Bonus Depreciation: What It Is and How It Works

Bonus depreciation, sometimes referred to as the “additional first-year depreciation deduction,” is a tax incentive under the U.S. Internal Revenue Code (IRC) that permits businesses to deduct a substantial portion of the cost of qualifying assets in the year they are placed in service, rather than spreading the deduction over the asset’s useful life. Essentially, it accelerates the depreciation process, allowing businesses to recover the cost of capital investments more quickly.

The concept of depreciation itself is rooted in the idea that assets, such as machinery, vehicles, or furniture, lose value over time due to wear and tear or obsolescence. Traditional depreciation methods, like the Modified Accelerated Cost Recovery System (MACRS), allocate the cost of an asset over a predetermined recovery period (e.g., 5 years for a vehicle or 7 years for office equipment). Bonus depreciation, however, supercharges this process by allowing a large percentage—sometimes up to 100%—of the asset’s cost to be deducted upfront.

Introduced as part of various economic stimulus packages, bonus depreciation is designed to encourage business investment in capital assets, stimulate economic growth, and provide immediate tax relief. While the specifics of bonus depreciation have evolved over time, its core purpose remains the same: to incentivize businesses to invest in new equipment, technology, and infrastructure by reducing their tax burden.

A Brief History of Bonus Depreciation

Bonus depreciation was first introduced in the U.S. as part of the Job Creation and Worker Assistance Act of 2002, in response to the economic downturn following the September 11, 2001, terrorist attacks. The initial provision allowed businesses to deduct 30% of the cost of qualifying assets in the first year, with the remaining balance depreciated over the asset’s useful life using standard methods.

In 2003, the Jobs and Growth Tax Relief Reconciliation Act increased the bonus depreciation rate to 50%, further encouraging capital investment during a period of economic recovery. Over the years, bonus depreciation has been extended, modified, and sometimes allowed to lapse, often in response to economic conditions.

The most significant overhaul came with the Tax Cuts and Jobs Act (TCJA) of 2017, which expanded bonus depreciation to allow a 100% deduction for qualifying assets placed in service between September 27, 2017, and December 31, 2022. Additionally, the TCJA extended eligibility to certain used property, a major departure from prior rules that limited bonus depreciation to new assets. However, the TCJA also introduced a phase-down schedule, reducing the bonus depreciation rate gradually starting in 2023:

• 80% for assets placed in service in 2023
• 60% for assets placed in service in 2024
• 40% for assets placed in service in 2025
• 20% for assets placed in service in 2026
• 0% (elimination) starting in 2027, unless extended by Congress

This phase-down reflects lawmakers’ intent to balance immediate tax relief with long-term fiscal considerations. As of April 12, 2025, the current bonus depreciation rate is 40%, assuming no legislative changes have occurred.

How Bonus Depreciation Works

To understand how bonus depreciation works, let’s break it down into its key components: eligibility, calculation, and application.

Eligibility Criteria

Not all assets qualify for bonus depreciation, and businesses must meet specific requirements to take advantage of the deduction. The primary eligibility criteria include:

1. Qualifying Property: The asset must be “qualified property,” which generally includes:
   • Tangible personal property with a recovery period of 20 years or less under MACRS (e.g., machinery, equipment, furniture, vehicles, or computers).
   • Certain qualified improvement property (e.g., interior improvements to nonresidential buildings, such as lighting or HVAC systems, made after the building was first placed in service).
   • Computer software that is not an integral part of a larger system.
   • Qualified film, television, or live theatrical productions (as defined under IRC Section 181).
   • Certain water utility property or plants bearing fruits and nuts (with specific conditions).
2. New or Used Property: Since the TCJA, bonus depreciation applies to both new and used property, provided the used property is acquired in an arm’s-length transaction and was not previously used by the taxpayer or a related party.
3. Placed in Service: The asset must be placed in service (i.e., ready and available for its intended use) within the applicable tax year and before the phase-out deadline (currently set to end in 2027).
4. Original Use or Acquisition Date: For property placed in service after September 27, 2017, the TCJA removed the requirement that the taxpayer must be the original user, broadening the scope to include used assets. However, the property must be acquired after this date to qualify for 100% bonus depreciation (or the applicable phased-down percentage).
5. Business Use: The asset must be used predominantly for business or income-producing purposes. If an asset is used partially for personal purposes, only the business-use portion qualifies for bonus depreciation.

Calculation of Bonus Depreciation

The calculation of bonus depreciation is relatively straightforward. Here’s a step-by-step process:

1. Determine the Cost Basis: Identify the cost of the qualifying asset, including any associated expenses (e.g., installation or transportation costs).
2. Apply the Bonus Depreciation Rate: Multiply the cost basis by the applicable bonus depreciation percentage (e.g., 40% in 2025).
3. Deduct the Bonus Amount: Subtract the bonus depreciation amount from the cost basis to determine the remaining basis.
4. Depreciate the Remaining Basis: The remaining basis is depreciated over the asset’s recovery period using the applicable MACRS method (e.g., double-declining balance or straight-line).

