A concept that can be confusing and frustrating for small business owners—especially come tax season—is depreciation. With depreciation, you buy an asset, like a computer, and even though the money has already left your bank account you can’t recognize the full expense. This accounting rule can make purchasing assets challenging for small businesses, which isn’t ideal.
Luckily, there are tax-saving alternatives business owners can use, including bonus depreciation. This guide to bonus depreciation will explain what this method is, what qualifies, how to claim it, and more.
What Is Bonus Depreciation?
When you buy an asset for your business, you normally depreciate the asset over its useful life. Say you buy $5,000 worth of computers for your business. Rather than writing off the full expense, you might depreciate it by writing off $1,000 per year for five years.
That can be tough for small businesses—you paid for something in one year and you won’t get the tax write-off right away. You have to wait five years to get the full benefit because of the accounting rule of depreciation. That can put a strain on your cash flow. But there are ways to avoid this situation.
Enter: bonus depreciation.
Bonus depreciation is a method for businesses to take a larger depreciation deduction on assets the year they start being used. You might also hear it referred to as additional first year depreciation.
Previously, bonus depreciation was 50%. That meant that a business could deduct 50% of the cost of an asset before taking standard depreciation.
The Tax Cuts and Jobs Act gave bonus depreciation a big boost, by increasing it to 100% for assets purchased and placed in service between September 28, 2017, and December 31, 2022. If you buy and start using an eligible asset during that period, you can elect to take 100% of the cost as depreciation, rather than depreciating it over a number of years.
Beginning in 2023, bonus depreciation will be phased down over four years:
- 80% bonus depreciation in 2023
- 60% bonus depreciation in 2024
- 40% bonus depreciation in 2025
- 20% bonus depreciation in 2026
How Does Bonus Depreciation Affect Taxes?
We’ve mentioned that bonus depreciation can help business owners get a bigger deduction in the year they buy an asset. But how does that work?
Let’s say your business just bought and started using a $30,000 piece of equipment that you’ll use for the next 10 years. Standard depreciation could leave you with an annual depreciation deduction of $3,000 per year. With a 21% corporate tax rate, that deduction would be worth $630 each year ($3,000 deduction x 21% tax rate).
While that’s a nice deduction to get each year, 100% bonus depreciation will give you a bigger deduction up front.
With bonus depreciation of 100%, you’ll take a depreciation deduction for the entire $30,000 cost that first year you start using your equipment. With a 21% corporate tax rate, that deduction is worth $6,300 ($30,000 deduction x 21% tax rate).
That puts more money back into your pocket immediately, rather than needing to wait 10 years to get the full benefit of the depreciation deduction. And this hopefully frees up more cash so you can continue investing in things your business needs to help it grow.
What Qualifies for Bonus Depreciation?
Not everything is going to qualify for bonus depreciation. Eligible property includes:
- Tangible property with a useful life of less than 20 years: This includes things like equipment, machinery, furniture, vehicles, appliances, and carpet.
- Depreciable computer software
- Water utility property
- Qualified leasehold improvement property: improvements made to the interior of a non-residential building.
- Qualified film, television, and live theatrical productions
Previously only new purchases were eligible for bonus depreciation. The Tax Cuts and Jobs Act also expanded the eligibility for bonus depreciation to include the purchase of used property. Not every used purchase will qualify though. The used property can’t be used by the taxpayer before buying it and it can’t have been purchased from a related party, among other restrictions.
How to Claim Bonus Depreciation
If you have purchased property that is eligible for bonus depreciation and placed it into service (started using it), you can claim bonus depreciation. You can file Form 4562, Depreciation and Amortization with your tax return, to claim the bonus depreciation.
Do You Have to Use Bonus Depreciation?
Bonus depreciation may not be right in every situation. If bonus depreciation isn’t going to be helpful for your business, you don’t have to take it. You can elect not to take it and instead use the appropriate depreciation method for your property.
Bonus Depreciation vs. Section 179 Expense
If you’ve heard about Section 179 depreciation deductions, you might be a little confused. What’s the difference? They both allow you to immediately write off the cost of the property that you purchase. But while they are very similar, there are some differences. Two of those differences include:
- $1,020,000 maximum: Section 179 allows you to deduct up to $1,020,000 of business property purchases immediately, rather than depreciating them over their useful life. That maximum is reduced if you have purchases over $2.5 million and completely phased out when your purchases exceed $3.5 million. Bonus depreciation isn’t subject to maximum dollar limits.
- Business income limits: Section 179 allows you to take a deduction up to your taxable income—a Section 179 deduction can’t be used if you have a loss. For example, say you bought a piece of equipment for $60,000. If you have taxable income of $50,000 before taking a Section 179 deduction, your Section 179 deduction is limited to $50,000. You can carry forward the unused Section 179 deduction. Bonus depreciation, on the other hand, isn’t subject to a taxable income limit.
Why do we have both Section 179 and bonus depreciation? They offer different benefits, depending on your situation.
If your business has a loss and can’t utilize the Section 179 deduction, you might consider using bonus depreciation instead. Or, if you have already used the maximum Section 179 deduction, you can potentially use bonus depreciation for your remaining property.
This is where working with an accountant can be very helpful: they can help you decide which option is best for your specific situation.
The Bottom Line
Bonus depreciation can be a powerful tax-saving tool for the small business owner. By being able to deduct the full amount of an equipment purchase up front, you’ll face a smaller tax bill and can free up more cash flow.
If you’re unsure whether the bonus depreciation is right for you—or whether that or a Section 179 deduction is best—consult a trained accountant to help you figure out the best more for your business.
- IRS.gov. “New Rules and Limitations for Depreciation and Expensing Under the Tax Cuts and Jobs Act”
- Journalofaccountancy.com. “Regulations Clarify Bonus Depreciation Treatment”
- IRS.gov. “Publication 946 (2019), How to Depreciate Property”