What is Bonus Depreciation?
Bonus depreciation allows businesses to deduct a percentage of the cost of a new property or equipment from their taxes in the year the asset is recognized for business use.
For example, Peter buys $100,000 worth of equipment in 2022. However, he started using it for the business in January 2023. As per the tax code, he can deduct 50% of its cost ($50,000) from the taxes in 2023 (year of service).
The reduction in payable taxes motivates businesses to purchase new equipment more often. It also helps in the nation’s economic growth in the long run. The IRS (Internal Revenue Service) offers helpful information about what types of property qualify for it and what the limits are in each year.
Key Highlights
- Bonus depreciation is the deduction of tax for qualified property acquired and placed in service after September 27, 2017.
- It works as an incentive for firms to encourage investment in advanced equipment.
- We can determine the deduction value by multiplying the depreciable basis of an asset by the tax rate.
- Although the depreciation rate has been 100% of the cost till 2022, it is subject to a gradual decrease towards the fiscal year 2026.
- Unlike in a Section 179 deduction, depreciation in real estate is not limited to a fixed annual dollar amount.
How does Bonus Depreciation Work?
Bonus depreciation is a tax incentive that allows businesses to deduct a more significant amount of their yearly capital investments. When companies deduct more, they will invest and buy more equipment, leading to higher productivity and economic growth.
It encourages investment in equipment and systems in a business with a long-term life (at least 20 years). The current depreciation rate is 80% for the property bought and used between December 31, 2022, and January 1, 2024.
Examples
#1. Industrialist
Sam, an industrialist, purchases equipment for the manufacturing units of his factories at $10,000,000. As the equipment becomes a part of a running business, the IRS marks it as a qualified asset. Thus, according to the given tax rate, of 80%, the deductible amount is $8,000,000.
#2. Baker
A baker buys a stand-mixer for the bulk orders he receives during festivals. Since he runs a business, the mixer falls under qualified assets. If the price of the mixer is $5000 and its tax rate says 60%, the deductible amount is $500.
When Does Bonus Depreciation Phase Out?
- The phase-out is when the depreciation rate will gradually decrease over the years, finally falling to null.
- According to the 2017 Tax Cuts and Jobs Act, the phase-out period will extend till 2026.
- The rate has remained at 100% till 2022 and will phase out gradually.
- Therefore, the deduction rate will be 80% for 2023, 60% for 2024, and 40% for 2025, and it will phase out with 20% in 2026.
- The depreciation rule will not apply to purchases after 2026.
Rules and Regulations
- Businesses, individuals, and organizations can claim the deduction on new or qualified assets.
- They need to include IRS Form 4562 and Schedule C when filing Form 1040 to claim such tax deductions.
- They must enter the date of acquisition, the type of property depreciating, and the amount of depreciation while claiming for the bonus.
- To optimize tax savings, they should keep complete records of all acquisitions and the dates they were put into service.
- Moreover, the IRS provides separate forms for different types of assets that the taxpayer can fill out to claim the depreciation bonus.
- As the depreciation rates vary according to different tax years, the deduction rate depends on the year of the asset’s purchase.
- However, if one purchases an asset during the tax year but doesn’t put it into service before year-ending, they won’t be able to claim the depreciation bonus.
Qualifications
- The asset must be a tangible property depreciated under MACRS (modified accelerated cost recovery system).
- However, under section 168(k)(2)(A), any new tangible property that is part of an ongoing business qualifies for depreciation.
- The original use of the asset must begin with the taxpayer between September 27, 2017, and January 1, 2023.
- The taxpayer must purchase the item as new or get it through a trade-in.
- Additionally, the business or individual must have acquired the property by purchase or as a gift from someone who earned it by purchase.
Restrictions
- The property must be depreciable under IRC (Internal Revenue Code).
- One should place the asset in service before a particular tax year ends.
- Any property acquired from a related party, such as a parent company or a partner, cannot be granted depreciation.
- Any improvements to a previously owned property do not qualify for it.
- To claim a newly purchased asset deduction, the taxpayer must not have held any ownership interest in a substantially identical asset in the last three years.
Bonus Depreciation vs. Section 179
| Bonus Depreciation | Section 179 |
| It allows you to reduce the cost of qualified property in its purchase year. | Section 179 deducts the total purchase price of the qualifying property in its purchase year. |
| The rate is 100% initially but gradually declines over time until it reaches zero. | The rate never changes and remains 100% throughout. |
| It deducts a percentage of the fixed asset’s acquisition cost. | It charges the same amount for all newly added assets to the business. |
| The deduction has no annual limit. | The purchase of fixed assets is subject to a limit. |
| Only when a company makes a profit can it deduct the depreciation from the tax. | Whether there is a profit or not, the IRS charges Section 179. |
Final Thoughts
One can treat bonus depreciation as an alternative to Section 179, which allows one to deduct a partial cost of eligible property in one year instead of taking a deduction over multiple years. One needs to understand the business’s taxable income and the phase-out period to determine the tax return.
Frequently Asked Questions (FAQs)
Q1. What is bonus depreciation?
Answer: Bonus depreciation is a tax deduction that allows a business to deduct the cost of an asset from its taxable income. This deduction is available for new purchases.
Q2. How do you calculate bonus depreciation?
Answer: There is a market rate of depreciation in the current tax year. One can derive it by multiplying the cost of the equipment by the individual rate.
For example, if the equipment cost is $5,000 and the depreciation rate is 50%, then the bonus depreciation amounts to 50% of $5,000, i.e., $2,500.
Q.3. What is the benefit of bonus depreciation?
Answer: It reduces the yearly tax a business has to pay according to the price of its newly bought equipment. It motivates the businessperson to purchase new equipment at specific gaps, resulting in economic growth.
Q.4. Does bonus depreciation have to be 100%?
Answer: Bonus depreciation varies between 50%-100% for qualified assets. It takes place according to the Tax Cuts and Jobs Act (2017).
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