Under today's federal income tax rules, your business may be able to claim big first-year depreciation write-offs for eligible assets that are placed in service in the current tax year. But that strategy might not be right for every small business every year. Here's what you should know before claiming 100% first-year bonus depreciation or first-year Section 179 deductions.
The Tax Cuts and Jobs Act (TCJA) included two generous first-year depreciation tax breaks for business taxpayers:
1. 100% first-year bonus depreciation deductions. New and used qualifying business assets placed in service between September 28, 2017, and December 31, 2022, are eligible for 100% first-year bonus depreciation. For certain assets with longer production periods and aircraft, the placed-in-service deadline is extended to December 31, 2023.
2. Section 179 deductions. For tax years beginning in 2020, a business taxpayer can potentially write off up to $1.04 million of the cost of qualifying new and used assets with the Sec. 179 deduction. Under a phaseout rule, the maximum $1.04 million Sec. 179 deduction for tax years beginning in 2020 is reduced dollar-for-dollar by the excess of Sec. 179 deduction-eligible asset additions over $2.59 million.
The allowable deduction for a tax year can't exceed the taxpayer's aggregate net business taxable income from all sources calculated before any Sec. 179 deductions. That means Sec. 179 deductions can't create or increase a federal income tax net operating loss (NOL). Deductions that would create or increase an NOL are disallowed and carried forward to the following tax year.
Finally, if your business operates as a pass-through entity – such as a limited liability company (LLC), partnership or S corporation – the $1.04 million Sec. 179 deduction maximum, the $2.59 million deduction phaseout threshold and the business taxable income limitation apply at both the entity level and your personal level. The interactions of these limitations can cause allowable Sec. 179 deductions for a year to be less than expected.
100% first-year bonus depreciation is generally preferred to Sec. 179 deductions. That's because there aren't any federal income tax limitations on 100% first-year bonus depreciation deductions. And, importantly in the COVID-19 era, 100% first-year bonus depreciation write-offs can create or increase an NOL that you can potentially carry back for up to five tax years to recover federal income taxes paid for those earlier years. That can be a big help for a cash-starved business. (See "CARES Act Changes Rules for NOL Carrybacks and QIP," at the bottom.)
If your business's federal income tax planning objective is to minimize taxable income for the year that depreciable property is placed in service, claiming big first-year deductions for eligible property is a good idea. But there are three reasons you may opt to depreciate assets placed in service in 2020 over time, rather than claim first-year depreciation write-offs.
1. To lower the tax rate on gain from depreciation when real estate QIP is sold. Any gain on the disposition of qualified improvement property (QIP) is treated as high-taxed ordinary income to the extent of additional depreciation allowed or allowable on the property. This federal income tax treatment is known as the Section 1250 ordinary income recapture rule. For QIP held for more than a year, additional depreciation means the amount of allowable depreciation claimed in excess of the depreciation that would have resulted if the QIP had been depreciated using the straight-line method.
First-year bonus depreciation and Sec. 179 depreciation aren't treated as straight-line depreciation. So, those deductions can create Sec. 1250 ordinary income recapture when QIP is sold.
On the other hand, for QIP held for more than a year, gain attributable to straight-line depreciation is so-called "unrecaptured" Sec. 1250 gain that's taxed at a maximum individual federal rate of 25%. If you opt to depreciate QIP over 15 years, you must use the straight-line method. The tax advantage is that there's no high-taxed Sec. 1250 ordinary income recapture on gain from selling QIP that has been depreciated using the straight-line method. There's only unrecaptured Sec.1250 gain that's subject to the 25% maximum federal rate for individual taxpayers.
In short, claiming bonus depreciation and/or Sec. 179 deductions for QIP can cause a higher federal income tax rate when the property is sold than if you depreciate QIP straight-line over 15 years. If you plan to hold the property for many years, however, the tax rate differential issue is less important.
Important: Higher-income individual taxpayers may also owe the 3.8% net investment income tax (NIIT) on gains from selling depreciable real property.
