Bonus depreciation phaseout planning

Editor: Michael Wronsky, CPA, MST

Taxpayers must consider many areas of accounting for fixed assets when determining the most advantageous methods to use for income tax purposes. Some of these methods were less significant in recent years due to the availability of 100% bonus depreciation on eligible property. However, under currently enacted law, bonus depreciation is phasing out, having reduced to 80% for 2023 and 60% for 2024. It will further decline to 40% for 2025, 20% for 2026, and 0% for 2027 and beyond. With this phaseout occurring, taxpayers should review their fixed-asset accounting methods to ensure they are applying the most beneficial methods, including methods applied to:

• Placed-in-service dates;
• Recovery periods;
• Repairs and maintenance expenses;
• De minimis safe-harbor election;
• Materials and supplies; and
• Remodel-refresh safe harbor.

Placed-in-service dates

As bonus depreciation winds down, taxpayers should pay close attention to the date on which property is placed in service. Bonus depreciation percentages are based on the year in which the property is placed in service. For example, property placed in service on Dec. 31, 2024, would be eligible for 60% bonus depreciation, while property placed in service on Jan. 1, 2025, would be eligible for only 40%.

Under the regulations, an asset is placed in service when it is “first placed in a condition or state of readiness and availability for a specifically assigned function” (Regs. Sec. 1.167(a)-11(e)(1)(i)). The IRS has issued rulings providing that the asset must be put into full operational use for it to be placed in service, although various courts have ruled that actual use is not a prerequisite for an asset to be placed in service. A taxpayer should closely review the facts and circumstances surrounding each asset’s placed-in-service date, particularly for assets that are placed in service near the end of a tax year.

Recovery periods

Taxpayers should review the recovery periods over which they are depreciating fixed assets. For tax years with a 100% bonus depreciation allowance, taxpayers may not have carefully reviewed whether shorter-life property had been assigned to the appropriate asset class and depreciated over the correct recovery period. With the phaseout, distinguishing between three-year, five-year, and seven-year property becomes more important.

As an example, many taxpayers may have special tooling assets, such as dies, molds, and jigs, that may be assigned a three-year life under Rev. Proc. 87-56, depending on the industry in which they are used. However, with 100% bonus depreciation, taxpayers may not have conducted a detailed review of their fixed-asset additions to ensure that these special tooling assets were identified separately from their other equipment, which may have been assigned a five-year or seven-year life.

In addition to reviewing depreciable lives of domestic assets, taxpayers should also review the lives assigned to property used outside the United States, as such property is required to use the alternative depreciation system (ADS) and is not eligible for bonus depreciation. Foreign property depreciation can affect foreign-derived intangible income (FDII), global intangible low-taxed income (GILTI), and global minimum tax calculations.

Repair and maintenance costs

Treating an expenditure as a capitalizable fixed asset or as a repair expense is another analysis taxpayers may have overlooked in the era of 100% bonus depreciation. With qualified improvement property qualifying for 100% bonus depreciation, many of these expenditures were written off in the first year regardless of whether they were capitalized as a fixed asset or deducted as a repair. With bonus depreciation phasing out, the categorization of an item as either a capital expenditure or a repair expense becomes more important.

An expenditure must be capitalized as an improvement if it results in a betterment to the unit of property, adapts the unit of property to a new or different use, or results in a restoration of the unit of property. Generally, an expenditure results in a betterment if it ameliorates a condition or defect that existed before the acquisition of the property or that arose during the production of the property; is for a material addition to the property; or materially increases the property’s productivity, efficiency, strength, etc. (Regs. Sec. 1.263(a)-3(j)(1)).

An expenditure results in an adaptation to a new or different use if it adapts the unit of property to a use inconsistent with the taxpayer’s intended ordinary use at the time the taxpayer originally placed the property into service (Regs. Sec. 1.263(a)-3(l)(1)). An expenditure results in a restoration of an asset if the expenditure restores basis that has been taken into account (e.g., as a deducted loss or in computing gain or loss on a sale or exchange); returns the unit of property to working order from a state of nonfunctional disrepair; results in a rebuilding of the unit of property to a like-new condition after the end of the property’s ADS class life; or replaces a major component or substantial structural part of the unit of property (Regs. Sec. 1.263(a)-3(k)).

