Another generous accelerated depreciation provision is the election under Internal Revenue Code, Section 179. This election is geared towards smaller to medium size businesses that do not place a huge amount of assets into service during the year. The election allows taxpayers to elect to immediately expense or deduct, a fixed dollar amount of eligible property used in a trade or business. This election applies to depreciate particular eligible assets. Therefore, you would individually select the assets that you wanted to use this accelerated depreciation on. Like bonus depreciation, Section 179 is mostly limited to business use, personal property. In general, no real property, so no apartment buildings, office buildings, warehouses, et cetera. However, Section 179 does allow for an election to treat certain limited categories of non-residential real property improvements as qualifying property. One example here would be a category of assets called qualified improvement property. These are non-structural, non elevator interior improvements to an existing building. Interestingly, Congress had intended for qualified improvement property to also be eligible for bonus depreciation in the TCJA by giving it a 15-year depreciable life. However, due to a drafting error in the TCJA, qualified improvement property was instead given a 39-year life, but it remained eligible for Section 179. Now, in March 2020, Congress retroactively corrected the qualified improvement property drafting error, sometimes called the retail glitch when they pass the Coronavirus Aid Relief and Economic Security Act, aka the CARES Act. This change in the CARES Act dated back to tax year of 2018. Qualified improvement property is now 15-year property and is eligible for bonus depreciation in addition to being eligible for Section 179, another type of real property eligible for Section 179 includes nonresidential roofs, heating and cooling systems, and fire and security systems, all of which have to be added after the main structure is placed into service. Moving along, what is the amount that you can elect under Section 179? Well, looking at our chart, we can see that the Tax Cuts and Jobs Act roughly doubled the eligible election from about a 0.5 million to $1 million for 2018. In 2018, assuming you meet all of the eligibility criteria, you can immediately depreciate up to $1 million of the cost basis of assets you place into service. Unlike with bonus depreciation, Section 179, depreciation has always been allowed on both new and used property. Now if you don't wish to or you can't completely depreciate a particular asset, you can combine Section 179 with both bonus depreciation and regular makers depreciation. Here's a formula to show how all the depreciation options worked together for a particular asset. First, the expense amount under Section 179 will reduce basis for purposes of calculating bonus depreciation and regular makers depreciation. That is, Section 179 depreciation expense is claimed before we claim bonus depreciation, and before we claim regular makers depreciation from the tables. If we purchase business use property, and our cost basis is A, the Section 179 election will allow us to reduce the basis through depreciation deductions by up to the applicable Section 179 limit. That's $1 million total across all eligible assets in 2018. Of course, we can never depreciate assets and excess of their cost basis. If our cost basis of eligible assets placed into service is greater than the maximum 179 election, we're left with an adjusted basis of C. Now C is eligible for bonus depreciation next. We can take the applicable bonus depreciation percentage and multiply by the remaining basis as seen in D. Which leaves us with E as the next adjusted basis, if any. Then we can take E, and apply the makers depreciation rates from the tables to figure out what the regular makers depreciation deduction is. In total, we can claim depreciation deductions related to Section 179, bonus depreciation and the maker's tables. This is literally depreciation on top of depreciation, on top of depreciation. Let's do a quick example of this order enroll, and here we'll use an asset placed into service and tax year 2016, so we can see each step being used. First, Roger places into service a five year piece of property costing $1.640 thousand. On August 15, 2016. He elects immediate expensing under section 179 up to the maximum amount, which was a half-million dollar for 2016. We'll also assume he does not elect out a 50 percent bonus depreciation, which was the applicable bonus percentage for 2016. This property appears to qualify because its new. Remember that this was a requirement before the TCJA. It has a class life and no more than 20 years. The total cost recovery deductions for 2016 are as follows. First, his cost-basis is 1.640 thousand and he can subtract out 500,000. The maximum amount electable under section 179. Now he's left with $1.140 thousand in basis for bonus depreciation. Next, he takes 50 percent of that amount and claims at his bonus depreciation. Now, we have the remaining half or 570,000 that is now eligible for regular makers depreciation. For five-year property being depreciated, and again, we'll assume the half year convention applies. The depreciation rate and recovery in year one is 20 percent. Therefore, we take the remaining $570,000 basis and multiply it by 20 percent to get our makers depreciation deduction of $1.14 thousand The total depreciation that Roger is potentially able to duct and the first year of use is $500,000 from section 179, $570,000 from bonus depreciation, and a $1.14 thousand from regular makers depreciation. In all over, 72 percent of this asset's cost is being immediately deducted. Not too bad. Of course, in 2018 with 100 percent bonus, he could have made that number 100 percent. Now, getting back to the eligibility requirements for Section 179, there are two main limitations. First, is the asset acquisition limitation. The second, is the taxable income limitation. Let's talk about the asset acquisition limitation. The amount of eligible 179 election is phased out dollar for dollar by the amount of property placed into service that is eligible for Section 179, that exceeds a threshold amount. When I say property eligible for Section 179, you wouldn't count real property in this calculation except for those limited categories and non-residential real property eligible for Section 179 if you make the appropriate