Depreciation occurs when a physical asset loses value over time due to normal use and wear and tear. To reflect this, the IRS requires that businesses write off or depreciate the cost of an asset over the years of its useful life.
Traditional depreciation requires that businesses write off the cost of an asset over its total useful life, matching the expense with the use of the asset. However, some vehicles allow the entire expense to be deducted in the year the asset was placed into service. Bonus depreciation and Section 179 are incentives designed by the IRS to encourage businesses to invest in themselves by purchasing new equipment and receiving an immediate tax benefit.
This is especially beneficial to start-ups who must purchase extensive equipment and can use these deductions for substantial tax relief. While the basic concept for both methods is similar, there are differences between the two methods. The good news is that you can take advantage of both (or one or neither) if you so desire.
- Both deductions allow for serious write-offs in the year an asset was placed in service.
- Both deductions can be applied to new and used tangible property that was not inherited, gifted, or acquired from a related party.
- Section 179 depreciation is capped by the IRS ($1,040,000 in 2020) and is reduced by the dollar amount of purchases that exceeds the IRS threshold ($2,580,000 in 2020). Bonus depreciation has no annual limit on the deduction.
- Section 179 offers greater flexibility. Under Section 179, businesses can deduct any dollar amount of their choosing within the thresholds and can allocate the deduction among assets according to preference. This offers businesses a chance to pick and choose which assets and how much of those assets to cover or save. Using bonus depreciation, a business must deduct the full bonus percentage (100% in 2020) for all assets within the chosen asset class, which would leave no depreciation remaining for future years.
- Section 179 is limited to the amount of taxable income, whereas bonus depreciation can be used to create a net loss.
How do the deductions work?
To better understand how this works, let's walk through an example. Susie and Mark started a specialty bakery and purchased commercial ovens and other kitchen equipment worth $2,100,000. Here is how the deductions for their business look in the first year of operations. Note that the IRS requires Section 179 depreciation to be calculated before bonus depreciation.
Equipment purchase price $2,100,000
- Maximum allowed Section 179 write-off ($1,040,000)
- Bonus depreciation for remaining cost ($1,060,000)
Total write-off in year one ($2,100,000)
Net income has now been reduced by the full purchase price of $2,100,000. Let's assume a corporate tax rate of 21%. By using both deductions, the bakery has just reduced net income by the full purchase price of $2,100,000. Multiply that by the 21% tax rate for a savings of $441,000.
Should you take Section 179, bonus depreciation, or both?
With bonus depreciation at 100% and covering new and used assets just like Section 179, you may be wondering why you might want to bother with Section 179 and its limitations.
While bonus depreciation offers sweeping savings, a Section 179 deduction can be used to fine-tune your company's bottom line.
This calculation will be unique for every individual company and should be based on careful consideration of the implications for the current year as well as future years.
Considerations for taking accelerated depreciation
As a business, you need to consider the fact that by electing to take accelerated depreciation, you are in essence relieving your current tax burden by giving up future deprecation in exchange.
You need to therefore weigh when the benefit of depreciation will be most impactful for your company's bottom line. Section 179 offers greater flexibility but also caps the benefit. Bonus depreciation has no limitations but may force a company to “waste" depreciation that it could benefit from in future years.
Accelerating depreciation also lowers the book value of your assets, which can affect balance sheet ratios that may impact your ability to borrow money. Also, should you choose to sell that asset, you may have to pay tax on the gain.
Careful consultation with a tax advisor or an accountant can help your business make the most of your money with an optimal combination of depreciation write-offs.