What Is Bonus Depreciation for Dummies?

Businesses often grapple with the complexities of tax laws, especially when it comes to capital investments. Understanding the nuances of the special depreciation allowance, also known as bonus depreciation, is crucial for maximizing tax benefits and optimizing financial strategies.

Exploring the Special Depreciation Allowance (Bonus Depreciation)

The special depreciation allowance is a tax provision designed to incentivize businesses to invest in capital assets. It provides an additional deduction in the year certain qualifying property is placed into service for use in a trade or business. Referred to interchangeably as “special depreciation” or “bonus depreciation,” this allowance can significantly impact a company’s tax liability.

Key Elements of the Special Depreciation Allowance

To grasp the significance of the special depreciation allowance, it’s essential to consider its key elements:

1. Percentage Basis: The deduction is based on a percentage of the cost of the asset. For instance, in 2021, the special depreciation allowance stands at 100% of the cost of qualifying property placed into service during the tax year.

2. Phased Reduction: As of the latest update, the special depreciation allowance is scheduled to decrease to 80% in 2023, with subsequent annual reductions until it is phased out entirely. However, Congress retains the authority to modify these rates before they take effect.

3. Timing of Claim: The allowance is claimed after applying any §179 deduction and before calculating regular depreciation under the Modified Accelerated Cost Recovery System (MACRS). It applies to both regular tax and Alternative Minimum Tax (AMT) purposes for the tax year in which the property is placed in service.

Legislative Impact and Summary

Special depreciation has been subject to significant legislative changes over the past few decades. The following table summarizes the special depreciation allowance percentages applicable to most property from 2013 to 2026:

Understanding and strategically leveraging the special depreciation allowance can yield substantial tax savings and enhance financial flexibility for businesses. By staying informed and adapting to legislative changes, businesses can effectively navigate the complexities of tax regulations and optimize their financial performance.

Qualifying Property

As of September 27, 2017, the definition of qualifying property for special depreciation has expanded, encompassing a diverse array of assets and categories. Let’s delve into the details to shed light on this complex yet crucial aspect of tax law.

Qualifying property, applicable to assets placed into service after the aforementioned date, spans various categories:

• Tangible Assets under MACRS: These are tangible assets subject to depreciation under the Modified Accelerated Cost Recovery System (MACRS) with a recovery period of 20 years or less. Notably, this includes qualified improvement property, a subject we’ll explore in greater detail shortly.

• Depreciable Computer Software: This category comprises software eligible for depreciation, a topic that will be elaborated upon in Chapter 3 of our discussion.

• Specialized Categories: There are also less common categories of qualifying property, such as:

  • Qualified reuse and recycling property.
  • Water utility property.
  • Certain fruit and nut-bearing plants.
  • Qualified film, television, and live theatrical productions.

Furthermore, there exist specific regulations concerning assets with production periods exceeding one year and noncommercial aircraft, which are beyond the scope of this discussion.

Qualified Improvement Property (QIP): Among the notable classifications is Qualified Improvement Property. QIP refers to enhancements made to nonresidential real estate that do not involve enlarging the building, constructing elevators or escalators, or altering the internal structural framework. These improvements must occur after the initial property has been placed into service. QIP adheres to a 15-year MACRS GDS class life and qualifies for both special depreciation and the §179 deduction.

For those seeking deeper insights into the nuances of these guidelines, IRS Publication 946, Chapter 3, offers a comprehensive resource.

Property Ineligible for Special Depreciation

When it comes to navigating the complexities of tax regulations, identifying property that doesn’t qualify for special depreciation is just as crucial as understanding what does. Let’s delve into the specifics to shed light on assets that fall outside the scope of special depreciation benefits.

Excepted Property: Certain categories of property are explicitly excluded from special depreciation benefits. These include assets such as:

• Property placed into service and disposed of within the same tax year: Assets that are both acquired and disposed of in the same tax year do not qualify for special depreciation.

• Property converted from business use to personal use within the same tax year: If an asset transitions from business to personal use during the year it’s acquired, it is ineligible for special depreciation.

• Property subject to the alternative depreciation system (ADS): This encompasses assets that must be depreciated using the alternative depreciation system, including listed property utilized for business purposes 50% or less of the time. 

• Property for which the taxpayer opted out of claiming special depreciation allowance: If a taxpayer chooses not to claim any special depreciation allowance for a particular asset, it becomes ineligible for such benefits.

Acquisition Requirement Test and Original Use Test

Assets placed into service after September 27, 2017, are subject to rigorous evaluation under two pivotal tests:

1. Acquisition Requirement Test: This test mandates that taxpayers refrain from using the asset for any non-business or non-income-producing purpose before its deployment into service. Furthermore, assets obtained from certain related parties, members of the same controlled group, or acquired through gift or inheritance are ineligible under this criterion.

   • For instance, assets purchased—whether new or used—and promptly allocated for business operations satisfy the Acquisition Requirement Test.
   • Conversely, assets initially acquired for personal use and subsequently repurposed for business utilization do not meet the Acquisition Requirement Test but may still qualify for special depreciation if they fulfill the Original Use Test, which we will explore next.
   • Additionally, assets received as gifts do not fulfill the Acquisition Requirement Test but could potentially qualify for special depreciation if they pass the Original Use Test.

2. Original Use Test: To meet this criterion, the asset must not have been utilized by any other entity before the taxpayer’s acquisition.

   • Used assets, regardless of their prior business use, do not meet the Original Use Test. However, they may still qualify for special depreciation if they satisfy the Acquisition Requirement Test.
   • Conversely, newly acquired assets initially designated for non-business purposes but subsequently repurposed for business usage fulfill the Original Use Test, thus qualifying for special depreciation despite failing the Acquisition Requirement Test.
   • Furthermore, newly gifted assets utilized for business objectives fulfill the Original Use Test and qualify for special depreciation, notwithstanding non-compliance with the Acquisition Requirement Test.

Assets Placed into Service Prior to September 28, 2017: Examining the Stipulations

Assets placed into service before September 28, 2017, are evaluated solely based on the Original Use Test. This implies that taxpayers can only claim the special depreciation allowance for used assets if they were deployed into service after September 27, 2017.

In essence, comprehending the intricacies of the Acquisition Requirement and Original Use Tests is indispensable for taxpayers navigating the terrain of special depreciation. By understanding these assessments and their implications, individuals can make informed decisions to optimize their tax strategies and maximize their financial efficiency.

Depreciation Basis for Current Year and Future Years

When claiming the special depreciation allowance for any asset, the depreciable basis of that asset must be decreased by the amount of the allowance claimed. For assets placed into service during years when the allowance stands at 100%, this implies that no further depreciation can be claimed for the asset beyond the initial year, as the asset has no remaining basis.

However, for assets placed into service during years when the allowance falls below 100%, the residual basis of the assets will undergo depreciation over the asset’s standard recovery duration.

Some states do not adhere to the federal regulations concerning special depreciation. It’s crucial to be familiar with the specific rules in your state to ensure necessary adjustments are made on your state tax return.