For example, suppose a business purchases a $100,000 piece of equipment in 2025, when the bonus depreciation rate is 40%. The calculation would be:

• Bonus depreciation: $100,000 × 40% = $40,000
• Remaining basis: $100,000 – $40,000 = $60,000
• The $40,000 is deducted in 2025, and the $60,000 is depreciated over the asset’s recovery period (e.g., 5 years for equipment).

Application in Tax Filings

To claim bonus depreciation, businesses must report it on their federal income tax return, typically using IRS Form 4562 (Depreciation and Amortization). The deduction is generally automatic for qualifying property, but taxpayers can elect out of bonus depreciation on a class-by-class basis (e.g., for all 5-year property) if it’s not advantageous for their tax situation. This election is made by attaching a statement to the tax return.

Benefits of Bonus Depreciation

Bonus depreciation offers several advantages for businesses, making it a valuable tool for tax planning and financial management:

1. Immediate Tax Savings: By allowing a large upfront deduction, bonus depreciation reduces taxable income in the year the asset is placed in service, lowering the business’s tax liability.
2. Improved Cash Flow: The tax savings from bonus depreciation free up cash that can be reinvested in the business, used to pay down debt, or allocated to other priorities.
3. Encourages Investment: Bonus depreciation incentivizes businesses to purchase new equipment, upgrade technology, or expand facilities, driving economic activity and modernization.
4. Flexibility with Used Property: The inclusion of used property under the TCJA makes bonus depreciation accessible to businesses acquiring secondhand assets, broadening its applicability.
5. Simplified Tax Planning: For businesses that qualify for 100% bonus depreciation (prior to 2023), the ability to deduct the entire cost in one year eliminates the need to track depreciation schedules for those assets.

Limitations and Considerations

While bonus depreciation is a powerful tool, it’s not without its limitations and complexities:

1. Phase-Down Schedule: The gradual reduction of the bonus depreciation rate (from 100% to 0% by 2027) means businesses must plan their capital investments strategically to maximize deductions.
2. Taxable Income Limitations: Bonus depreciation can create or increase a net operating loss (NOL), which may be carried forward to offset future income. However, businesses with limited taxable income may not fully benefit from the deduction in the current year.
3. State Tax Conformity: Not all states conform to federal bonus depreciation rules. Some states disallow or limit the deduction, requiring businesses to maintain separate depreciation schedules for federal and state tax purposes.
4. Electing Out: Businesses may choose to forgo bonus depreciation if accelerating deductions would push them into a lower tax bracket or if they expect higher tax rates in future years. This decision requires careful tax planning.
5. Recapture Rules: If a depreciated asset is sold or disposed of before the end of its recovery period, the IRS may recapture a portion of the depreciation, including bonus depreciation, as ordinary income.

Practical Applications and Examples

To illustrate how bonus depreciation works in practice, consider the following scenarios:

Scenario 1: Small Business Equipment Purchase

A small manufacturing company purchases a $50,000 CNC machine in 2025 to improve production efficiency. The machine qualifies for 40% bonus depreciation. The company deducts $20,000 ($50,000 × 40%) in 2025, reducing its taxable income. The remaining $30,000 is depreciated over the machine’s 7-year recovery period using MACRS. Assuming the company is in the 21% corporate tax bracket, the bonus depreciation alone saves $4,200 in taxes for 2025.

Scenario 2: Real Estate Improvement

A commercial property owner spends $200,000 on qualified improvement property, such as renovating the interior of a retail store, in 2025. The improvements qualify for 40% bonus depreciation, allowing a $80,000 deduction in the first year. The remaining $120,000 is depreciated over the applicable recovery period (typically 15 years for qualified improvement property). This deduction significantly reduces the owner’s tax liability, freeing up cash for further investments.

Scenario 3: Electing Out

A startup with minimal taxable income in 2025 purchases $100,000 in office furniture. Anticipating higher profits in future years, the company elects out of bonus depreciation to spread the deductions over the furniture’s 7-year recovery period, preserving deductions for when they’ll offset more income.

Strategic Tax Planning with Bonus Depreciation

To maximize the benefits of bonus depreciation, businesses should consider the following strategies:

1. Timing Purchases: Acquiring assets before the bonus depreciation rate decreases (e.g., before the 40% rate drops to 20% in 2026) can maximize deductions.
2. Coordinating with Section 179: Bonus depreciation can be used in conjunction with Section 179, another tax provision that allows businesses to expense the cost of qualifying property. However, Section 179 has dollar limits and income caps, so businesses must prioritize which deduction to apply first.
3. Consulting Tax Professionals: Given the complexities of state conformity, recapture rules, and electing out, businesses should work with tax advisors to optimize their depreciation strategy.
4. Monitoring Legislative Changes: Congress has a history of extending or modifying bonus depreciation, especially during economic downturns. Staying informed about potential changes can inform investment decisions.

Conclusion

Bonus depreciation is a cornerstone of U.S. tax policy, offering businesses a powerful incentive to invest in capital assets while reducing their tax burden. By allowing accelerated deductions—up to 100% in some years—it provides immediate tax relief, improves cash flow, and encourages economic growth. However, its phased-down rates, state-specific rules, and strategic considerations require careful planning to fully leverage its benefits.