Depreciation Rewind

By Janet C Hagy, CPA-Austin

 

Depreciation method choices became even more complex beginning in 2023 with the reduction of 100% bonus depreciation to 80% of the cost of qualified property placed in service in 2023. For 2024, the percentage will be reduced to 60% of the cost and is scheduled to phase out completely after 2026. It is not affected by the sunset of the Tax Cuts and Jobs Act (TCJA) in 2025.

 

Other depreciation methods have always been available, but businesses usually preferred to claim the maximum amount allowable, which was 100% bonus depreciation beginning Sept. 28, 2017, through 2022.

 

Bonus depreciation is mandatory unless a formal election-out is attached to the timely filed tax return for the year placed in service. The opt-out election to forgo bonus depreciation applies to all qualified properties in the same class placed in service in that year. (See IRC Section 168(k)(7).) The formal election must designate the Code section type of election (Section 168(k)(7) or (5)) and each class of property covered under the opt-out election. (See IRC Regulation 1.168(k)-2(f).)

 

Failure to file a properly completed opt-out election statement can result in expensive consequences for the taxpayer, including IRS penalties, and harrowing legal consequences for the preparer if discovered while under IRS examination or by a successor tax preparer.

 

Remedies

 

Timing is everything for the opt-out election and the remedies to fix a failed election. Failure to opt-out in a timely filed tax return while using other methods of depreciation, or not claiming depreciation at all, is considered to be the use of an improper method of accounting. Revenue Procedure 2024-23 describes the nuances of making an opt-out election under the automatic change in accounting method procedures.

 

Failure to include the opt-out election when bonus depreciation was not claimed can be fixed with an amended return and Form 3115 during specific time periods. Automatic changes can only be requested for the taxpayer’s first or second year after the year the property was placed in service. A Form 3115 with a Section 481(a) adjustment will be generated and included in that filing year. Absent an approved change request, allowable bonus depreciation will be considered to have been claimed in the placed-in-service year, thereby affecting or eliminating subsequent year allowable depreciation. Upon discovery of the improper method, amended returns may be required for open years. Fortunately, there is a saving procedure if an improper method of deducting depreciation was used and the two-year automatic change window has passed. In the year of sale, Form 3115 can be filed to claim any missed depreciation. (See the DCN 107 explanation in the Form 3115 instructions.)

 

If the opt-out election is made in error and is discovered quickly, an amended return revoking the election and showing the resulting changes can be filed within six months after the original due date, not including extensions. This procedure is only for revocation of the opt-out election. Failure to meet this deadline will require a private letter ruling to request revocation.

 

Automatic changes to making or revoking a bonus depreciation election are not available after the windows described above have expired. Changes can still be requested but the taxpayer will have to submit an IRS private letter ruling (PLR) request. This is a time-consuming and expensive process. IRS user fees apply to non-automatic changes of accounting method. (See Rev Proc 2024-1.)

 

Section 179 Election

 

With the bonus percentage phase out, electing Section 179 expensing for all or part of the cost of qualified property, in lieu of bonus depreciation, may be advantageous. Section 179 is the election to expense qualified property in the year placed in service. The deduction is limited to net income before the deduction, with the excess carried over to the next year. The Section 179 amount elected for each property can be dialed in to meet the needs of the taxpayer. The elected amount of Section 179 for each property reduces the basis available for bonus depreciation and the amount potentially subject to the mid-quarter convention. No opt-out election is required for the Section 179 elected amount. The Section 179 election is made by completing Part I of Form 4562 and including the form in the tax return or

 

by showing as a separate item on the taxpayer's income tax return the following items:
(1) The total Section 179 expense deduction claimed with respect to all Section 179 property selected, and
(2) The portion of that deduction allocable to each specific item. (See IRC Regulation 1.179-5.)

For example:

In 2023, XYZ Company purchases and places in service a five-year asset for $100,000. Net income before the Section 179 deduction exceeds $100,000. XYZ may elect any amount of Section 179 deduction up to $100,000. XYZ elects to deduct $80,000 under Section 179. The remainder of $20,000 would be subject to bonus depreciation at 80% or $16,000, plus regular first year five-year class depreciation at 20% of the remaining $4,000 or $800. The total depreciation for this asset would be $96,800 in 2023.  

 

Alternatively, XYZ could elect to opt-out of bonus depreciation for the remaining $20,000 basis, producing $4,000 in regular depreciation or $84,000 total deduction for 2023.

 

Section 179 elections are allowed for individual and corporate taxpayers. Trusts, estates and certain non-corporate lessors may not use the Section 179 election. S corporations and partnerships make the election at the entity level, but the deduction is passed through to the shareholders and partners. Each owner calculates their allowable deduction. Estate and trust members of passthrough entities cannot use the Section 179 deduction. Therefore, consider the member’s ability to use the Section 179 deduction when making a Section 179 election at the entity level. For the portion that would have been allocated to the trust or estate, a partnership or S corporation may claim a depreciation deduction under Section 168. (See IRC Regulation 1.179-1(f)(3)). For more information about this issue, see AICPA’s article, Reporting Depreciation When Trusts Own Business Entities.

 

Federal maximum amounts of Section 179 deductions for 2023/2024 are $1,160,000 and $1,220,000, respectively. Dollar-for-dollar reduction in the amount of the Section 179 deduction begins when the cost of property placed in service in 2023 exceeds $2,890,000, and $3,050,000 in 2024.

 

Qualifying Section 179 property includes purchased MACRS class property with a life of no more than 20 years, qualified nonresidential real property improvements, and certain specific use properties. (See Section 179(d).) Property acquired from related parties is ineligible for Section 179. In a win for nonresidential property owners, TCJA added roofs, HVAC and other previously capitalized improvements to the list of qualified Section 179 property. (See Section 179(e).) Residential property that qualifies as a trade or business may also qualify for Section 179. Tread with caution on this as the trade or business rules for residential real estate are complex.

 

Consideration of the opportunities and limitations for depreciating business property is more complicated than in the recent past. Differences in state tax depreciation rules for bonus depreciation and Section 179 must also be considered. Adding review of depreciation elections and required tax return disclosures to the preparer and reviewer checklists and educating less experienced staff who have only dealt with 100% bonus depreciation is a wise decision.