Bonus Depreciation: Definition and How It Works

What Is Bonus Depreciation?

Bonus depreciation is a tax incentive that allows a business to immediately deduct a large percentage of the purchase price of eligible assets, such as machinery, rather than write them off evenly over their useful life.

Bonus depreciation is also known as the additional first-year depreciation deduction.

Understanding Bonus Depreciation

When a business buys an asset, the tax treatment for that asset is traditionally to spread its cost of over its useful life. This process, known as depreciation, reduces a company’s net earnings and tax liability.

Bonus depreciation is an accelerated business tax deduction. Instead of allocating the cost evenly over the life of an asset, Congress enacted rules that allow businesses to deduct a fixed percentage of an eligible asset’s cost upfront.

Although a company might otherwise expense the same total amount over the asset’s life, bonus depreciation gives it a substantial tax break right away.

The Tax Cuts and Jobs Act, passed in 2017, made major changes to the rules on bonus depreciation. Most significantly, it doubled the bonus depreciation deduction for qualified property, as defined by the Internal Revenue Service (IRS), from 50% to an initial 100%. The 2017 law also extended the bonus to cover used property under certain conditions.

History of Bonus Depreciation

Bonus depreciation has been around since 2002, but has changed over the years as the law has been updated.

Qualifying Assets for Bonus Depreciation

Bonus depreciation is only applicable to certain business assets. For example, tangible property must have a maximum useful life of 20 years.

Under the Tax Cuts and Jobs Act, eligibility requirements also stipulated that:

• The asset was not used by the taxpayer prior to acquisition.
• The asset was not acquired by a related party to the taxpayer.
• The asset was not formerly owned by a component member of a controlled group of corporations.
• The asset’s basis is not figured in reference to the adjusted basis of the property when under ownership of the seller.
• The asset’s basis is not figured in reference to a basis acquired from a decedent.

Disqualified Assets

The rules explicitly disqualify certain types of assets from being eligible for bonus depreciation. Under the Tax Cuts and Jobs Act, assets are not eligible if they are:

• Primarily used in the trade of furnishing or sale of electrical energy, water, or sewage disposal services
• Primarily used in the trade of furnishing or the sale of gas or steam through distributed systems
• Primarily used in the trade of furnishing or the sale of gas or steam by pipeline
• Used in a trade or business that has had floor-plan financing indebtedness under certain circumstances
• Qualified improvement property such as leasehold improvements acquired after Dec. 31, 2017
  

How to Report Bonus Depreciation

Bonus depreciation is reported on federal tax returns using IRS Form 4562, Depreciation and Amortization (Including Information on Listed Property). This form is also used to report or claim other types of depreciation, such as the Section 179 deduction.

To figure the depreciable base of the asset, the business should subtract any credits or deductions allocated to the property from the basis of the asset. Special treatment exists for assets acquired in a like-kind exchange or involuntary conversion.

Electing Not to Take the Accelerated Deduction

If businesses decide it would be more advantageous to recognize depreciation over the life of the asset instead of using an accelerated method, such as bonus depreciation, they can elect not to take it. To make this election, they must attach a statement to their tax return indicating which class of property they wish to not make the election for. Once the election has been made, the decision cannot be revoked without the IRS’s consent.

Bonus Depreciation Schedule and Phaseout

The current bonus depreciation percentages depend on when the eligible property was placed in service. Here is how bonus depreciation is scheduled to be phased out:

Bonus Depreciation vs. Section 179

Section 179 is another tax provision that allows businesses to claim a larger depreciation deduction for qualifying property for the tax year it was put into service.

Broadly speaking, Section 179 rules are often more flexible in terms of timing than bonus depreciation rules. Under Section 179, a business can elect to save certain assets for future tax breaks or claim only a portion of the cost and defer the other portion for a future tax year. With bonus depreciation, the amount of depreciation that’s allowable is strictly defined.

However, bonus depreciation may apply to higher spending amounts. Bonus depreciation is not capped in dollar terms; a multimillion-dollar deduction for the cost of a single asset may be recognized in a single year. On the other hand, Section 179 deductions are limited by law.

As the IRS explains, “For tax years beginning in 2023, the maximum section 179 expense deduction is $1,160,000. This limit is reduced by the amount by which the cost of section 179 property placed in service during the tax year exceeds $2,890,000.”

In addition, the IRS notes, “The maximum section 179 expense deduction for sport utility vehicles (SUVs) placed in service in tax years beginning in 2023 is $28,900.”

Each of these two tax breaks have rules that can make them more or less appealing to certain types of businesses. Some real estate improvements, for example, do not qualify for bonus depreciation but do qualify for Section 179 treatment. On the other hand, Section 179 deductions are limited to annual business income, while bonus depreciation can exceed that amount. It is also possible to claim both bonus depreciation and Section 179 deductions in the same tax year.

The Bottom Line

Bonus depreciation is a tax incentive for businesses that purchase certain new assets. It is similar to Section 179 depreciation but has higher dollar limits in some cases. Bonus depreciation is currently phasing out and scheduled to end as of 2027.