Businesses: Act Now to Make the Most Out of Bonus Depreciation

The Tax Cuts and Jobs Act (TCJA) significantly boosted the potential value of bonus depreciation for taxpayers — but only for a limited duration. The amount of first-year depreciation available as a so-called bonus will begin to drop from 100% after 2022, and businesses should plan accordingly.

Bonus depreciation in a nutshell

Bonus depreciation has been available in varying amounts for some time. Immediately prior to the passage of the TCJA, for example, taxpayers generally could claim a depreciation deduction for 50% of the purchase price of qualified property in the first year — as opposed to deducting smaller amounts over the useful life of the property under the modified accelerated cost recovery system (MACRS).

The TCJA expanded the deduction to 100% in the year qualified property is placed in service through 2022, with the amount dropping each subsequent year by 20%, until bonus depreciation sunsets in 2027, unless Congress acts to extend it. Special rules apply to property with longer recovery periods.

Businesses can take advantage of the deduction by purchasing, among other things, property with a useful life of 20 years or less. That includes computer systems, software, certain vehicles, machinery, equipment and office furniture.

Both new and used property can qualify. Used property generally qualifies if it wasn’t:

• Used by the taxpayer or a predecessor before acquiring it,

• Acquired from a related party, and

• Acquired as part of a tax-free transaction.

Qualified improvement property (generally, interior improvements to nonresidential property, excluding elevators, escalators, interior structural framework and building expansion) also qualify for bonus depreciation. A drafting error in the TCJA indicated otherwise, but the CARES Act, enacted in 2020, retroactively made such property eligible for bonus depreciation. Taxpayers that placed qualified improvement property in service in 2018, 2019 or 2020 may, generally, now claim any related deductions not claimed then — subject to certain restrictions.

Buildings themselves aren’t eligible for bonus depreciation, with their useful life of 27.5 (residential) or 39 (commercial) years — but cost segregation studies can help businesses identify components that might be. These studies identify parts of real property that are actually tangible personal property. Such property has shorter depreciation recovery periods and therefore qualifies for bonus depreciation in the year placed in service.

The placed-in-service requirement is particularly critical for those wishing to claim 100% bonus depreciation before the maximum deduction amount falls to 80% in 2023. With the continuing shipping delays and shortages in labor, materials and supplies, taxpayers should place their orders promptly to increase the odds of being able to deploy qualifying property in their businesses before year-end.

Note, too, that bonus depreciation is automatically applied by the IRS unless a taxpayer opts out. Elections apply to all qualified property in the same class of property that is placed in service in the same tax year (for example, all five-year MACRS property).

Bonus depreciation vs. Section 179 expensing

Taxpayers sometimes confuse bonus depreciation with Sec. 179 expensing. The two tax breaks are similar, but distinct.

Like bonus deprecation, Sec. 179 allows a taxpayer to deduct 100% of the purchase price of new and used eligible assets. Eligible assets include software, computer and office equipment, certain vehicles and machinery, as well as qualified improvement property.

But Sec. 179 is subject to some limits that don’t apply to bonus depreciation. For example, the maximum allowable deduction for 2022 is $1.08 million.

In addition, the deduction is intended to benefit small- and medium-sized businesses so it begins phasing out on a dollar-for-dollar basis when qualifying property purchases exceed $2.7 million. In other words, the deduction isn’t available if the cost of Sec. 179 property placed in service this year is $3.78 million or more.

The Sec. 179 deduction also is limited by the amount of a business’s taxable income; applying the deduction can’t create a loss for the business. Any cost not deductible in the first year can be carried over to the next year for an unlimited number of years. Such carried-over costs must be deducted according to age — for example, costs carried over from 2019 must be deducted before those carried over from 2020.

Alternatively, the business can claim the excess as bonus depreciation in the first year. For example, say you purchase machinery that costs $20,000 but, exclusive of that amount, have only $15,000 in income for the year it’s placed in service. Presuming you’re otherwise eligible, you can deduct $15,000 under Sec. 179 and the remaining $5,000 as bonus depreciation.

