Contractors are advised to take advantage of bonus depreciation before phase-out begins in 2023, gradually decreasing to zero by 2027. Understanding proper depreciation can maximize tax benefits and accurately reflect equipment value on balance sheets. Various methods and strategic tracking can aid in managing equipment duration efficiently.
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Contractors who take the time to learn the ins and outs of bonus depreciation can deduct a portion of the cost of eligible assets, namely heavy construction machinery.
Contractors who correctly apply the concept of bonus depreciation have the advantage of maximizing their tax benefits while the rate is still relatively high. In 2023, the fed began a gradual phase-out of this tax provision, which allows businesses to deduct a significant portion of the cost of eligible assets in the year these assets are placed into service.
Understanding the ins and outs of depreciation takes some effort, but with it you can offset taxable profit.
It works when you take into account the artificial expense you're incurring as your equipment ages and loses value. Plus, correctly depreciating your equipment gives contractors a more accurate picture of their balance sheet. That picture, in turn, shows the accurate value of the equipment that the contractor owns and the assets the business controls.
As you grow your business, make sure you have a good depreciation strategy, advises construction accounting software provider CrewCost.
Taking Different Depreciation Tact
Bonus depreciation can lower taxable income for the year you purchase and deploy equipment, freeing up capital for operations or even business reinvestment.
A "departure from the traditional depreciation method," as Volvo Construction Equipment describes it, the rate was 100 percent for several years.
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With the phase-out, in 2025 the rate will be 40 percent; in 2026, 20 percent. Starting in 2027 and thereafter, the rate is zero.
"Just remember, a company can take both Section 179 and bonus depreciation allowances, but Section 179 must be applied first," noted Volvo.
As a result, any qualified property purchased over the set limit of $1,220,000 may then be taken in bonus depreciation.
"So, it's great for businesses that spend more than the Section 179 spending limit," said the construction equipment manufacturer.
In Canada, the phase-out period has begun for property that becomes available for use after 2023.
Eric Wallace, CPA of accounting information service CCH, describes the provision as "an additional first-year depreciation allowance."
He notes that the bonus depreciation rate for qualified property acquired before Sept. 28, 2017, and placed in service before 2018 is 50 percent.
"A taxpayer may elect not to claim bonus depreciation for any class of property," said Wallace. "The election is made annually on a statement filed with Form 4562, Depreciation and Amortization."
Also known as special depreciation, or IRC §168(k) depreciation, is technically a depreciation deduction, he said.
"Like other depreciation deductions, it counts toward accumulated depreciation."
It reduces the basis for purposes of determining gain or loss when an asset is sold and is subject to section 1245 and section 1250 recapture.
There are many nuances, Wallace said.
Bonus depreciation applies to property placed in service after Dec. 31, 2007, and before Jan. 1, 2027.
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Qualified Modified Accelerated Cost Recovery System MACRS property is property with a recovery period of 20 years or less.
Used property acquired and placed in service after Sept. 27, 2017, also may qualify for bonus depreciation, said Wallace.
"A taxpayer must claim bonus depreciation unless an election out is made," said Wallace. "Generally, a taxpayer who fails to claim bonus depreciation must file an accounting method change."
The depreciation amount is the applicable bonus rate and the original cost of the property, reduced by a percentage of certain tax credits claimed on the property and a section 179 allowance.
Bonus Depreciation Versus Section 179
As CCH explains it, taxpayers can claim the section 179 deduction for the cost of most tangible property that is bought for use in a business. The section 179 deduction is an expense allowance on certain qualifying property purchased for use in a business.
Though both rules allow deductions on all or a significant portion of costs, they have numerous important differences, notes CCH:
- Bonus depreciation applies to property used in a trade or business or for production of income.
- Section 179 only applies to property used in an active trade or business.
- Bonus depreciation generally applies to MACRS property that has a recovery period of 20 years or less.
- In the case of section 179, the recovery period does not matter.
- Bonus depreciation may be claimed on real or personal property, i.e. section 1245 or section 1250 property.
- Section 179 only applies to section 1245 property with a limited exception for qualified real property.
- Section 179 claimed on section 1250 property is subject to recapture under the section 1245 recapture rules (full recapture to extent of gain).
- Bonus depreciation claimed on section 1250 property is subject to section 1250 recapture (recapture in excess of straight-line to extent of gain).
