Sec. 179 Expensing And Bonus Depreciation: Beware Of Pitfalls

If eligible, you can elect to use Section 179 expensing or bonus depreciation to deduct a large portion of the cost (and in some cases the full cost) of eligible property in the year it’s placed in service. Alternatively, you may follow regular depreciation rules and spread deductions over several years or decades, depending on how the asset is classified under the tax code.

While taking current deductions can significantly lower your company’s taxable income, it isn’t always the smartest move.

Sec. 179 and bonus depreciation 101

Section 179 expensing may allow you to currently deduct the full cost of purchasing eligible new or used assets, such as equipment, furniture, off-the-shelf computer software, and qualified improvement property (QIP). An annual expensing limit applies ($1.16 million for 2023 and $1.22 million for 2024), which begins to phase out dollar for dollar when asset acquisitions for the year exceed the applicable threshold ($2.89 million for 2023 and $3.05 million for 2024). You can claim the election only to offset net income, not to reduce it below zero to create a net operating loss.

First-year bonus depreciation is available for qualified assets, which include new tangible property with a recovery period of 20 years or less (such as office furniture and equipment), off-the-shelf computer software and water utility property. Under the TCJA, through 2026, the definition has been expanded to include used property and qualified film, television and live theatrical productions. In addition, QIP is now eligible for bonus depreciation. For 2023, bonus depreciation was 80%. It drops to 60% for 2024, to 40% for 2025 and to 20% for 2026. After that, it will be eliminated, unless Congress acts to extend it.

When to consider forgoing these breaks

Here are two examples when it may be preferable to forgo Sec. 179 expensing and bonus depreciation:

1. You’re planning to sell QIP. If you claim Sec. 179 expense or bonus depreciation on QIP and sell the building soon, this current write-off may be a tax trap. That’s because your gain on the sale up to the amount of Sec. 179 or bonus depreciation deductions you’ve claimed will be treated as “recaptured” depreciation that’s taxable at ordinary-income tax rates, up to 37%. But if you deduct the cost of QIP under regular depreciation rules (generally, over 15 years) and sell the building, any long-term gain attributable to the deductions will be taxable at a top rate of 25%.

2. You’re eligible for the qualified business income (QBI) deduction. This deduction allows eligible business owners to deduct up to 20% of their QBI from certain pass-through entities, such as partnerships, limited liability companies and sole proprietorships. The deduction can’t exceed 20% of an owner’s taxable income, excluding net capital gains. (Other restrictions apply.)

Claiming Sec. 179 or bonus depreciation deductions reduces your taxable income, which may deprive you of an opportunity to maximize the QBI deduction. Because the QBI deduction is scheduled to expire after 2025, taking full advantage of it while you can generally will make sense.

Timing is everything

Keep in mind that only the timing of deductions is affected by the strategy you choose. You’ll still have an opportunity to write off the full cost of eligible assets if you forgo Sec. 179 expensing and bonus depreciation; it will just be over a longer time period. Your tax advisor can analyze your company’s overall tax benefit picture and help you determine the optimal strategy.

Appraisals Aren’t Just For Businesses

Whether you’re in the process of making a retirement or estate plan or you intend to donate property to charity, you’ll need to know the value of your assets. For many hard-to-value items, such as closely held business interests, real estate, art and collectibles, an appraisal may be necessary.

Retirement and estate planning

To enjoy a comfortable retirement, you’ll need to calculate the income that can support your lifestyle when you’re no longer working. This means understanding the value of the assets you own. Once you have this information, you may decide to move your retirement date up or back.

Knowing the value of your assets is also necessary to assess whether you’ll potentially be subject to gift and estate taxes. It also allows you to identify strategies for minimizing or eliminating those taxes. In addition, without appraisals of hard-to-value assets, it’s nearly impossible to divide your overall property equally among your children (if that’s your wish).

Appraisals may also be necessary to avoid running afoul of tax basis consistency rules. The rules are intended to prevent heirs from arguing that estate property was undervalued, which would raise their basis for income tax purposes. According to these rules, the income tax basis of inherited property equals the property’s fair market value as finally determined for estate tax purposes. Appraisals can help ensure that your heirs receive the basis they deserve.

Gifts and charitable giving

The IRS has an unlimited amount of time to challenge the value of gifts for gift and estate tax purposes, unless they’re “adequately disclosed,” which generally binds the IRS to a three-year statute of limitations. A qualified professional appraisal with a timely filed gift tax return is the best way to disclose the value of a gift of a hard-to-value asset.

Charitable gifts of property valued at more than $5,000 (other than publicly traded securities) must be substantiated with a qualified appraisal by a qualified appraiser. This means that the appraiser meets certain education and experience requirements.

Know what you have

Without appraisals of your hard-to-value assets, it’s difficult to develop a realistic financial plan, to create an estate plan that will achieve your desired results and to avoid unwelcome tax liabilities. Asset values can fluctuate dramatically over time, so make sure you get updated appraisals periodically.