The Tax Cuts and Jobs Act (TCJA) of 2017 created new depreciation rules. And both business owners and real estate investors want to learn the new rules in order to maximize depreciation deductions.
In the paragraphs that follow, accordingly, I briefly describe the three big depreciation changes in the new law.
A Little Background
But before you step into the details, however, let me explain a few basic depreciation concepts.
Tax laws and the IRS require business owners to capitalize fixed assets and real property. Essentially, capitalization means a business or investor deducts costs of long lived assets not at the time of purchase but as depreciation deductions over time.
Not every long-lived asset matters, though. Typically, taxpayers capitalize and then depreciate only assets costing more than $2,500.
What gets capitalized and depreciated then? Lots of items. Common fixed assets include furniture and fixtures, machinery and equipment, computer hardware and software, buildings, and even some intangible assets such as loan fees and organizational expenses.
Furthermore, a bunch of rules govern how the cost of these assets get deducted, or “depreciated,” over time.
Bonus Depreciation: Often the Right Way to Maximize Deduction
Bonus depreciation perhaps counts as the easiest way to maximize depreciation deductions.
Historically, bonus depreciation allowed businesses to expense 50% of the cost of qualifying fixed assets immediately in the year placed in service.
But prior to the TCJA rules, a catch existed. Qualifying property only included brand new property. Bonus depreciation, then, excluded used property.
Under the new current rules, bonus depreciation now includes used property as well. Not only that, but the deduction increased from 50% to 100% of the cost.
Example: You buy two trucks for your business, one brand new for $50,000 and one slightly used for $25,000. Under the new tax law, bonus depreciation works for both trucks. The first truck creates $50,000 of bonus depreciation. The second truck creates $25,000 of bonus depreciation.
Two other important bonus depreciation features to consider. First, no phase out limitation exists. In other words, a business or investor may “bonus depreciate” any dollar amount spent on fixed assets (assuming the assets qualify).
Example: A small business which buys $100,000 of qualified assets deducts $100,000 of bonus depreciation. A much larger business which buys $100,000,000 of qualified assets deducts $100,000,000 of business depreciation.
And one other important feature of bonus depreciation to consider: Bonus depreciation ignores a taxpayer’s taxable income.
The “no taxable income limitation” means bonus depreciation can eliminate taxable net income and can even create losses that can be carried forward to future years.
Example: A taxpayer earns $50,000 in dividend and interest income and $100,000 in a sole proprietorship. If the business puts $150,000 of bonus depreciation on the taxpayer’s tax return, the bonus depreciation zeroes out taxable income and the taxpayer’s tax bill.
Section 179 Expense: Another Powerful Depreciation Approach
Section 179 expensing of qualifying fixed assets represents another method to maximize depreciation deductions.
Resembling bonus depreciation, Section 179 expensing allows businesses to deduct 100% of the cost of qualifying fixed assets. However, Section 179 burdens taxpayers with more limitations.
First, the taxpayer’s total income from her or his active trades or businesses sets the upper limit on the taxpayer’s Section 179 income.
Example: A taxpayer earns $100,000 in an active trade or business and another $50,000 in interest on bonds. Tax law limits the taxpayer’s Section 179 deduction to $100,000.
A second limitation? Tax law limits the maximum Section 179 expense allowed on a taxpayer’s return to $1,000,000.
Note: Prior to the TCJA, Section 179 allowed businesses to deduct up to a maximum of $510,000.
Furthermore, fixed assets placed in service over $2.5 million begin to phase out dollar for dollar, meaning that if a business places in service $3.5 million in a single year that firm loses its ability to take the deduction.
These limitations may allow a taxpayer to maximize the depreciation deduction or its tax savings, however.
For example, Section 179 allows you to pick and choose which assets you want to apply the deduction to. Bonus depreciation represents an “all or nothing” choice for each class of property. Sometimes Section 179 provides flexibility that allows taxpayers to “schedule” depreciation deductions when they generate the most savings.
And as another example, Section 179’s taxable income limitation sometimes extends the life of net operating loss (NOL) deductions because it delays when NOLs first appear. That delay benefits taxpayers because NOLs can only be carried forward for 20 years and could potentially expire with no future benefit to the business. A smaller or even Section 179 deduction instead of a larger bonus deduction preserves future depreciation deductions.
Understand Qualified Improvement Property to Maximize Savings
One last depreciation change to discuss: Qualified Improvement Property (QIP).
I won’t get into the long history of this class of depreciable property. Nobody cares about that except tax practitioners.
However, I do want to point out some new changes and opportunities within this unique class of depreciable property.
First, let’s define what it is though… QIP refers generally to any improvement to an interior portion of a nonresidential building placed in service after the building itself has been placed in service.
And then the exceptions to the general rule? Some sort of obvious items if you think about the fact that Congress and the Treasury’s tax attorneys possess considerable experience writing our tax laws. QIP excludes expenditures attributable to the enlargement of the building, elevators and escalators, or the buildings internal structural framework.
Prior the TJCA, most qualified real property was subject to a 15-year life and was eligible for bonus depreciation. Post TJCA, property that falls into QIP is now, unfortunately, subject to a 39-year life. Fortunately, QIP is now eligible for Section 179 and can be 100% expensed in the year it is placed into service.
Another benefit resulting from TJCA is that QIP can be placed into service any time after the building is. In contrast, the old rules made you wait 3 years or else it was ineligible. Furthermore, the IRS also expanded the 179 deduction to include roofs, HVAC systems, fire and protection alarms, and security systems.
This final thought. Savvy taxpayers enjoy some wonderful new opportunities to maximize depreciation deductions.
Accordingly, take the time to strategize about these with your CPA. You may potentially save thousands of dollars in income taxes.