What it means
Governments use tax depreciation rules to influence investment. Allowing a business to deduct the cost of new equipment immediately, rather than over five or seven years, reduces the tax bill in the year of purchase and so reduces the effective price of investing.
Bonus depreciation is the US version of this incentive. It was introduced in 2002, extended and expanded repeatedly, set at 100% for assets placed in service from late 2017 under the Tax Cuts and Jobs Act, and scheduled to phase down by 20 points a year from 2023 (80% in 2023, 60% in 2024, and so on) unless Congress changes the schedule, which it has done before.
The current percentage should always be checked for the year in question. The mechanics are straightforward.
A business buys a qualifying asset and, in its tax return for the year the asset is placed in service, deducts the bonus percentage of the cost immediately. The remaining cost is depreciated under the normal tax schedule.
Unlike the separate Section 179 expensing election, bonus depreciation has no annual dollar cap and no taxable income limit, so it can create or increase a tax loss that is carried forward. It applies to new and, since 2017, used assets, provided the taxpayer did not previously use them.
The benefit is timing. A deduction taken today is worth more than the same deduction spread over years, because the tax saved can be used now.
But the total deduction is unchanged, so future years have less depreciation and higher taxable income. The accounts reflect this as a deferred tax liability: the business has paid less tax than its book profit implies and will pay more later.
Businesses with volatile profits or expiring losses sometimes elect out of bonus depreciation for a year to preserve deductions for when they are worth more. Bonus depreciation is a US concept, but many countries offer analogous accelerated allowances, such as first-year allowances and full expensing in the United Kingdom and instant asset write-offs in Australia, with similar logic and similar caveats.
In practice
Real-world examples.
Example
A trucking company buying $2 million of new vehicles deducts the bonus percentage in the year of purchase and uses the resulting tax loss to reclaim tax paid in the prior year.
Example
A restaurant fitting out a new site deducts bonus depreciation on kitchen equipment and qualifying interior improvements, but not on the building itself.
Example
A start-up with no taxable income elects out of bonus depreciation on its equipment purchases, preserving the deductions for years when it expects to be profitable.
Think of it
“Bonus depreciation lets you deduct most or all of an asset's cost immediately for tax purposes.
Formula
Calculation
First-Year Tax Deduction = Bonus Percentage x Cost of Qualifying Asset + Regular first-year depreciation on the remaining cost
Tax Saved in Year One = First-Year Deduction x Marginal Tax Rate
Deferred Tax Liability = (Tax depreciation taken to date minus Book depreciation taken to date) x Tax Rate
Worked example (illustrative percentages; check the rate for the tax year). A manufacturing company buys a machine for $500,000 in a year when bonus depreciation is 60%. The machine has a seven-year tax recovery period and, for the financial statements, a ten-year useful life with straight-line depreciation. The company's tax rate is 25%.
Tax deduction in year one:
- Bonus depreciation = 60% x $500,000 = $300,000
- Remaining cost of $200,000 depreciated under the normal seven-year schedule (first-year rate 14.29%) = $28,580
- Total year-one tax deduction = $328,580
- Tax saved in year one = $328,580 x 25% = $82,145
Without bonus depreciation, the year-one deduction would have been $500,000 x 14.29% = $71,450 and the tax saved $17,863. Bonus depreciation brings forward about $64,000 of tax saving into the purchase year.
Financial statements: book depreciation is $500,000 / 10 = $50,000 in year one. Tax depreciation exceeds book depreciation by $278,580; the company records a deferred tax liability of $278,580 x 25% = $69,645, which will unwind in later years as book depreciation continues after the tax deductions are exhausted. Reported profit is unaffected by the timing; only the cash tax and the deferred tax balance move.
Decision value: at the company's 8% cost of capital, the present value of the $64,000 of accelerated saving (instead of receiving it spread over years two to eight) is roughly $16,000. That is the true incentive, about 3% of the machine's price.Case study
Seen in the real world.
A construction company bought $3 million of equipment in a year when bonus depreciation was 100%, deducted the full amount, and paid no federal tax that year, saving about $630,000. Its owners took the saving as distributions. Over the following six years the company had almost no tax depreciation on that equipment, its taxable income exceeded its book profit by $500,000 a year, and its cash tax bills were correspondingly higher than its accounts suggested.
In the fourth year, a downturn cut book profit to near zero while taxable income remained positive, and the company had to borrow to pay tax. The owners had treated a timing benefit as a permanent one. The company's accountant now presents a schedule each year showing the deferred tax liability and the expected cash tax for the next five years alongside the book profit, and the owners set distributions against that forecast rather than against the current year's tax bill.
Watch out
Common mistakes.
- Treating bonus depreciation as a permanent tax saving. It is a timing difference; the deductions taken now are not available later.
- Assuming the percentage is fixed. It has changed frequently and is scheduled to phase down; check the rate for the year the asset is placed in service.
- Taking bonus depreciation in a year when the deduction is worth little (low income, expiring losses) instead of electing out and preserving it.
Questions
People also ask.
Does bonus depreciation change the depreciation in the financial statements?
No. Book depreciation follows accounting standards. The difference between tax and book depreciation creates a deferred tax liability.
What assets qualify?
Most tangible property with a recovery period of 20 years or less, including machinery, equipment, vehicles, furniture, computers and qualified improvement property. Buildings and land do not qualify.
How is bonus depreciation different from Section 179?
Section 179 is an election to expense qualifying assets up to an annual dollar limit, subject to a taxable income cap. Bonus depreciation has no dollar limit and can create a loss. Businesses often use both.
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