By: Lance Williams, CPA, Manager, and Kimber Sutton, CPA, Staff Accountant
The Tax Cuts and Jobs Act (TCJA) was passed at the end of 2017. Of the many changes it made to the tax code, one that is temporary and currently scheduled to begin sunsetting, is the provision to allow for bonus depreciation under Section 168(k).
For five years, we’ve enjoyed the benefit of 100 percent bonus depreciation and the ease of making the decision between bonus and Section 179. Now that the phase-out of bonus depreciation begins next year, more taxpayers will need to strategically consider when to elect Section 179 or bonus depreciation.
On 1/1/2023, bonus depreciation will decrease from 100 percent to 80 percent and will annually decrease 20 percent until it has completely phased-out on 12/31/2026.
If you’re considering purchasing assets and/or real estate in the next few months, it may be best to have them placed in service by the end of the year (12/31/2022).
For those purchasing real estate, you might explore having a cost segregation study completed to take advantage of the final year of 100 percent bonus depreciation. Timing is crucial.
What Qualifies as 100 Percent Bonus Depreciation Property?
- New or used assets qualify if the asset was considered new to the taxpayer and not acquired from a related party
- Machinery, equipment, vehicles, and software are all qualified. Also qualified are leasehold improvements that are considered qualified improvement property (QIP)
- Qualified improvements are non-structural improvements made to the interior of a non-residential building that has already been placed into service
What is Section 179 and What Qualifies as Section 179 Property?
Section 179 allows taxpayers to deduct the entire cost of qualifying property used in their business when it is placed into service, rather than having to spread the depreciation expense over the useful life of the asset.
This presents several limitations that are not present with bonus depreciation; however, Section 179 can still be a beneficial way to expense asset purchases.
The Section 179 maximum deduction allowed has increased $30,000 from 2021 to 2022; you can now expense up to $1,080,000 of qualifying property under Section 179.
The phase-out threshold for Section 179 has also increased $80,000 from 2021 to 2022. Qualifying property up to $2.7 million can be purchased prior to phasing out any Section 179 deduction.
The following qualifies as Section 179 property:
- Tangible personal property, such as machinery and equipment, used in the trade or business
- Non-residential real property, such as roofs, HVAC property, fire protection, alarm systems, and security systems
What are the Differences for Residential Property, Commercial Property, and Qualified Improvement Property When it Comes to Bonus Depreciation and Section 179?
Residential rental property, in general, is depreciated over 27.5 years.
Other asset classes, such as land improvements, are depreciated over 15 years, where appliances and flooring are over five years.
For those assets with useful lives less than 20 years, bonus depreciation is allowed, but Section 179 is not for most residential property.
The TCJA did expand the definition of Section 179 property to include certain depreciable tangible personal property used predominately to furnish lodging or in connection with furnishing lodging (i.e., beds or furniture used in hotels and apartment buildings).
Commercial property, or non-residential property, is depreciated over 39 years.
Assets mentioned above, such as roofs, HVAC property, fire protection, alarm systems, and security systems, are all considered non-residential property, and are eligible for Section 179, but not bonus.
With that being said, Section 179 is not allowed on the purchase of a whole commercial building.
Qualified Improvement Property
TCJA eliminated the separate definitions of qualified leasehold improvement, qualified restaurant, and qualified retail improvement property.
Instead, it provides simplification with a general 15-year recovery period for QIP. QIP is considered any improvement made to the interior of a non-residential building after the building is originally placed into service.
It specifically excludes improvements for enlargement of the building, internal structural framework improvements, roofs, windows, stairs, elevators, exterior HVAC equipment, etc. The improvements do not need to be made pursuant to a lease. QIP is bonus and Section 179 eligible.
What Factors to Consider When Purchasing Potentially Bonus Eligible Property?
If you are thinking about buying property soon, the timing of your purchase could not be more crucial than it is right now.
To take advantage of 100 percent bonus depreciation, the property must be purchased and placed into service by 12/31/2022.
As noted previously, bonus depreciation is beginning to phase out starting 1/1/2023; the deduction is decreasing from 100 percent to only 80 percent and will continually decrease 20 percent each year until it has completely phased-out on 12/31/2026.
Cost Segregation Study
Another important factor to take into consideration when purchasing property is whether to have a cost segregation study completed.
The benefit of doing a cost segregation study has increased drastically since the implementation of 100 percent bonus depreciation.
It is critical that the cost segregation study separates out bonus eligible assets and real property.
Typically, a cost segregation study makes sense when the purchase price of the property is at least $1 million. This is not to say that a property purchased for a lesser amount cannot benefit from a cost segregation study; however, it is also important to weigh in on the cost-benefit analysis and how it will impact your business.
Passive Income vs. Nonpassive Income
Bonus depreciation can be very advantageous, but this is not always the case.
Taking a large deduction for bonus depreciation can cause substantial losses for real estate investors; this sounds like a great deal, but what if you are not able to take that loss and offset any of your income?
It is vitally important to understand how the income/loss from rental real estate is treated based upon your individual tax situation. Income/losses from rental real estate activities are typically considered passive income for most real estate investors.
The issue at hand is that passive losses can only be utilized and taken against passive income. Therefore, taking bonus depreciation and creating a large passive loss may not make sense for you if you do not have any other passive income to offset it.
For the income/loss from rental real estate to be considered nonpassive, and offset other income, you must qualify as a “real estate professional” as defined by the IRS.
To help determine if you qualify as a real estate professional, take a further look into our article: Do your rental activities qualify you as a real estate professional for tax purposes?.
It is important to note that to the naked eye, 100 percent bonus depreciation or Section 179 looks like a great opportunity, but that does not mean it will always bring immediate tax benefits to you.
There are many variables, with tax implications, to consider when looking to purchase assets and real estate.
If you’re looking to purchase before the end of the year, or to determine if taking advantage of the 100 percent bonus depreciation prior to 12/31/2022 is right for you, reach out to your local Blue & Co. tax professional for specific tax planning.
Lastly, if you’re a current or prospective real estate professional and have any questions regarding your qualifications for tax purposes, please reach out to your local Blue & Co. advisor today.