What You Should Know About Section 179 and Bonus Depreciation

PROFIT MASTERY COLUMN

BY JULIE MURPHY

Section 179 of the Internal Revenue Code allows eligible businesses to take an immediate deduction for business expenses related to depreciable assets such as equipment, vehicles, and software. The Internal Revenue Service has been helping small businesses reduce their tax burden since the 1950s, when Congress first passed Section 179. They originally provided for a tax deduction of up to $2,000. (See sidebar for historical reference).

Section 179 allows a taxpayer to deduct the cost of certain qualified property on their income taxes as a one-time expense, rather than requiring the cost of the property to be capitalized and depreciated over time. Today, the deduction has increased to $1,040,000 for tax year 2020, but the details of how to qualify for the deduction are more complicated. Therefore, while the provision’s goal remains the same, deciding how best to exploit its potential benefits isn’t straightforward.

As you read this Section 179 primer for the 2020 tax season, keep in mind that neither I nor Commercial Credit Group Inc. are offering tax advice. This information is designed to help you prepare for the most productive meeting possible with your tax preparer, adviser, or attorney to strategize your company’s short- and long-term financial goals.

What is an ‘Eligible’ Business?

Any business that bought or financed new or used equipment, including some real property improvements, and placed the equipment or improvements into service before Jan. 1, 2021, should qualify for Section 179 in tax year 2020.

What Equipment/Property Qualifies?

Eligible equipment includes new or pre-owned tangible personal property used in a business, which includes machinery, heavy equipment, computer and office equipment, off-the-shelf software, and certain vehicles for business use.

Pre-owned equipment qualifies if you didn’t use it before acquiring it (i.e., rent to own) and didn’t acquire it from a related party (i.e., from another, related business you may own or that owns you) or member of a controlled group of corporations. Eligible equipment also must be used more than 50% of the time on business needs.

The Tax Cuts and Jobs Act (TCJA) of 2018 expanded the definition of “qualified real property” to include improvements to nonresidential real estate such as roofs; HVAC systems’ and fire protection, alarm, and security systems. For example, if you’re thinking of updating or replacing your factory’s HVAC system to help mitigate risks associated with  potential disease spread by improving air flow, that expense may qualify – but you must complete improvements by Dec. 31.

Additional details can be found in IRS fact sheet “New Rules and Limitations for Depreciation and Expensing Under the Tax Cuts and Jobs Act.”

The Coronavirus Aid, Relief, and Economic Security (CARES) Act made changes to the treatment of qualified improvement property (QIP), classifying it as 15-year property rather than 39-year property and no longer subjecting it to the $2-million-a-year limit for bonus depreciation. These changes are retroactive to 2018. Refunds may be available for tax years 2018 and 2019. Consult your tax preparer to determine if amended tax returns are in your company’s best interest.

Are There Limits to Section 179?

Yes. The maximum deduction is $1,040,000 for tax year 2020 for expenses related to eligible property with a maximum cost of $2,590,000. If you spend more, the deduction is reduced dollar for dollar. For example, if your business spends $3,630,000 you would not be entitled to any section 179 deduction.

Also, you can’t take the deduction if doing so puts the business into a position of negative income. Even if equipment purchases qualify for the full $1,040,000 deduction, if your company’s gross income is $1,000,000 you’re limited to taking only $1,000,000 in deductions. All is not lost, however: you can carry the additional $40,000 forward to later years until it’s fully deducted.

What About Bonus Depreciation Section 168(k)?

Section 168(k) or “bonus” depreciation allows a business to depreciate, up to 100%, the full cost of equipment (new or used) in the year in which it was placed into service. Unlike Section 179, there’s no limit on how much you spend.

Before tax year 2018, the bonus depreciation rate was 50% and could be used only for new equipment. After revisions made in the TCJA, used equipment now qualifies and the deduction was raised to 100%. Now many companies may opt to use bonus depreciation instead of Section 179.

One thing to keep in mind: The bonus depreciation rate is 100% only for tax years 2020 through 2022. Thereafter, it’s scheduled to decrease by 20% each year until 0% in 2027.

Benefits of Using Section 179 and Bonus Depreciation

The main purpose of Section 179 and the bonus depreciation is to reduce the amount of taxable income in a given year. Under standard straight-line depreciation, for a 10-year asset you would only deduct 10% of the equipment cost in each of 10 years. Deducting the full amount in a single year can dramatically reduce the amount of taxes owed in that year.

For example, if you deducted the full amount allowed (without bonus depreciation) under Section 179 in 2020, you’d reduce your taxable income by $1,040,000. At a corporate tax rate of 21%, this would save you $218,400 in taxes. You can estimate your potential tax savings using this Section 179 Calculator.