If an expenditure does not meet these capitalization standards, it can generally be deducted as a repair. Taxpayers should review their fixed-asset records to determine if certain expenditures that have been capitalized for book or financial statement purposes do not meet the standards described above.

De minimis safe-harbor election

Taxpayers can immediately expense de minimis amounts paid for the acquisition of tangible property under the de minimis safe-harbor election. Under this election, taxpayers with an applicable financial statement can deduct amounts up to $5,000 per invoice or per item, as long as the taxpayer has a written book capitalization policy in place at the beginning of the year and the taxpayer treats the eligible property as an expense on its financial statements. Taxpayers without an applicable financial statement are limited to deducting items up to $2,500 (see also Galletta and Lau, “The De Minimis and Routine Maintenance Safe Harbors,” 55-5 The Tax Adviser 46 (May 2024)).

Many taxpayers have not revisited their book capitalization policies in recent years and may have been capitalizing property that is de minimis. In years with 100% bonus depreciation, the tax results would have been the same for bonus-eligible property. With the phaseout, a review of capitalization policies can accelerate tax deductions. It is important that taxpayers review and memorialize their book capitalization policies before the first day of the tax year to meet the election requirements.

Materials and supplies

Materials and supplies are often capitalized for book purposes but may be deductible earlier for tax purposes. Materials and supplies are generally defined as units of property that are used or consumed in the taxpayer’s business that have an acquisition or production cost of $200 or less, or items with an economic useful life of 12 months or less (used or consumed within 12 months). There are three categories of materials and supplies:

1. Nonincidental materials and supplies: Items for which a record of consumption is kept are deductible when consumed (Regs. Sec. 1.162-3(a)(1));

2. Incidental materials and supplies: Items for which no record of consumption is kept are deductible when purchased (Regs. Sec. 1.162-3(a)(2)); and

3. Rotable and temporary spare parts: Rotable spare parts are items that are installed on a unit of property, removable from that unit of property, repaired or improved, and then reinstalled (or stored for later installation). Temporary spare parts are items that are temporarily used until a new or repaired part can be installed. Rotable and temporary spare parts are deductible when disposed of (Regs. Sec. 1.162-3(c)(2)).

Taxpayers may also deduct materials and supplies that qualify under the de minimis safe harbor, discussed above.

Remodel-refresh safe harbor

Taxpayers in the retail and restaurant industries that are undergoing remodel or refresh projects on their locations can benefit from the remodel-refresh safe harbor provided in Rev. Proc. 2015-56. If a qualified taxpayer undertakes a remodel-refresh project for a qualified building and elects the safe-harbor method, the taxpayer may treat 75% of the qualified costs as deductible during the tax year in which they are incurred.

Taxpayers are not allowed to claim partial dispositions of a qualified building when using the remodel-refresh safe harbor. To benefit from the safe harbor in a year prior to the year of change, a taxpayer must revoke any partial disposition elections made in a prior tax year with respect to a qualified building. As such, the taxpayer will be required to recognize a Sec. 481(a) adjustment to add back the loss previously claimed on the partial disposition, adjusted for any additional depreciation allowance that would have been claimed had the partial disposition not occurred.

Procedural considerations

Some of the items discussed above relate to annual elections or determinations to be made on new items (e.g., placed-in-service date analysis). However, some of the planning ideas may relate to methods of accounting, which generally require the filing of a Form 3115, Application for Change in Accounting Method. Many of the methods are automatic accounting method changes under Rev. Proc. 2024-23 and can be filed with the taxpayer’s timely filed return (including extensions). However, taxpayers should review the eligibility requirements in Section 5.01 of Rev. Proc. 2015-13 to ensure they are eligible to file the change automatically.

Editor Notes

Michael Wronsky, CPA, MST, is managing director of Baker Tilly’s Washington Tax Council.

For additional information about these items, contact Wronsky at michael.wronsky@bakertilly.com.

Contributors are members of or associated with Baker Tilly US, LLP.