With bonus depreciation starting to phase out this year and limits on Section 179 deductions increasing, now is a good time to re-evaluate capital asset depreciation strategies. The 2023 changes could also affect the timing of upcoming purchases to maximize potential tax savings.
The Alternatives at a Glance
The Internal Revenue Code and related IRS guidance contain detailed rules about how to depreciate the cost of various types of capital assets. In addition, two alternatives are available that can allow businesses to lower their current year tax liability by immediately deducting all or most of the purchase price of certain assets as a business expense, rather than depreciating them over several years.
One method—Section 179 of the tax code—allows companies to immediately deduct the full cost of many types of purchases but limits the amount of the deduction. In addition, the Section 179 deduction is limited to the business’s taxable business income in a given year. In other words, a business cannot use Section 179 unless it reports a profit and cannot use Section 179 deductions to generate a loss.
The other method is a special depreciation allowance under Section 168(k) of the code, commonly referred to as bonus depreciation. Unlike the Section 179 deduction, there are no specific dollar limits on bonus depreciation, and a business does not need to be profitable to use it. However, the Tax Cuts and Jobs Act (TCJA) of 2017 began phasing out bonus depreciation over time, beginning in 2023. This year, businesses can write off only 80 percent of the cost of eligible purchases using bonus depreciation and, unless Congress revises the law, the write-off will drop another 20 percent each year until it phases out completely in 2027.
Comparing the Alternatives – A Closer Look
In many cases, businesses can use either Section 179 or bonus depreciation and sometimes they can use both. Deciding which—if any—method to use requires careful analysis, beginning with an understanding of the two approaches’ key features:
- Deduction limits. The Section 179 deduction limit for 2023 is $1.16 million, and begins to phase out if eligible purchases exceed $2.89 million. The deduction is reduced dollar for dollar for all amounts over the limit, phasing out completely if acquisitions exceed $4.05 million. On the other hand, there are no fixed dollar limits to bonus depreciation but, as mentioned earlier, the deduction this year is limited to 80 percent of an asset’s cost.
- Eligible assets. The types of assets that are eligible for Section 179 or bonus depreciation include heavy equipment and machinery, computer equipment, off-the-shelf software, vehicles, and various other depreciable assets. Land and buildings are not eligible, but the TCJA expanded Section 179 to include certain improvements to commercial real property, such as new roofs, HVAC, fire protection, and security systems. This expansion did not apply to bonus depreciation, but both methods can be used for various other building interior improvements.
- Types of assets. Under both methods, the assets being deducted may be either new or used, but they must be “new to the company.” For example, a company might be able to deduct the cost of a used vehicle, but only if neither the company nor its owners previously owned the vehicle. There are additional limitations on certain types of vehicles, so consultation with a tax professional is essential.
- Section 179 offers more flexibility. A company may deduct some purchases immediately under Section 179, while choosing to depreciate others over time. But a company that uses bonus depreciation for one item must also apply it to all other purchases made that year with the same depreciation life.
- Using both methods. A company may also choose to apply Section 179 to some purchases and use bonus depreciation for others or in certain cases both methods can be used for the same asset.
- Both methods require that the acquired asset be put into service before the end of the tax year. With recent supply chain issues, companies should plan ahead to be sure they will receive equipment in time to claim the deduction in the year they want.
Complicating Factors
Both Section 179 and bonus depreciation can produce sizable tax savings, but they should be applied strategically. In certain situations, businesses might be better off capitalizing and depreciating assets.
For example, if the company expects to sell an asset before the end of its useful life, the company could be required to recapture some or all of the Section 179 deduction or bonus depreciation and report it as income at the time of disposal. Likewise, if the company expects significant future revenue growth, it might want to retain the ability to deduct depreciation expenses in coming years when taxable income will be higher.
Pass-through entities must also evaluate how Section 179 or bonus depreciation could reduce their qualified business income (QBI) deduction under Section 199A, negating some of the benefits. Further complicating things, the Section 179 deduction limits can apply at the owner level for pass-through entities.
A business must also consider the various jurisdictions in which it has state income tax obligations. Some states’ tax codes are consistent with the federal Section 179 and bonus depreciation provisions but others are not.
With so many variables, a qualified tax professional is indispensable in helping to weigh the pros and cons of the various depreciation scenarios, please contact us if you have any questions.