DGC Blog

Bonus Depreciation Can Have Multiple Benefits

  

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By Patrick J. Bevington, CPA, MST

Taxpayer friendly transactions are hard to come by, and even more sought after in a tough economy.  One that has recently been discussed and highlighted by tax professionals and their clients relates to a double dipping of sort with regard to bonus depreciation. The Internal Revenue Code and the Treasury Regulations allow a taxpayer to take bonus depreciation on a newly purchased asset, dispose of that asset in a tax-free exchange and take bonus depreciation on that newly acquired asset. This allows a taxpayer to potentially take advantage of taxpayer friendly provisions three separate times.

Bonus Depreciation – First Event

The first step occurs when a taxpayer acquires an asset for use in their trade or business. In order to claim bonus depreciation, the asset must fit certain criteria. It must be a Modified Accelerated Cost Recovery System (MACRS) asset with a recovery period of 20 years or less, have its original use begin with the taxpayer, and it must be timely purchased and placed in service by the taxpayer. 

For example, a manufacturing company purchases a piece of machine equipment with a five-year recovery period for $200,000 and places it in service in the current tax year. Because the machine qualifies, the manufacturing company may write off 50 or 100% of the cost in the year placed in service as opposed to over the five-year period.

Exchange of Asset

There are two types of asset exchange that may occur. One is a like-kind exchange. Let’s say the company decides it would prefer a different piece of equipment and they set up a tax-free exchange with another company for a different machine. (The assets must be of like kind.) The newly acquired asset generally takes the basis of the relinquished asset plus/minus any additional considerations paid/received and gain/loss recognized. 

The other type of exchange can occur in the form of an involuntarily conversion (i.e. theft, destruction, seizure, or other), in which the company recognizes no gain on this transaction, but must replace the property. We’ll assume the insurance company pays $200,000 to replace the property. Even having a basis of zero in the original equipment (100% was written off to bonus depreciation), the company will recognize no gain on the transaction if it acquires a new asset. Because bonus depreciation was taken on the machine originally, the manufacturing company is deferring a much larger gain than it would have if they did not take bonus depreciation.

Bonus Depreciation – Second Event

A second bonus depreciation event happens when the manufacturing company decides to purchase a new $300,000 piece of equipment in place of the old machine. The new basis in the new piece of equipment will be $100,000 (zero carryover basis plus 100,000 additional considerations paid in excess of the insurance proceeds).  As long as the newly acquired asset fits into the same rules described above for bonus depreciation, the company may expense the entire new asset as well. That means the additional $100,000 paid for the new machine may be written off in the year placed in service.

The tax-free exchange provisions treat the transaction as an exchange of the first machine with a carryover basis to the new one, while the depreciation provisions look at these transactions in two steps as if they sold the original machine and purchased a new one. The company benefits in the following ways:

• Claiming bonus depreciation on newly acquired assets
• Having a tax free disposition of potentially appreciated assets
• Being able to claim bonus depreciation on a second asset with a carryover basis

In the example described throughout, the manufacturing company would be deducting $200,000 in the year of acquisition as opposed to the life of the asset, not recognizing a gain of $200,000 on the insurance proceeds, and again expensing the $100,000 paid in the new year of acquisition. If these assets are both five-year assets, the depreciation deductions are being taken over two tax years as opposed to over ten. 

These transactions, broadly depicted, have great potential to taxpayers, but they should be very careful to structure their transactions correctly in order to satisfy all the complex variables. Contact a DGC representative if you think you may be able to capitalize on such a transaction.