Definition and Examples of Bonus Depreciation
Depreciation allocates the cost of a tangible asset (larger, more permanent items such as machinery or vehicles) over its useful life. It is an accounting method that allows businesses to spread the cost of an asset over time.
Bonus depreciation is a tax incentive that encourages businesses to invest in equipment and property by deducting a more significant percentage of the cost of certain types of property in the year they are purchased.
Alternate name: Bonus percentage
It was created to help businesses invest in new equipment and property, increasing economic activity. The Internal Revenue Service (IRS) describes bonus depreciation as an additional first-year depreciation deduction of the cost of certain tangible property, such as machinery and equipment.
As an example of bonus depreciation, suppose you purchase a new computer for your business. With typical depreciation, you’d write off the asset over time. With bonus depreciation, you’d be able to deduct 100% of the cost of this asset in the year you purchased it instead.
How Does Bonus Depreciation Work?
Bonus depreciation is a provision in Section 168(k) in the U.S. Tax Code that allows you to deduct the cost of certain assets in the year they are purchased instead of over time. There are some rules for how it works.
Bonus Depreciation for New vs. Used Assets
Bonus depreciation was put in place in 2002, but it has become even more useful for certain taxpayers since the Tax Cuts and Jobs Act (TCJA) was passed in 2017 when the provision was expanded again.
The bonus depreciation deduction is now available for new and used property acquired and placed in service after Sept. 27, 2017.
- You are entitled to 100% bonus depreciation on new qualified property in the year you place it in service.
- You can claim 100% bonus depreciation on certain used qualifying property, too.
- The amount that business owners can deduct from recently purchased used assets is 50% of the cost of qualified property, as long as they are acquired and placed in service before Dec. 31, 2019.
For more details on claiming the deduction, see the final regulations and the instructions to Form 4562, Depreciation and Amortization (Including Information on Listed Property).
Don’t confuse special depreciation allowance (Section 179) with bonus depreciation [Section 168(k)]. Even though they serve similar tax break purposes, there are distinct differences. Section 179 allows qualified property to be expensed immediately. However, the bonus depreciation deduction is allowed after the basis of an asset has been decreased due to expensing any of the asset's costs.
What Counts as Qualified Property?
According to the IRS, qualified property eligible for bonus depreciation includes:
- Tangible property depreciated under MACRS
- New tangible property (other than buildings or structural components)
- Used tangible property (other than buildings or structural components)
- Certain production property
- Qualified film, television, and live theatrical productions.
- Property that will last 20 years or less
- Computer software, as defined in and depreciated under section 167(f)(1).
- Water utility property
Currently, bonus depreciation allows for 100% expensing of the depreciable basis. You can deduct the entire cost of an asset from your taxes in the year it is purchased instead of depreciating it over a number of years. For more information, refer to IRS Publication 946 on depreciating property.
The Future of Bonus Depreciation
This tax break won't last forever. Bonus depreciation will be phased out by 2027 unless new legislation is passed. The bonus depreciation percentage will gradually be reduced by 20% increments from 2023 until it is eliminated after 2026. After 2026, this will no longer be available as a tax incentive for business owners, so if you’re going to use it, do it now.
When Does Bonus Depreciation Apply?
Bonus depreciation applies to the purchase of equipment and other eligible assets. You can use this tax incentive in the following situations:
- The asset is new, not used
- The asset is acquired by the taxpayer or lessee
- The taxpayer or lessee makes a qualified improvement to the property
- It has a useful life of 20 years or less
- It's not listed property (listed property includes items such as cars, boats, and computers)
Bonus depreciation also applies to real estate, which is defined as "the excess of qualified real estate investment over qualified real estate basis."
What Are the Limitations of Bonus Depreciation?
Bonus deducting the cost of a new asset from your business income in the year is a substantial tax benefit. However, the amount you can deduct is limited by the type and class of the asset.
The main limitation of bonus depreciation is that it only applies to newly purchased assets - not ones already in use or previously purchased. The other limitation is restrictions on the types and classes of property that qualify for this tax incentive, so not all assets qualify.
For example, you cannot claim a deduction for depreciation or amortization for any property for which you already elected to claim the special depreciation allowance under Section 168(k).
Additionally, the 2017 law removed “computer or peripheral equipment" from the list of properties that can be bonus depreciated. Also excluded are properties primarily used in the trade or business of providing or selling electrical energy, water or sewage disposal services, and gas or steam local transportation and pipeline distribution.
- Bonus depreciation is a tax incentive that allows businesses to deduct the cost of certain types of property more quickly.
- It allows you to deduct a portion of the cost of a particular property, such as equipment, machinery, or software, in the year it is placed in service.
- First enacted by Congress in 2002 and extended numerous times since then, the most recent extension, signed into law on Dec. 22, 2017, allows for deducting 100% of the depreciable basis of the asset.
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