election. In 2018, this threshold acquisition amount was $2.5 million. If you place less than $2.5 million of qualifying Section 179 assets into service, you can elect up to one million dollars in Section 179 depreciation, or up to the basis of the qualifying assets if the amount you place in service is less than a million. But again, if you go over the threshold with your asset acquisitions, your eligible Section 179 election phases out dollar for dollar. In short, for every dollar above the limitation, that's a dollar less of the maximum 179 amount the taxpayer is allowed to elect. If you place $3.5 million of qualifying section 179 assets into service in 2018, your eligible 179 election is going to be zero, because it has been completely phased out. What about if a taxpayer placed $2.6 million of Section 179 assets into service, what would their eligible one Sunday night election be in that case? Well, here the taxpayers are $100,000 over the threshold. The eligible election is phased out by $100,000. One million minus 100,000 gives us a $900,000 maximum 179 election. The asset acquisition limitation determines how much section 179 depreciation you can elect, but it doesn't determine how much you can deduct. Instead, how much of a Section 179 election you can deduct is determined by a second limitation, the taxable income limitation. That's because a Section 179 deduction cannot create a business taxable loss for the taxpayer. In other words, the amount expense cannot exceed the years business taxable income computed without regard to the Section 179 expense. Any amount of elected 179 depreciation the taxpayer wanted to deduct but could not, is carried forward to a future year and can be deducted in the future, but it's going to be subject to those same limitations. The business taxable income limitation plus the total deduction for the year can never exceed the overall dollar limit. That's that one million dollar number adjusted annually for inflation. We'll also note here that while Section 179 cannot create a loss, both regular makers depreciation and bonus depreciation can create and drive up losses. Let's do an example. In 2017, Pam places $2,060,000 of qualifying Section 179 property for use in her business and the service. Pam's 2017 business income before considering the Section 179 deduction is $200,000. How much Section 179 can Pam elect in tax year 2017? How much Section 179 expense can Pam deduct in 2017?. Let's look at limitation one. The asset acquisition threshold. Here, the $510,000 maximum amount that can be elected for 2017 is reduced by $30,000. Thirty thousand is the excess amount of qualifying Section 179 property placed in the service above that $2.03 million asset acquisition threshold. 510,000 minus 30,000 gives us a maximum $480,000 Section 179 election. Next, we need to determine how much of any elected amount can be deducted by Pam. Now we turn to the taxable income limitation. Here, because Pam's business income before the 179 deduction is only $200,000, that is the maximum amount of Section 179 expense you can deduct in the current year. Pam has two options. One, she can choose to elect only up to the deductible amount, or two, she can elect more than the deductible amount, and anything that is elected but not deducted would be carried forward to a future year. That means we can potentially have two different Section 179 numbers, the elected amount, and the deducted amount. With these two potentially different numbers, it's important to know that we reduced the basis of an asset by the elected amount in the year elected. Thinking back to our formulas shown in Section 179 bonus and regular makers, we reduced the basis eligible for bonus and makers by the elected Section 179, not the deducted Section 179. In practice, this usually means it makes more sense to only elect Section 179 up to the amount you can actually deduct. That's because any depreciable basis you don't elect under Section 179 is still going to be eligible for some type of bonus or regular makers depreciation in the current year. In other words, you're at least getting some current deductions. Remember, bonus and makers depreciation don't have a taxable income limitation. They can create losses, they can increase losses. You can contrast this with a suspended Section 179 deduction, which is not deductible in the current year, and may or may not be deductible anytime soon. Another twist about Section 179 is to know how it interacts with the mid-quarter convention calculation. You'll recall that the mid-quarter convention is required if greater than 40 percent of makers assets, that's generally tangible personal property, are placed into service in the fourth quarter of the tax year. Well, when you claim Section 179 on particular asset, it's the adjusted basis after applying the Section 179 election, that is used and the mid-quarter calculation. This means that strategic election or what assets you apply Section 179 to, can actually shift a taxpayer from mid-quarter to half year in a particular tax year. Finally, with a 100 percent bonus depreciation, you may ask yourself, why would you need to use Section 179? Well, 100 percent bonus is definitely going to make 179 less use over the next few years. But there are still a few reasons the section 179 is important to understand. First, as we've seen, there are slight differences in eligible property. For example, when you are required to capitalize a new roof on an existing nonresidential building, that's a 39-year asset. It doesn't qualify as qualified improvement property, because it is not an interior improvement. This means, it's not eligible for bonus depreciation, but it is eligible for Section 179. Second, certain states may provide more advantageous treatment to Section 179 as opposed to bonus. State taxation may motivate depreciation decision-making. Third, bonus depreciation is an all or nothing proposition by asset class. For example, either you take bonus on all of your eligible seven-year property, or you don't. There's no middle ground. However, with Section 179, you can make an election anywhere from zero to your maximum electable amount. You can even take Section 179 on only a portion of an asset's cost. This flexibility could be useful if you're trying to target a particular taxable income number, for example, to claim a tax credit. Finally, don't forget, 100 percent bonus is temporary. On the other hand, Section 179 expensing is a permanent feature of the tax code.