Also in contrast to bonus depreciation, the Sec. 179 deduction isn’t automatic. You must claim it on a property-by-property basis.

Some caveats

At first glance, bonus depreciation can seem like a no-brainer. However, it’s not necessarily advisable in every situation.

For example, taxpayers who claim the qualified business income (QBI) deduction for pass-through businesses could find that bonus depreciation backfires. The amount of your QBI deduction is limited by your taxable income, and bonus depreciation will reduce this income. Like bonus depreciation, the QBI deduction is scheduled to expire in 2026, so you might want to maximize it before then.

The QBI deduction isn’t the only tax break that depends on taxable income. Increasing your depreciation deduction also could affect the value of expiring net operating losses and charitable contribution and credit carryforwards.

And deduction acceleration strategies always should take into account tax bracket expectations going forward. The value of any deduction is higher when you’re subject to higher tax rates. Newer businesses that currently have relatively low incomes might prefer to spread out depreciation, for example. With bonus depreciation, though, you’ll also need to account for the coming declines in the maximum deduction amounts.

Buy now, decide later

If you plan on purchasing bonus depreciation qualifying property, it may be wise to do so and place it in service before year end to maximize your options. We can help you chart the most advantageous course of action based on your specific circumstances and the upcoming changes in tax law.

© 2022

Take a balanced approach to retirement and estate planning using a split annuity

If you’re approaching retirement or have already retired, one of the biggest challenges is balancing the need to maintain your standard of living with your desire to preserve as much wealth as possible for your loved ones. This balance can be difficult to achieve, especially when retirement can last decades. One strategy to consider is the split annuity, which creates a current income stream while preserving wealth for the future.

ABCs of an annuity

An annuity is a tax-advantaged investment contract, usually with an insurance company or other financial services provider. You pay either a lump sum or annual premiums, and in exchange, the provider makes periodic payments to you for a term of years or for life.

For purposes of the split annuity strategy discussed below, we’ll focus on “fixed” annuities, which generally provide a guaranteed minimum rate of return. Other types of annuities include “variable” and “equity-indexed,” which may offer greater upside potential but also involve greater risk.

Annuities can be immediate or deferred. As the names suggest, with an immediate annuity, payouts begin right away, while a deferred annuity is designed to begin payouts at a specified date in the future.

From a tax perspective, annuity earnings are tax-deferred — that is, they grow tax-free until they’re paid out or withdrawn. A portion of each payment is subject to ordinary income tax, and a portion is treated as a tax-free return of principal (premiums). The ability to accumulate earnings on a tax-deferred basis allows deferred annuities to grow more quickly than comparable taxable accounts, which helps make up for their usually modest interest rates.

Annuities offer some flexibility to withdraw or reallocate the funds should your circumstances change. But keep in mind that — depending on how much you withdraw and when — you may be subject to surrender or early withdrawal charges.

Split annuity strategy

A split annuity may sound like a single product, but in fact, it simply refers to two (or more) annuities, usually funded with a single investment. In a typical split annuity strategy, you use a portion of the funds to purchase an immediate annuity that makes fixed payments to you for a specified term (10 years, for example). The remaining funds are applied to a deferred annuity that begins paying out at the end of the initial annuity period.

Ideally, at the end of the immediate annuity term, the deferred annuity will have accumulated enough earnings so that its value is equal to your original investment. In other words, if the split annuity is designed properly, you’ll enjoy a fixed income stream for a term of years while preserving your principal.

At the end of the term, you can reevaluate your options. For example, you might start receiving payments from the deferred annuity, withdraw some or all its cash value, or reinvest the funds in another split annuity or another investment vehicle.

If you’re interested in learning more about a split annuity, please contact us. We’d be pleased to help you determine if this strategy is right for your situation.