Bonus Depreciation: A Definitive Guide

KEY TAKEAWAYS

• Bonus depreciation is a useful tax-saving measure for businesses.
• It was created as a way to encourage investment by small businesses and to stimulate the economy.
• Businesses need to use IRS Form 4562 to record bonus depreciation.

What Is Bonus Depreciation?

Bonus depreciation is a tax incentive. It allows a business to segregate cost and identify portions of real property that are separate tangible personal properties subject to shorter depreciable recovery periods. Some of these properties may also qualify for additional first-year depreciation, which is known as “bonus” depreciation. 

In order to qualify for bonus depreciation, the original use of the property must begin with the taxpayer and the property must be:  

1. MACRS property with a recovery period of 20 years or less
2. Depreciable computer software
3. Water utility property, or 
4. Qualified leasehold improvement property.  

Certain acquisition requirements and placed in service dates must also be met in order to qualify for bonus depreciation.
Businesses can use IRS Form 4562 in order to record bonus depreciation. This form is also used to record other types of depreciation and amortization.

How Does Bonus Depreciation Work?

When a business makes a purchase, for tax accounting purposes, the cost is normally spread out over the useful life of the asset. This is a process known as depreciation which can tend to work in favor of the company. Bonus depreciation can be calculated by taking the bonus depreciation rate and multiplying it by the cost basis of the acquired asset. This would be the initial cost. 

An example is when a business acquires machinery, the cost is not normally recognized in the year it’s been purchased, but instead spread across its useful life (e.g. 5 years). So a portion of the purchase price is expensed in each year of its useful life.

From an accounting perspective, that makes sense as it represents a company’s real financial situation. However, from a tax perspective, businesses would prefer to not use depreciation. That’s because if depreciation is not applied, then the company’s taxable income could be reduced more in the year of purchase, and it can harvest immediate financial benefit by paying less tax.

In 2017, the Tax Cuts and Jobs Act was passed. This made large changes to the rules regarding bonus depreciation. One of the significant changes was that the bonus depreciation deduction for qualified property doubled (50% to 100%).  This law also extended the bonus in order to cover used property, though this had to be under certain conditions. This was mainly applied to property that was bought new instead of used. 

The new rules for bonus depreciation apply to property acquired and placed in service after September 27, 2017, and before January 1, 2023. At this time, the provision will expire unless Congress renews it. 

In 2023, the rate for bonus depreciation will stand at 80%. This will continue to go down by 20% until 2026 when it will reach 20%. This is under the assumption that Congress doesn’t change the law before 2026. Any property that was acquired before September 27, 2017, remained subject to the previous rules.

Qualifications and Restrictions to Use Bonus Depreciation

In order to be qualified to use bonus depreciation, the asset must be first used in the year in which the first depreciation deduction was claimed. Only certain types of assets can be eligible for bonus depreciation. These types are as follows:

• Modified accelerated cost recovery system (MACRS) property with a recovery period of 20 years or less
• Depreciable computer software
• Water utility property
• Qualified leasehold improvement property

Certain assets are specifically excluded from being eligible for a bonus depreciation deduction. This includes equipment that is used to build capital improvements, certain intangible assets, and assets that are disposed of in the year they were purchased. 

Some assets must be used for business use 50%+ of the time in order to qualify for bonus depreciation. These assets are known as listed property. This includes autos and other properties that can be used for both business and personal use. Although things such as computers or laptops are no longer considered listed property.

Summary

Bonus depreciation is a useful tax incentive and a valuable tax-saving tool that businesses can use to reduce their pre-tax income. It was created to allow small businesses to invest and then claim a bonus depreciation expense. This, therefore, stimulates the economy. The rules and limits for bonus depreciation are ever-evolving and changing, with the latest set of rules due to expire in 2023.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.