If you spend more than the Section 179 allowance of $1,040,00 but still under the $2,590,000 maximum, you can use bonus depreciation to obtain additional benefits. For example, if you spend $2,000,000 on eligible equipment and property, your Section 179 deduction would be $1,040,000 and bonus depreciation would be $960,000, allowing for the total deduction of $2,000,000. At a corporate tax rate of 21%, you would save $420,000 in taxes.

Before You Do Anything…a Couple of Caveats

There are various conditions which have to be met for property and expenses to be eligible for Section 179 or bonus depreciation. You need to consult your tax adviser to determine which options are available and most advantageous to you.

Section 179 and bonus depreciation accelerates the amount of depreciation you can take in a given year, but reduces the amount of depreciation you can take in future years, thus eliminating the ability to use that equipment to reduce future tax burdens.

Accelerated depreciation also reduces the equipment’s book value, effectively lowering the book value to $0. If the equipment has an associated loan balance, this affects the balance sheet ratios. You have $0 on the asset side of the balance sheet, but still carry the liability of the loan.

For many companies this isn’t a problem; but because it affects debt-to-worth ratio, it could affect your ability to borrow in the future depending on how a potential lender looks at your situation. Also, if you decide to sell the equipment in the future, selling it for a price above the book value would result in a net gain, potentially having a negative impact on your tax situation.

NOTE: This article is not tax advice. You should contact your accountant or an attorney for advice and information.

Sidebar 1

How to Take Advantage of Section 179 and Bonus Depreciation

Step 1. Consult your tax preparer, adviser, or attorney to discuss your short- and long-term goals and determine if it makes sense for your business to use Section 179 and/or bonus depreciation.

Step 2. Place your qualified equipment or property into service before Jan. 1, 2021.

Step 3. Complete IRS Form 4562 (which is used for both Section 179 and Bonus depreciation) when submitting your company’s tax returns.

Sidebar 2

History of Section 179

• 1958. Section 179 is written into federal tax code to reduce burden on small businesses and stimulate investment. Deduction limited to $2,000 ($4,000 for married filing jointly).
• Economic Recovery Tax Act raises allowance to $5,000 and allows for gradual increase to $10,000 in 1986.
• 1984. Deficit Reduction Act of 1984 postpones the increase to $10,000 from 1986 to 1990.
• 1993. Omnibus Budget Reconciliation Act raises allowance to $17,500 and adds “enterprise” and “empowerment” zones (EZs) as special geographic areas in which additional benefits could be allowed.
• 1996. Small Business Job Protection Act includes timetable for scheduled increases up to $25,000 in 2003.
• 2000. Community Renewal Tax Relief Act adds “renewal communities” (RCs), economic development areas, granting businesses in those areas an additional $35,000 qualified asset allowance.
• 2002. Job Creation and Worker Assistance Act adds areas in lower Manhattan, designated the “Liberty Zone,” to list of geographic areas included in EZs and RCs, to receive additional allowances.
• 2003. Jobs and Growth Tax Reduction and Reconciliation Act (JGTRRA) increases allowance to $100,000 for 2003, 2004, and 2005; reduces it to $25,000 for 2006. Raises phaseout threshold to $400,000 and adds off-the-shelf software to list of eligible assets.
• 2004. American Jobs Creation Act extends JGTRRA change to 2007.
• 2005. After Hurricane Katrina, Gulf Opportunity Zone Act adds “Gulf Opportunity Zone” (GOZ) and increases allowances for businesses in that region.
• 2005. Tax Increase Prevention and Reconciliation Act extends JGTRRA allowances through 2009.
• 2007. U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Appropriations Act extends the changes; raises allowance to $125,000 and phaseout threshold to $500,000 for tax years 2007 through 2010, indexing both amounts for inflation and extending, through 2008, the GOZ allowance.
• 2008. Economic Stimulus Act increases allowance to $250,000 and phaseout to $800,000 with a reset to $125,000 and $500,000, respectively, for 2009.
• 2009. American Recovery and Reinvestment Act extends 2008 amounts through 2010.
• 2010. Small Business Jobs Act increases allowance to $500,000 and phaseout to $2 million for 2010 and 2011, with resets to $25,000 and $200,000, respectively, for 2012. Adds leasehold improvement property and other property to list of eligible assets.
• Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act increases allowance and phaseout thresholds for 2012 to $125,000 and $500,000, respectively, with resets to $25,000 and $200,000, respectively, for 2013.
• American Taxpayer Tax Relief Act increases allowance to $500,000 and phaseout to $2 million for 2012 and 2013.
• 2014. Tax Increase Prevention Act extends the previous allowances through 2014.
• 2015. Protecting Americans from Tax Hikes Act permanently sets Section 179 allowance at $500,000 and phaseout at $2 million, with inflation indexing beginning in 2016.
• 2017. Congress passes tax revision bill increasing allowance to $1 million and phaseout threshold to $2.5 million, allowing for inflation indexing beginning in 2019.

For additional details, visit https://fas.org/sgp/crs/misc/RL31852.pdf.