Special 100% Depreciation Allowance Ending This Year

Over the last five years, we’ve grown accustomed to advising clients about being able to write off a lot of items that would otherwise be depreciated over a period of years. Like an old friend, the special depreciation allowance has faithfully helped our small business clients. With its aid, they have more rapidly recovered the cost of their investments. But starting just a few months from now, on January 1, only 80% of an asset’s cost will be deductible, so we have a short time to help clients plan purchases while 100% allowance is still available.

The special depreciation allowance, or bonus depreciation, has enabled a business entity or a sole proprietorship to deduct in one year the full cost of an item that would otherwise be depreciated over many. Thus, a significant portion of the cost of the item would be recouped in the same year that it was put into service. Special depreciation for the full amount came into being because of the 2017 Tax Cuts and Jobs Act (TCJA). The special depreciation provision was set to be gradually phased out starting in 2023. At the time, that seemed like the distant future. So many of us took it for granted.

Because we can no longer take it for granted, we’ll look at how the special depreciation allowance is calculated next year and what happens when the end-of-year deadlines are missed. We’ll review what property is eligible for this allowance and how §179 expensing may or may not be a good way of mitigating the change that’s coming on January 1. We will look at an example that illustrates how this change affects acquisition decisions before we conclude by considering the next steps tax practitioners should take with their clients.

Computing The Special Allowance Starting January 1

Until now, the computation of the allowance was pretty easy. The amount of the deduction was just the cost of the equipment purchased. The formal computation multiplied an “applicable percentage” by the adjusted basis of the property put into service. Because the applicable percentage has been 100%, the allowance was the entire basis of the property.

Starting January 1, 2023, however, a little math will be required. The applicable percentage drops to 80%, so the special depreciation allowance is 0.8 multiplied by the asset’s adjusted basis. Although most of the cost of an asset will be deductible through the special allowance, 20% of an asset’s cost is no longer eligible. It must be depreciated or treated as §179 expense.

Timing Purchases Before Deadline

Tax practitioners may wish to advise their clients who own businesses to consider making purchases well before the deadline. For the entire cost of the property to be deductible through special depreciation, it must be placed in service by the end of 2022. It does not have to be actually used in its intended function, but it must be ready for use.

For most equipment, this is a readily understood requirement. The equipment should be on-premises and in operational condition. For example, a piece of snow removal equipment that arrives at the business at which it will be used to clear driveways and walkways is in service if it has arrived, is filled with oil and gasoline, and is ready to operate. It doesn’t need to snow before December 31 to be placed in service. Similarly, a lawnmower acquired in December is placed in service if it could be used to mow the business’s lawn, even if the grass is unlikely to grow that month. The business that purchases it would be eligible for the special depreciation allowance if equipment like this arrives before December 31.

If the equipment calls for the preparation of the equipment once it is on site, however, that work must be completed before the equipment is considered to be placed in service. As another example, the business might acquire robotic manufacturing equipment that requires special configuration or programming. If the configuration cannot be completed until January 2023, the system would not be eligible for 100% special depreciation, even if it arrived during 2022. If the equipment is not “ready and available” for its “specifically assigned function” until 2023, it would not be eligible for any special depreciation until tax year 2023, even though it was paid for and physically acquired in 2022.

For this reason, tax practitioners should contact clients soon who are planning to acquire property, especially if supply chain problems could delay delivery of that property. Not only would a delay in delivery of the parts adversely delay the expense allowance by a year but it would also be quantitatively reduced because only 80% of its cost would be deductible.

Eligible Property Requirements

The TCJA placed a few restrictions on the property that qualified for the special allowance. The property had to have a recovery period of 20 years or less. It could also be computer software for which a deduction is available under IRC §167(a). However, this excludes software developed by the taxpayer. Here’s a list of additional requirements for eligible property, taken from IRC §168(k)(2):

• Water utility property,
• Qualified film or television production, or
• Qualified theatrical production.

There are two overarching requirements that any property be put into service no later than December 31, 2026. Because the applicable percentage decreases 20% each year starting next January, property put into service after 2026 is scheduled to have no special depreciation eligibility. Secondly, the property must not have been previously used by the taxpayer or a related party. Not surprisingly, inherited property is not eligible property, nor is property received by a taxpayer as a gift.

Section 179 Expensing May Be Available

For assets put into service starting January 1, 2023, some of their purchase cost cannot be taken as a special depreciation deduction for the year the property is put into service. If the property is put into service in 2023, that amount is 20%. Normally, this amount is eligible for MACRS depreciation.

However, the taxpayer may decide to apply §179 expensing to the remaining amount. Generally, this means that the entire amount would be immediately expensed during the year the asset is placed in service: 80% through special depreciation and 20% through §179 expense.

Section 179 expensing has its own set of rules that differ from the special depreciation rules. For example, suppose an asset is acquired by a pass-through entity, either an S corporation or a partnership, In that case, the §179 deduction is passed through to the shareholder or partner as a separately stated item on the entity’s Schedule K-1. Wherever it lands, it cannot be deducted if doing so would also cause a loss on the activity. If there are multiple shareholders or partners, this could result in one benefiting from the §179 deduction, while another has to carry it forward to a future year when it would not cause a loss.

Example of a Missed Opportunity

Consider the following example. XYZ Construction Company, a calendar-year C corporation, decides that it needs a new boring machine to dig small diameter tunnels. After being told to expect delivery in November 2022, XYZ places an order for a $78,000 boring machine in October 2022, and pays the full amount as a deposit. It pays another $2,000 to have it shipped. However, XYZ decides to not pay an additional amount for expedited shipping. Assume the property acquired by XYZ has a 7-year recovery period and thus does not qualify for the 1-year extension of special depreciation. A delay in shipping means that the machine does not arrive at XYZ until January 4, 2023. It requires another week of acceptance testing and configuration and consequently is not placed in service until January 11. Hence, XYZ is only eligible for an 80% special depreciation allowance of $64,000, but not until its 2023 tax return is filed in early 2024. At that time, XYZ will have a $64,000 special depreciation allowance for the equipment it acquired in January 2023. The remaining $16,000 can be depreciated using MACRS depreciation, or in some cases, a §179 deduction may be available.

Next Steps: Talk With Your Clients Soon

Even though time is slipping away, your clients are likely to be able to acquire the assets they need and put it into service before 100% special depreciation goes away. But given uncertainties in shipping schedules, a delay in acting makes it more likely that the property won’t be available before that applicable percentage slips to 80%. So a conversation with a client now could result in a lower after-tax cost of any property acquired.

Even though the applicable rate drops to 80%, our old friend, special depreciation, isn’t going away completely this year. It’s going away gradually over the next five years, available to offer more opportunities to help our small business clients, although at a lower rate.

By John W. Richmann, EA, MBA
Tax Materials Specialist, U. of I. Tax School

Sources: 

• IRC §§168(k), 167(a), and 197(e)(3)(B).
• Treas. Reg. §1.179-4(e).