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Bonus Depreciation is Still a Valuable Tool for Year-End Tax Savingsby
Bonus depreciation – the ability to claim boosted first-year depreciation deductions for qualifying assets – has been a staple of year-end tax planning since it was introduced by the Job Creation and Worker Assistance Act of 2002.
It has been overshadowed somewhat by the generous expensing allowance under Code Section 179 and the de minimis safe harbor in the capitalization regulations, but bonus depreciation under Section 168(k) is still an important year-end tax-saving tool for the many businesses that can’t write off all their machinery and equipment purchases by way of these other cost recovery breaks.
The 50 percent first-year bonus depreciation deduction is permitted without any proration based on the length of time that an asset is in service during the tax year. As a result, the 50 percent first-year bonus write-off for qualifying assets bought and placed in service in 2016 is available even if the assets are in service for only a few days in 2016.
Illustration: As year-end approaches, XYZ Inc., a calendar-year business, needs to buy $1,000,000 of five-year Modified Accelerated Cost Recovery System (MACRS) property. If it can move quickly to accelerate the purchase, and place the property in service before 2017, XYZ may claim a first-year depreciation allowance of $600,000 [($1,000,000 × .50 = $500,000 bonus depreciation) + ($1,000,000 - $500,000 × .20 first-year MACRS depreciation allowance = $100,000 regular first-year depreciation)]. This assumes that the half-year convention applies for 2016 (conventions are discussed below).
If bonus depreciation wasn’t available, XYZ’s regular first-year depreciation allowance using the half-year convention would be only $200,000 (20 percent of $1,000,000).
Accelerating a purchase into 2016 may not always be a good idea. For example, it may not produce good results for a taxpayer who has an about-to-expire net operating loss. On the other hand, a taxpayer for whom accelerating the purchase will produce a net operating loss for 2016 that can be carried back to 2014, and who had income taxed at the highest rate in that year, has a good reason to make the purchase in 2016.
How to qualify for bonus depreciation. In general, an asset acquired and placed in service in 2016 qualifies for the bonus depreciation allowance under Section 168(k) if:
1. It falls into one of the following categories:
- Property to which the MACRS rules apply with a recovery period of 20 years or less;
- Computer software other than computer software covered by the amortization of goodwill and other intangibles rules of Section 197;
- Qualified improvement property (i.e., certain interior improvements to nonresidential buildings); or
- Certain water utility property.
2. Its original use commences with the taxpayer. Original use is the first use to which the property is put, whether or not that use corresponds to the taxpayer’s use of the property. (Section 168(k)(2))
For eligible qualified property (generally, qualified property eligible for bonus depreciation), corporations can elect to forego bonus depreciation and accelerated depreciation in exchange for an increased alternative minimum tax credit limitation. (Section 168(k)(4))
Extra-generous luxury auto depreciation limits. Under Section 168(k)(2)(F)(i), the first-year depreciation deduction for new vehicles that qualify for bonus depreciation is $8,000 more than the first-year depreciation limit that would otherwise apply.
For new vehicles bought and placed in service in 2016, and that qualify for bonus first-year depreciation, the boosted first-year dollar limit is $11,160 for autos (not trucks or vans) and $11,560 for light trucks or vans (passenger autos built on a truck chassis, including minivans and sport-utility vehicles [SUVs] built on a truck chassis). The regular first-year luxury auto limits (e.g., for vehicles not eligible for bonus depreciation, or for which the taxpayer elects out of bonus depreciation) are $3,160 for autos and $3,560 for light trucks or vans.
Heavy SUVs – those that are built on a truck chassis and are rated at more than 6,000 pounds gross (loaded) vehicle weight – are exempt from the luxury-auto dollar caps because they fall outside of the definition of a passenger auto. Under Section 179(b)(5), not more than $25,000 of the cost of a heavy SUV may be expensed under Section 179.
The balance of the heavy SUV’s cost may be depreciated under the regular rules that apply to five-year MACRS property (e.g., a 20 percent first-year depreciation allowance if the half-year convention applies for the placed-in-service year). However, with the 50 percent first-year bonus depreciation available for qualified assets bought and placed in service in 2016 (in addition to the $25,000 expensing allowance and regular depreciation), taxpayers buying and placing in service new heavy SUVs in 2016 may be entitled to write off most of the cost of the vehicle in the first year.
Effect of half-year and midquarter conventions on year-end planning. The half-year convention generally applies in the computation of depreciation deductions for property (other than real property) first placed in service during the current tax year. Under this convention, a business asset placed in service at any time during the tax year is generally treated as having been placed in service in the middle of that year. (Section 168(d)(1))
However, the half-year convention only applies if property depreciable under Section 168 and placed in service during the last three months of the tax year (other than property expensed under Section 179, residential rental property, nonresidential realty, and certain other excluded categories) doesn’t exceed 40 percent of all of such property placed in service during the entire year. If it does, then a midquarter convention applies. (Section 168(d)(3)) Under that rule, personal property placed in service during any quarter of the tax year is treated as if it had been placed in service at the middle of the quarter in which it was placed in service.
Illustration: Ace Inc. buys one depreciable asset during 2016 – a $10,000 used machine that’s five-year property under MACRS. Assume Ace isn’t eligible for Section 179 expensing. If it places the asset in service during the first three quarters of its tax year, the first-year depreciation allowance is $2,000 (20 percent). If it places the asset in service during its fourth quarter, the write-off is slashed to $500 (5 percent midquarter table percentage for five-year property placed in service in the fourth quarter).
The availability of bonus first-year depreciation on most new machinery and equipment purchases (see discussion above) substantially diminishes the hazards of buying new assets in the last quarter. The 50 percent first-year bonus depreciation allowance is available even if the midquarter convention applies. In that case, the midquarter allowance is taken on the adjusted basis of the property after reduction for the bonus depreciation allowance.
Use of the bonus first-year depreciation allowance has no effect on the determination of whether or not the midquarter convention applies. The 40 percent test is computed with reference to the adjusted basis of nonrealty assets placed in service during the year, without reduction for the bonus depreciation allowance.
It may be possible in some cases to avoid application of the midquarter convention by electing to expense under Section 179 property placed in service during the last quarter. On the other hand, deliberately exceeding the 40 percent limit to trigger the midquarter convention may be a sound strategy where the taxpayer has placed a large amount of property in service during the first quarter of the year.
For instance, if a calendar-year taxpayer placed a large amount of five-year recovery property in service in March 2017, triggering the midquarter convention for 2017 will produce a 10 1/2-month regular first-year depreciation deduction for that property.