2. To shift depreciation write-offs to future years, when tax rates may be higher than today. When you claim 100% bonus depreciation or Sec. 179 deductions, you effectively front-load your deductions. That is, your federal income tax depreciation deductions for future years are reduced by your first-year deductions. If federal income tax rates go up in future years, you've effectively traded more valuable future-year depreciation write-offs for less valuable first-year write-offs.
If you're unsure where tax rates are headed, consider an extension to file your return for the current tax year. Then you'll have until the extended due date to decide how to depreciate assets that are placed in service in the current tax year.
3. To maximize your QBI deduction. An individual taxpayer can claim a federal income tax deduction for up to 20% of qualified business income (QBI) from an unincorporated business activity. However, the QBI deduction from an activity can't exceed 20% of net income from that activity, calculated before the QBI deduction. Claiming first-year depreciation deductions will reduce net income and potentially result in a lower QBI deduction.
Furthermore, the QBI deduction for a year can't exceed 20% of your taxable income for that year, calculated before the QBI deduction and before any net capital gain. (Your net capital gain equals your net long-term capital gains in excess of net short-term capital losses plus qualified dividends.) So, moves that reduce your taxable income, such as claiming 100% bonus depreciation and Sec. 179 deductions, can reduce your allowable QBI deduction.
Important: The QBI deduction is scheduled to expire after 2025 – and it could disappear sooner, depending on tax law changes. So, it may be a use-it-or-lose it proposition. If you forgo big first-year depreciation deductions, your allowable QBI deduction may be higher. However, foregone first-year depreciation isn't lost. It's just deducted in later years when depreciation write-offs might be more valuable because tax rates are higher.
Claiming big 100% bonus depreciation and/or Sec. 179 deductions for assets placed in service in the 2020 tax year might result in an NOL that could be carried back to a prior tax year to recover federal income tax paid for that year. (See "CARES Act Changes Rules for NOL Carrybacks and QIP," at the bottom.)
So, claiming big 2020 first-year depreciation write-offs isn't necessarily a bad idea, especially during the COVID-19 crisis. A cash-strapped taxpayer could benefit from an NOL carryback and the resulting tax refund.
This is an election year, and anything could happen in the future. Before choosing when to claim depreciation deductions on qualifying business assets – in the first year they're placed in service or over time – discuss the matter with your tax advisor. He or she can help determine what's right for your small business, based on current and prospective federal income tax rules.
Consider these two favorable federal income tax rule changes included in the Coronavirus Aid, Relief and Economic Security (CARES) Act when deciding whether to take advantage of first-year depreciation breaks for assets placed in service this year.
1. NOL carrybacks. The CARES Act allows net operating losses (NOLs) that arise in tax years beginning in 2018 through 2020 to be carried back for up to five years. Many businesses may have 2020 NOLs due to the COVID-19 economic fallout. Those NOLs can be carried back as far as 2015.
NOL carrybacks to any pre-2018 tax year could be especially beneficial. That's because the federal income tax rates for both individuals and corporations were lowered for tax years beginning in 2018 under the Tax Cuts and Jobs Act (TCJA).
2. Real estate qualified improvement property (QIP). When drafting the TCJA, Congress intended to allow 100% first-year bonus depreciation for real estate QIP placed in service in 2018 through 2022. Congress also intended to give you the option of claiming 15-year straight-line depreciation for QIP placed in service in 2018 and beyond.
QIP is defined as an improvement to an interior portion of a nonresidential building that's placed in service after the date the building was first placed in service. However, QIP doesn't include expenditures:
Due to an error in drafting the TCJA, the intended first-year bonus depreciation break for QIP never made it into the statutory language. The CARES Act includes a retroactive technical correction to fix that oversight.
The correction causes QIP to be treated as property that can be depreciated over 15 years for federal income tax purposes, making it eligible for first-year bonus depreciation. That means real estate owners can claim 100% first-year bonus depreciation for QIP placed in service in 2018 through 2022.
Important: The correction has a retroactive effect for QIP that was placed in service in 2018 and 2019. Before the correction, taxpayers generally had to treat QIP placed in service in those years as nonresidential real property to be depreciated over 39 years using the straight-line method. Consult your tax advisor to determine whether you should file an amended tax return for 2018 and/or 2019.
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