Construction business owners, we’re heading into fall. The end of the year will be here before you know it. That makes this a critical time to seriously consider buying any assets you’ve had your eye on so you can take advantage of potentially hefty depreciation-related deductions when you file your 2022 federal tax return.
Current tax law allows two particularly valuable deductions on purchases of equipment, tools, machinery and other assets essential to construction companies. But you’ll need to move fast to make the most of them.
With continuing supply chain issues, labor shortages and other delays, you could face challenges in making the types of purchases that can reap big tax savings — especially with one of the deductions set to begin phasing out in 2023.
Section 179 expensing
Section 179 of the Internal Revenue Code is technically an expensing provision. It allows eligible businesses to deduct 100% of the purchase price of new and used eligible assets for the year in which the assets are put into service. That’s one of the reasons why you might want to place orders for certain equipment sooner rather than later. Used assets qualify for the deduction only if they haven’t been used by the taxpayer or a predecessor at any time before acquisition.
Eligible assets include:
- Machinery,
- Office and computer equipment,
- Software, and
- Certain business vehicles (for example, heavy construction vehicles).
Under the Tax Cuts and Jobs Act, you can also claim a Sec. 179 deduction for improvements to nonresidential real property — including roofs as well as systems related to HVAC, fire protection and security.
The maximum Sec. 179 deduction for 2022 is $1.08 million. It begins phasing out on a dollar-for-dollar basis when your qualifying property purchases exceed $2.7 million. In other words, you can’t take the deduction if the cost of your Sec. 179 property placed in service during the year is $3.78 million or more.
Your maximum deduction is also limited to the amount of income from business activity. Any cost not deductible in the first year because of this limit can be carried over to the next year for an unlimited number of years. You must, however, deduct carried-over costs from the earliest year before you deduct costs from the next year.
The Sec. 179 deduction isn’t automatic. You must elect it on an asset-by-asset basis on IRS Form 4562, “Depreciation and Amortization (Including Information on Listed Property).”
Bonus depreciation
An additional first-year depreciation deduction provided under Section 168(k) of the tax code has long been called “bonus depreciation.” And it’s still available. Most businesses can apply this form of depreciation to eligible purchases that exceed Sec. 179 limits. Bonus depreciation isn’t subject to any limits or phaseouts.
For 2022, you can deduct 100% of the cost of new and used (subject to certain conditions) eligible property, assuming it’s placed in service by year-end. That percentage will begin to fall in 2023, dropping 20% each subsequent year. Absent congressional action, bonus depreciation will be eliminated entirely in 2027.
You can take advantage of bonus depreciation by buying assets such as computer systems, software, vehicles, machinery, equipment and office furniture. It’s also available for qualified improvement property — generally, interior improvements to nonresidential real property — placed in service this year.
Note: A provision in the Coronavirus Aid, Relief, and Economic Security Act enacted in 2020 retroactively made qualified improvement property eligible for bonus depreciation. If you made such improvements in 2018 or 2019, you can claim a tax refund for the missed deduction.
The IRS automatically applies bonus depreciation to eligible property, but you can opt out. See “Accelerated depreciation isn’t always best” below for details on why you might, under some circumstances, want to do so. If you elect to opt out, the election will apply to all qualified property in the same property class (for example, all five-year MACRS property) that’s placed in service that taxable year.
The best path forward
The total amount you’re allowed to deduct for depreciation of an asset is the same whether or not you accelerate under Sec. 179 or bonus depreciation. What’s important is that you and your leadership team discuss which assets you really need to buy (don’t make any purchase only for tax purposes) and, if you decide to move forward, which depreciation method is best. Your CPA can help you choose the best path forward.
Accelerated depreciation isn’t always best
Taking accelerated depreciation tax breaks such as Section 179 expensing and bonus depreciation (see main article) provides some clear advantages for construction businesses making asset purchases. But, in some situations, taking standard depreciation could prove preferable.
For example, you might want to skip accelerated depreciation if you claim the qualified business income (QBI) deduction for pass-through entities such as partnerships and limited liability companies. The amount of the deduction is limited by your taxable income, and depreciation reduces such income. The QBI deduction is set to expire after 2025, so it might make more sense to take this tax break while you can.
Other tax breaks also hinge on taxable income. Expiring net operating losses, charitable contributions or credit carryforwards might suggest a different approach.
Last, you might have second thoughts about Sec. 179 and bonus depreciation if you expect to land in a higher tax bracket in the future. The value of any deduction is based on how much it can cut your tax bill — therefore, a deduction is worth more when you face a higher tax rate.
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