"If the bonus rate is less than 100 percent, taxpayers should apply section 179 first to expense assets with the longest recovery period," said Wallace.
Managing Your Equipment Duration
CrewCost believes there's a lot more to equipment depreciation than initially meets the eye.
"With a little bit of strategy, depreciation can be a valuable way to mitigate taxes on the profit your business generates," said the company. "Keeping accurate track of depreciation is also a smart business move. For construction accounting purposes, it gives you insight into what your equipment is actually worth."
Tracking depreciation also allows your accountant to accurately determine what your balance sheet looks like.
CrewCost explains in detail how a contractor can potentially manage construction equipment duration:
- Depreciation is the gradual loss of value of a piece of equipment over time. For tax purposes, it allows construction companies to deduct the declining value as an expense to lower taxable income.
- There are several different methods of calculating depreciation, including straight-line, sum-of-the-years, and the declining balance method.
- Tracking depreciation accurately describes the real value of the equipment assets on a business' balance sheet over time. This helps with accounting and can make it easier for contractors to decide when to replace aging equipment.
Depreciation is a way of looking at an asset and recognizing that it won't be worth the same amount of money over the course of its lifespan.
"Assets depreciate for several reasons, including wear and tear, or because newer models of equipment come out," said CrewCost. "While it may seem like a bad thing, depreciation actually has some advantages."
For example, construction businesses can write off the lost value of the asset during tax season and have that count against profit generated over the year.
When it comes to equipment depreciation, here a couple of terms to get familiar with:
- Book Value — The value of the piece of equipment minus the value that has depreciated. The book value is depreciated until it reaches the salvage value, where it is fully depreciated.
- Depreciable Value — The depreciable value is the equipment's purchase price minus the book value. In other words, this is the amount of value you expect the piece of equipment to lose during the period during which you use it.
- Depreciation Period — The depreciation period is the period of time over which you plan to use the equipment and incrementally subtract the depreciable value from it.
With an estimated salvage value, depreciable value and the depreciation period, you have the basic information you need to depreciate the equipment.
There are a few different methods of depreciation you can use to depreciate your equipment. "Each method offers a slightly different benefit," said CrewCost
"Ultimately, you want to consult with an accountant or tax professional to see which method best fits your business."
- Straight-Line Method — This is the simplest and most commonly used method of depreciation and is the one you are probably most familiar with. Straight-line depreciation is just like it sounds; you take the depreciable value, let's use $40,000 from the earlier example, and you divide that by the number of years you will depreciate the equipment (aka its estimated useful life). So, $40,000 divided by five years gives us a depreciation value of $8,000/year. This is the easiest method to use and gives a nice, steady rate of depreciation over the useful life of the asset.
- Sum-of-the-Years Method — This method takes into account the number of years you plan to own and depreciate the piece of equipment. Sum-of-the-Years applies a variable rate to the total depreciable amount that changes each year, starting at a higher rate and gradually becoming smaller. This is a good method to depreciate a larger proportion of the equipment earlier in its operational lifetime.
- Declining-Balance Method — This depreciation method, similar to the Sum-of-the-Years method, is an accelerated method that determines a constant rate to apply to the remaining depreciable amount and is applied until the equipment is completely depreciated and reaches its salvage value.
Often, a piece of equipment will be carried on a contractor's accounting books at a different amount. In this case, sometimes it's noted as the depreciation included versus what's shown on the contractor's tax records. "These differences could be pretty significant," said CrewCost. "They may not be able to show a piece of equipment with accelerated depreciation on their accounting records compared to what happened on a tax basis."
Or the equipment may be required to be depreciated over a different time frame, noted the company.
"Carefully tracking these makes it easier to reconcile book accounting profitability versus tax profitability over time." CEG
Lucy Perry
Lucy Perry has 30 years of experience covering the U.S. construction industry. She has served as Editor of paving and lifting magazines, and has created content for many national and international construction trade publications. A native of Baton Rouge, Louisiana, she has a Journalism degree from Louisiana State University, and is an avid fan of all LSU sports. She resides in Kansas City, Missouri, with her husband, who has turned her into a major fan of the NFL Kansas City Chiefs. When she's not chasing after Lucy, their dachshund, Lucy likes to create mixed-media art.
Read more from Lucy Perry here.
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