- If you expense the purchase price in your financial statements, you can deduct it as an expense on your taxes if it's $5,000 or less.
- If you don't have financial statements, you can deduct up to $2,500 as long as you have an invoice.
- You can write off more than that, but you'll be doing it without the safe-harbor protection.
Section 179 of the federal tax regulations also gives you the option to treat assets as an expense rather than depreciating them. The most recent changes to the tax law let you claim up to $1 million in asset purchases, adjusted for inflation in future years. If you buy more than $2.5 million in qualifying property, the dollar limit on what you can deduct goes down and above $3.5 million, you get no write-off.
- You can use Section 179 to write off machinery, equipment and some types of nonresidential property.
- You cannot write off land or land improvements such as parking lots, bridges, fences or swimming pools.
- If you use the property primarily outside the U.S., you probably can't use Section 179.
- Property you lease to others isn't deductible, though there are exceptions.
The Special Depreciation Allowance
Suppose you buy $2.6 million in equipment this year, and none of it qualifies for the de minimis write-off. It does qualify for Section 179, but because you spent $100,000 above $2.5 million, you can only write off $900,000 that way. That leaves you with $1.7 million in purchases to depreciate.
Now, the special depreciation allowance comes into play. You can claim 100% of depreciation on this year's taxes for any property you buy or manufacture that meets the federal requirements:
- You didn't use the property before you bought or made it.
- You didn't acquire the property from a related party. Buying it from your business partner or a corporate subsidiary would look fishy.
- You can't use the seller's adjusted basis in the property to set your own basis.
- When someone dies, this affects the basis the decedent had in the property. You can't let that affect your basis in the property.
- Property bought for electrical, water, sewer, gas or steam services can't qualify. Specifically, it's excluded if rates related to the sale have to be approved by the government or an electric cooperative.
- Any part of the basis that you can't depreciate with de minimis rules, Section 179 or the special allowance will have to be written off over time the regular way.
Depreciation and Timing
Constant changes to the tax laws have made the special depreciation allowance slightly more complicated. How much you can deduct depends partly on when you bought the deductible item:
- Property you bought before September 27, 2017 and put into use before 2018 qualifies for a 50% bonus depreciation allowance.
- From September 28 of that year through the end of 2022, property you purchased and put to use in your business qualifies for 100% allowance.
- The allowance phases down over the next four years. In 2023, it's 80%, then 60%, 40% and finally 20% for 2026 and the years after.
- If you work in horticulture, some kinds of plants that you graft or plant are eligible for bonus depreciation. The allowance for plants ends after 2026.
When you sit down to figure out how to minimize your taxes, the special depreciation allowance is obviously something about which to think. There are several aspects to keep in mind:
- Unlike the Section 179 deduction, you don't need a positive net income to claim special depreciation.
- Bonus depreciation doesn't have the dollar limits that Section 179 does.
- Because of the different cut-off dates for the amount of bonus depreciation you can claim, the IRS will look at the timing of your purchase and when your business actually placed the asset in service.
- Some states don't follow the federal depreciation rules. Research your state's tax law to learn if you'll have to calculate deductible depreciation differently on your state taxes.
- Baker Tilly: Bonus Depreciation Rules, Recovery Periods for Real Property and Expanded Section 179 Expensing
- IRS: New Rules and Limitations for Depreciation and Expensing Under the Tax Cuts and Jobs Act
- Journal of Accountancy: Regulations Clarify Bonus Depreciation Treatment
- AccountingTools: Fixed Assets
- AccountingTools: Tax Depreciation
- AccountingTools: Useful Life
- AgriSolutions: Depreciation: What You Can Deduct and How to Calculate Deductions
- IRS: Basis of Assets
- IRS: Tangible Property Regulations - Frequently Asked Questions
- IRS: How to Depreciate Property
- IRS: Amortization of Goodwill
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com