Section 179 vs. Bonus Depreciation 2023: How to Choose

Two tax deductions available to businesses, Section 179 and bonus depreciation, allow for the immediate write-off of asset costs in the year of purchase. Recent changes to these provisions, particularly the scheduled reduction in bonus depreciation, make a direct comparison between the two important for tax planning.

Understanding Section 179 Expensing

Section 179 of the Internal Revenue Code allows a business to treat the cost of certain qualifying property as an immediate expense rather than capitalizing it over a period of years. A business can expense a maximum of $1,250,000 in qualifying asset purchases. This deduction is aimed primarily at small to medium-sized businesses.

The deduction has an investment limitation. The full deduction is available only to businesses placing less than $3,130,000 of new and used equipment into service during the year. If a business’s total qualifying purchases exceed this amount, the Section 179 deduction is reduced on a dollar-for-dollar basis. For example, a business that places $3,230,000 of property in service would see its maximum deduction reduced by $100,000.

The total Section 179 deduction also cannot exceed the business’s net taxable income for the year. A business cannot use this provision to create or increase a net operating loss (NOL). If the deduction is limited by taxable income, the disallowed amount can be carried forward to future tax years and applied when the business has sufficient income.

The types of property eligible for Section 179 are broad and cover most tangible business assets. This includes machinery, equipment, business vehicles, computers, and off-the-shelf software. Additionally, the provision covers certain improvements made to nonresidential real property, such as roofs, HVAC systems, and security systems, which are referred to as qualified improvement property.

Understanding Bonus Depreciation

Bonus depreciation is an additional first-year depreciation allowance that a business can claim for qualifying assets. It is calculated after any Section 179 deduction is taken. For property placed in service in 2025, the rate is 40%. This phase-down was established by the Tax Cuts and Jobs Act of 2017 and is scheduled to continue decreasing to 20% in 2026 before being eliminated in 2027.

Unlike Section 179, bonus depreciation has no annual dollar limit on the total amount that can be claimed. A business can apply the 40% deduction to all its qualifying property placed in service during the year, regardless of the total cost. There is also no investment phase-out threshold, making it a valuable tool for businesses of all sizes, especially those making substantial capital expenditures.

Bonus depreciation is not limited by a business’s taxable income. A business can use bonus depreciation to create or increase a net operating loss (NOL). This NOL can then be carried forward to future years to offset taxable income, providing a tax benefit even when the business is not currently profitable. This makes it a useful tool for startups or companies in a temporary downturn.

Property qualifying for bonus depreciation must have a tax recovery period of 20 years or less, which includes assets like equipment, machinery, furniture, and computer software. It applies to both new and used property, as long as the used property is new to the taxpayer. Bonus depreciation is automatically applied to all eligible property; a business must file an election to formally opt out of taking it for any specific class of assets.

Key Differences and Strategic Application

State tax laws are a factor in decision-making. Many states do not conform to the federal bonus depreciation provisions, meaning they do not allow the 40% first-year deduction. However, a larger number of states have adopted their own version of Section 179 expensing, sometimes with different deduction limits. This discrepancy can create a situation where taking a large bonus depreciation deduction on a federal return adds back to state taxable income, resulting in a higher state tax bill.

For businesses that can benefit from both, there is a clear order of operations to maximize tax savings. The standard strategy is to first apply the Section 179 deduction to specific, targeted assets up to the allowable limit. After expensing those assets, the 40% bonus depreciation is then applied to the remaining cost basis of those assets and to any other eligible property placed in service during the year. This approach allows a business to fully expense certain assets while still benefiting from the broad applicability of bonus depreciation.

Making the Choice for Your Business

Consider a profitable small business that purchases a single piece of equipment for $100,000. Using Section 179 to expense the full cost is the most advantageous choice. This provides an immediate $100,000 deduction on both federal and, in many cases, state tax returns, simplifying the tax filing and preserving the bonus depreciation allowance for any other assets it might purchase.

A different scenario involves a large manufacturing company investing $5 million in new machinery. This company would quickly surpass the Section 179 limits. The strategy would be to first expense $1,250,000 of the cost using Section 179. Then, it would apply 40% bonus depreciation to the remaining $3,750,000 cost basis, generating an additional deduction of $1,500,000. This combined approach maximizes the immediate write-off.

For a startup that invested $200,000 in new computer hardware and software but expects to report a net loss for the year, bonus depreciation is the only viable option. Because the Section 179 deduction is limited by taxable income, it cannot be used. By applying the 40% bonus rate, the startup can claim an $80,000 depreciation deduction, creating a larger net operating loss to carry forward and reduce taxes in future profitable years.