How Does the Bonus Depreciation Deduction Work?
Gain a clear understanding of the bonus depreciation deduction, its scheduled phase-down, and the key differences in federal versus state tax treatment.
Bonus depreciation is a tax incentive allowing businesses to deduct a large portion of the cost of certain assets in the year they are placed in service. This accelerated depreciation provides a more immediate tax benefit than traditional depreciation, which spreads the deduction over an asset’s useful life. The rules for bonus depreciation have evolved since its introduction. The Tax Cuts and Jobs Act of 2017 (TCJA) made changes, including temporarily increasing the deduction to 100% for certain property.
Determining Qualified Property
To be eligible for bonus depreciation, an asset must be qualified property. The main category for this is Modified Accelerated Cost Recovery System (MACRS) property with a recovery period of 20 years or less. This includes a wide range of business assets, such as machinery, equipment, computers, software, and office furniture.
A change introduced by the TCJA expanded qualified property to include used assets. Previously, only new property was eligible. A business can claim bonus depreciation on used property as long as it is the first time that taxpayer is using the asset and it was not acquired from a related party.
Certain types of property are excluded from bonus depreciation eligibility. Common exclusions are land, which is not depreciable, and buildings.
Qualified Improvement Property
A category of eligible property is Qualified Improvement Property (QIP). QIP refers to any improvement made by a taxpayer to the interior of a nonresidential building that has already been placed in service. This does not include improvements related to enlarging the building, any elevator or escalator, or the internal structural framework.
Initially, a drafting error in the TCJA assigned QIP a 39-year recovery period, making it ineligible for bonus depreciation. The Coronavirus Aid, Relief, and Economic Security (CARES) Act corrected this, retroactively assigning QIP a 15-year recovery period and making it eligible for bonus depreciation.
Calculating the Bonus Depreciation Deduction
The bonus depreciation calculation begins with the cost of the qualified property and the date it was placed in service, which determines the applicable percentage. Under the TCJA, property placed in service after September 27, 2017, and before January 1, 2023, was eligible for a 100% deduction, allowing the entire cost to be written off in the first year.
The 100% bonus depreciation provision is phasing down. For property placed in service during 2023, the rate was 80%, and for 2024, it was 60%. The phase-down continues with a rate of 40% for 2025 and 20% for 2026, before being eliminated in 2027, unless Congress intervenes.
For example, a business that purchases and places in service a $50,000 piece of equipment in 2025 can claim a bonus depreciation deduction of $20,000. This is based on the 40% rate for 2025 ($50,000 cost x 40%). This amount is deducted from the business’s income for the year.
After applying bonus depreciation, the remaining cost basis of the asset is subject to regular MACRS depreciation. In the example above, the remaining basis is $30,000 ($50,000 – $20,000). The business would then calculate its regular first-year depreciation deduction on this $30,000 amount based on the asset’s MACRS recovery period.
State Tax Treatment Considerations
The treatment of bonus depreciation at the state level is an area of complexity for businesses. States are not required to follow the federal tax code, and their approaches to bonus depreciation vary.
State tax conformity falls into three categories. Some states have “rolling conformity,” automatically adopting changes to the federal Internal Revenue Code. Other states use “fixed-date conformity,” where they conform to the IRC as of a specific date and do not adopt federal changes made after that date without new legislation. The third group of states “decouples” from the federal provision, disallowing bonus depreciation.
Because many states decouple from or modify the federal rules, businesses often cannot claim the same deduction on their state income tax returns. This requires an adjustment on the state return, where the federal bonus depreciation amount is added back to state taxable income. The business must then calculate depreciation for state purposes using a different method over the life of the asset. Taxpayers must verify the rules for each state where they file a tax return.
Claiming the Deduction on Your Tax Return
The deduction is reported on the business’s federal tax return using IRS Form 4562, Depreciation and Amortization. Bonus depreciation is reported in Part II of this form. The total amount then flows to the business’s main tax form, such as Schedule C for sole proprietors or Form 1120 for corporations, to reduce taxable income. Form 4562 must be attached to the tax return.
Businesses have the option to elect out of taking bonus depreciation for any class of property. This election is made on a class-by-class basis, allowing a business to forgo bonus depreciation for 5-year property while claiming it for 7-year property. To make this election, the taxpayer must attach a statement to their timely filed tax return for the year the property was placed in service. This election is irrevocable.