The Effects of Bonus Depreciation and 1031 Exchanges

Bonus depreciation, whether 30%, 50%, or 100%, has been popular with taxpayers for very good reasons. For all my readers who undoubtedly understand the time value of money, the allure of a greater tax deduction taken earlier in the asset’s life cycle is quite compelling. So, like 1031 exchanges which defer taxes and save taxpayers money, bonus depreciation increases tax deductions and saves taxpayers money. Both 1031 exchanges and bonus depreciation can be great tax reduction strategies. Unlike 1031 exchanges though, bonus depreciation is more easily utilized.

Bonus depreciation has been part of the federal income tax law for a decade now, starting with the original bonus depreciation statute enacted as part of the Job Creation and Worker Assistance Act of 2002 that provided an additional 30% first year depreciation deduction. Section 168(k) of the Tax Code has been amended and extended repeatedly since 2002, but unless it is extended yet again, the statute will terminate for most assets at the end of this year.

What is bonus depreciation?

Bonus depreciation is simply depreciation that is taken in the first year that the asset is placed in service in addition to the asset’s “normal” depreciation deduction. Bonus depreciation is computed prior to the adjustment of the depreciable basis to take into account the first year’s depreciation “normal” deduction, and it ignores the effect of the half-year rule and similar conventions. As discussed below, bonus depreciation applies to a wide array of assets, and it is elective, rather than mandatory. But, if elected, it applies to all qualifying property in the same depreciation class.

What assets are eligible for bonus depreciation?

Regardless of the type of asset, the qualifying asset must be new, not used.  The property must also either be:

  • Depreciable under the Modified Accelerated Cost Recovery System (MACRS) and must have a depreciation recovery period of 20 years or less
  • Water utility property (which generally has a MACRS recovery period of 25 years)
  • Qualified leasehold improvement property (made to the interior portion of a building) or
  • Certain computer software that would be depreciated over a 36-month period

Here are some common examples of qualifying assets:

  • Cars, trucks, vans
  • Corporate aircraft
  • Tractors, trailers
  • Construction equipment
  • Agricultural equipment
  • Railroad cars
  • Ships, barges, tugboats
  • Office furniture
  • Computer equipment

How is bonus depreciation computed?

Determining the amount of bonus depreciation that can be claimed depends upon the year and the date that the asset was placed in service.  Later extensions of the statute increased the amount of the additional depreciation deduction dramatically, starting with 50% in 2003 and rising to 100% in 2010 and 2011.  Currently, for years 2012 and 2013, the bonus depreciation increment is 50%. To summarize very briefly:

  • 50% bonus depreciation applies to qualifying assets placed in service between January 1, 2010 and September 8, 2010
  • 100% bonus depreciation applies to qualifying assets placed in service on or after September 9, 2010 through December 31, 2011
  • 50% bonus depreciation applies to qualifying assets placed in service during 2012 or 2013, except that for certain assets with longer production periods and certain types of aircraft, the deadline is extended to December 31, 2014

The tax “price” of bonus depreciation

These earlier and greater depreciation deductions mean that the tax basis of the asset becomes very low much more quickly than it would in the absence of bonus depreciation.  This translates into a large potential gain on the sale of the asset. Qualifying assets, unlike most real estate, may be subject to depreciation recapture, which is taxed at ordinary income rates, not capital gains tax rates.

How about a 1031 exchange?

Take a good look at the tax basis of your asset before you decide to sell it. If you have taken bonus depreciation, there may be a lower basis in the property and more potential gain than you might have expected. If you want to replace your low-basis property with similar property, a 1031 exchange may be a viable solution to help you manage the tax bill.  A properly structured 1031 exchange can defer some or all of the taxes due on the sale of the asset, including tax on depreciation recapture.  The same time value of money concepts that make bonus depreciation a good idea apply equally to 1031 exchanges:  paying tax later is better than paying tax now.

If you replace your old qualifying asset with another like-kind new qualifying asset that is placed in service in 2013, there is an additional benefit:  the full amount of the basis of a qualifying asset acquired in the exchange is eligible for bonus depreciation.  This includes the carryover basis from the old asset surrendered in the exchange plus any new basis (created by debt assumption or an infusion of cash).

We’re here to help!

As you probably know, 1031 exchanges are subject to some very specific rules.  At NES Financial we are committed to 1031 regulatory compliance and outstanding client service.  We would be happy to help guide you through the 1031 exchange process.

So if you’ve taken a lot of bonus depreciation and are considering a like-kind exchange, you’ve come to the right place.  Give us a call or schedule a free consultation, with no obligation, by clicking below!

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