Most companies require specialty machinery & equipment to manage a business efficiently and profitably. But, technology advances so rapidly, businesses need to upgrade their equipment often because newer machinery runs faster & smarter, which allows for increased revenue and profits. In this article we answer the question – is Bonus Depreciation Subject to Recapture?
The federal tax code allows for special upfront write-offs to make these upgrades more affordable and encourage economic activity. The IRS Sec. 179 deduction (known as “first-year expensing”) permits taxpayers to deduct certain expenses in the year business property was placed in service.
The Internal Revenue Service also has a special allowance (aka, a tax incentive that is revised over time) that allows for a write-off of taxable income equal to the cost of specific qualified property, known as bonus depreciation.
Bonus depreciation seeks to encourage small businesses to invest to stimulate the larger economy further.
What is Bonus Depreciation?
For tax accounting purposes, when a business acquires property, its cost is typically spread across the asset’s useful life – a process known as depreciation. Often, this non-cash deduction works in the business’s best interests, and if not applied, the company’s bottom-line profits are often significantly impacted.
Bonus depreciation simply allows for more significant deductions during the first years the asset is owned. This option can be quite beneficial, especially for those investors who have no plans to use the asset for extended periods, as bonus depreciation allows for an improved cash flow immediately after the asset’s purchase.
And while helpful to a company’s bottom line, depreciation can set up a future financial pothole when the asset is sold. Upon the sale of the qualified property, the IRS will want the taxes the depreciated asset has deferred.
This IRS provision is known as depreciation recapture. Depreciation recapture is the way in which the IRS taxes the profit on the sale of Section 179 property if the property owner had previously claimed depreciation.
Bonus depreciation is a temporary option that allows 100% of a qualified property write-off for assets placed into service after September 27, 2017, but before January 1, 2023. Note that the bonus depreciation phases out slowly through 2027 unless it is extended by future legislative action.
Bonus Depreciation Essentials
- Bonus depreciation is NOT an extra write-off; it is simply an accelerated deduction of regular depreciation. It is a coveted deduction, a non-cash expense that may reduce effective tax rates and improve cash flow.
- Bonus depreciation is available for new & previously owned property, which is a revision to previous guidelines. But note, the property cannot be acquired from a related party.
- Bonus depreciation is automatically applied, and one must choose to opt-out if they wish to avoid this automatic deduction. But note, electing to opt-out is irrevocable and includes all assets within the same class that were placed in service during the same year.
- Bonus depreciation is claimed using IRS Form 4562.
- Qualified property must not have a useful life of more than 20 years, which excludes real property from this beneficial tax shelter.
- Bonus depreciation can be used with or without financing on the property.
- Taxpayers can deduct the entire bonus depreciation amount even if this amount exceeds defined maximum limits on deductions.
- Property that qualifies for this deduction is not limited to tangible property (i.e., equipment & machinery) and may include TV/Theater productions, fruit/nut trees, and computer software.
- Bonus depreciation kicks in after Section 179 has expensed for property purchases.
- The taxpayer/business does not need to be profitable to be eligible for the bonus depreciation deduction. This differs from typical Sec. 179 deductions that require profitability.
- State income tax rules regarding bonus depreciation may be different from federal rules guidelines.
- More details about bonus depreciation can be found in IRS Publication 946, How to Depreciate Property.
The TCJA – The Tax Cuts & Jobs Act of 2017’s Impact on Bonus Depreciation
The TCJA created temporary changes to business property expensing. Business property that was acquired after September 2017 can be expensed at 100%. This allowance of 100% starts decreasing after 2022, each year by about 20%. These bonus depreciation provisions are set to expire on January 1, 2027.
TCJA provisions now distinguish between real property and tangible assets. This differs from previous years in which tangible property included eligible property sold using a 1031 exchange.
The Tax Cuts & Jobs Act advises that state law determines the way in which an asset is classified in terms of federal taxable income. The changes created by TCJA provide additional taxpayer benefits in that many fixtures/improvements are now eligible for bonus depreciation and 1031 exchanges – increasing a taxpayer’s deferred taxes.
Is Bonus Depreciation Subject to Recapture Tax?
Bonus depreciation is subject to a recapture tax on property that has been sold and has also taken bonus depreciation.
This means that a financial gain on a property sale (if there was bonus depreciation) is taxed as ordinary income (rather than the reduced capital gain rate) up to the extent of the deduction. Additionally, this income must be taxed in the year of the sale.
As such, it is important for investors to be strategic and plan to use a 1031 exchange if they wish to indefinitely defer the liability created by the depreciation recapture tax.
How Can the 1031 Exchange Help Defer Bonus Depreciation Recapture?
The 1031 exchange is a practical investment instrument that can be used to avoid the bonus depreciation recapture tax during the year in which the qualified property has been sold. But note that an investor must classify each property similarly within the 1031 exchange if they are to be eligible to indefinitely defer the tax liability created by applying bonus depreciation and the depreciation recapture tax.
To postpone the tax liability created by depreciation recapture tax, it is wise to consult a tax professional to ensure that the property to be used within a 1031 exchange is eligible and the process proceeds without incident. Failing to meet the like-kind exchange requirements may result in taxable gain when the property is sold, which essentially defeats the purpose of the 1031 exchange.