The Internal Revenue Code (IRC) allows businesses to claim bonus depreciation, calculated as a percentage of an asset’s adjusted basis, in the year that qualified property is placed in service. Prior to the Tax Cuts and Jobs Act (TCJA), the rules allowed for bonus depreciation of 50% and the provision was set to phase out at the end of 2019. The TCJA extended the availability of bonus depreciation to qualified property placed in service before Jan. 1, 2027, and it temporarily increased the allowance to 100% of the value of assets acquired and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Beginning in 2023, the percentage will decrease by 20 percentage points each year until the bonus allowance goes to zero in 2027.
Assets that qualify for bonus depreciation are known as “qualified property,” and they include:
- Depreciable property with a recovery period of 20 years or less, such as vehicles, furniture, manufacturing equipment, and heavy machinery (Land and buildings generally don’t qualify, but as we noted previously, certain shorter-lived components of buildings can be depreciated separately. If those components meet the other requirements, they’re eligible for bonus depreciation.)
- Computer software
- Water utility property
- Qualified film, television, or live theatrical productions
- Qualified improvement property
Qualified improvement property (QIP) includes improvements made to the interior portion of nonresidential property that are placed in service after the initial date that the building was placed in service, excluding the cost of elevators, escalators, changes to the structural framework, or building expansions. This basically covers the costs of renovations to existing buildings that don’t change the structural footprint. Prior to the Coronavirus Aid, Relief and Economic Security (CARES) Act, a drafting error had inadvertently caused QIP to be classified as 39-year property, making it ineligible for bonus treatment. The CARES Act included a technical correction designating QIP as 15-year property, thus making it eligible for the bonus deduction.
The TCJA also made an important change to the qualified property rules by allowing businesses to claim bonus depreciation on used assets that they acquire and place in service during the life of the statute. Some restrictions apply; for instance, the property can’t be acquired from a related party. But the end result is a significant increase in current-year deductions for businesses that rely on secondhand equipment.
Unlocking the benefits of bonus depreciation
Properly qualifying assets for bonus depreciation can have a significant impact on a business’s bottom line. In the case of building components that are separated out from the cost of real estate via a cost segregation study, it can be the difference between claiming a tax refund now based on an NOL carryback generated by the higher depreciation number and claiming a deduction for some percentage of the cost of the asset in 2059.
Consider a business that buys a commercial building in January of 2019 for $10,000,000. Without any additional analysis, the taxpayer will depreciate the cost of the building in a straight line over 39 years. Within the building however, there is certain personal property that can be depreciated over a shorter lifespan of only five years. Using a cost segregation study, the taxpayer is able to document that 10% of the cost of the building is attributable to those personal property items with the five-year life. As a result, $1,000,000 of the purchase price qualifies for bonus depreciation and 100% of that amount can be deducted in the year it’s placed in service. The remaining $9,000,000 is 39-year property and that cost will be recovered in much smaller annual increments over the life of the building.
Businesses that have placed assets in service in prior years still have options available to segregate shorter-lived component assets and depreciate them more quickly. The rules allow for a “lookback” study that can result in a catch-up depreciation deduction and, potentially, a current-year refund for deductions not taken in prior years.
Planning ahead
As noted above, the percentage of qualified property basis that can be deducted under bonus depreciation rules will begin to decline after Dec. 31, 2022. If no legislative action is taken, the provision will sunset completely after Dec. 31, 2026. In addition to the favorable bonus depreciation percentage, the CARES Act also reinstated a five-year carryback for net operating losses arising in 2018, 2019, and 2020. Businesses that may be in the market to make significant fixed asset purchases in the next few years should keep these dates in mind as the ability to deduct 100% of a large asset’s cost in the year of acquisition can generate significant tax savings (possibly even refunds) as well as simplify depreciation recordkeeping.
To learn more about how bonus depreciation and other fixed asset management strategies can recover costs sooner and improve your business’s cash flow, contact your Plante Moran advisor.
