Bonus depreciation sounds great! It’s like depreciation, but better. What could be bad? Well, if you’re a New York taxpayer that invests in passive activities (like real estate or a business venture that you are not actively participating in), and that investment takes bonus depreciation, it could put you in an unexpected tough spot when it comes time to file your personal tax return. Let’s quickly recap what this all means.
What is Depreciation?
When you purchase an asset (like a building or piece of machinery), instead of showing the full amount of the purchase price as an expense on your company’s income statement, you will show it as an asset on your company’s balance sheet.
Then, each year you will depreciate (i.e. take as an expense) a portion of the asset’s value. The portion you take depends on the asset’s useful life (which is generally determined by IRS rules). For example, residential real estate has a useful life of 27.5 years, whereas machinery may have a useful life of 5 years.
If you buy a piece of 5-year machinery for $100, you may show an expense equal to 1/5 of this, or $20, each year for 5 years. This expense is called depreciation.
What is Bonus Depreciation?
Bonus depreciation is a special rule that lets you take as an expense more than just one year’s worth of depreciation in the year the asset is first purchased. How much you can depreciate in year one depends on the Bonus Depreciation rules in place at that time. In a “regular” year, Bonus Depreciation is 0%, meaning it’s not in place at all, however, Bonus Depreciation has been used as a way to encourage businesses to invest in new assets in times of economic slowdowns such as after the 2008 financial crisis or during COVID.
In 2022 you could take 100% Bonus Depreciation, meaning you could fully depreciate the purchase price of the asset immediately upon purchasing it. Starting in 2023, the bonus depreciation rate will drop 20% per year until it’s back to 0% (in 2023 it is 80%, then in 2024 it will be 60%, etc.).
What is a Passive Activity and Why Does It Matter?
A passive activity is, in plain English, one that you don’t actively participate in (the actual rules are more complicated, but you get the idea). Additionally, rental real estate is (by IRS rule) considered to be passive, not active, even if you are actively managing the property (unless you’re a real estate professional).
Why does it matter? Because losses from passive activities cannot offset active income (e.g. W-2 wages you earned from your job) on your tax return.
If you have $100 of wages and a $100 passive loss, your taxable income will be $100, because the passive loss cannot offset the active income. (Note that the passive loss is not gone, it is carried forward to future years, waiting to be used to offset some future passive income or until you sell the passive activity).
Why is This Combination of Bonus Depreciation on a Passive Activity Particularly Bad for New Yorkers?
This is where it gets a little tricky, stay with me. Here are a few relevant facts:
- New York (like many states) does not allow for bonus depreciation deductions
- New York’s tax return starts it’s calculation of your taxable income with your Federal Adjusted Gross Income (“AGI”)
- If you have bonus depreciation deductions on your federal tax return, you will add back the bonus depreciation on your New York tax return
- You will then subtract the depreciation that was recalculated using New York’s rules
- The result is your New York Adjusted Gross Income, which will be used to calculate your New York tax
First let’s look at an example of this with an active activity:
Your only sources of income or losses are W-2 wages from your full-time job and a loss from E Street LLC, a business you actively participate in. For simplicity, let’s assume E Street LLC’s whole Profit & Loss (“P&L”) statement is comprised of:
| Revenue | $0 |
| Bonus Depreciation from Purchased 5-Year Machinery | ($100) |
| Active Profit / (Loss) | ($100) |
Here’s how this would flow to your personal tax return:
Your Federal Tax Return
|
Income from W-2 |
$100 |
| Loss from active business | ($100) |
| Federal AGI | $0 |
Your New York Return
| Federal AGI | $0 |
| Add – bonus depreciation | $100 |
| Subtract – NY allowed depreciation | ($20) |
| New York AGI | $80 |
This seems reasonable. New York doesn’t allow bonus depreciation, so they effectively recalculate your taxable income using regular depreciation instead. So far we’re okay. But, as we said above, this is an active activity, and it really gets bad when you have a passive activity.
Let’s see an example with a passive activity:
Your only sources of income or losses are W-2 wages from your full-time job and a loss The Boss LLC, a business in which you are a passive investor. For simplicity, let’s assume The Boss LLC’s whole P&L is comprised of:
| Revenue | $0 |
|
Bonus Depreciation from Purchased 5-Year Machinery |
($100) |
|
Passive Profit / (Loss) |
($100) |
Remember, the passive loss cannot offset active income, such as wages!
Here’s how this would flow to your personal tax return:
Your Federal Tax Return
| Income from W-2 | $100 |
|
Loss from passive business |
($0) |
| Federal AGI | $100 |
Your New York Return
| Federal AGI | $100 |
| Add – bonus depreciation | $100 |
| Subtract – NY allowed depreciation | ($20) |
| New York AGI | $180 |
Do you see the problem here?! Despite the fact that you did not deduct the passive loss, which was the original source of the bonus depreciation, New York still makes you add back the bonus depreciation (which you never deducted in the first place)!
So you’re starting with your Federal AGI (that does not reflect the bonus depreciation because it was passive), and then adding the bonus depreciation back on your New York tax return anyway. This effectively takes a passive activity that, for federal tax purposes, had a $100 loss and leaves you with $80 of income taxed to New York.
This is (imho) crazy! I can fully understand New York not recognizing bonus depreciation (this is actually pretty common among the states) and making you adjust for it, but to make you adjust for it when it was never deducted in the first place just makes no sense.
In Conclusion
Bonus depreciation on a passive activity in New York can be a rough combo. To make it worse, the fact that the activity is passive means that you’re likely not involved in the decisions that the underlying company makes. One of those decisions might be whether or not to take bonus depreciation!
As you saw above, this deduction acts very differently for active and passive investors. The active participants are likely the ones making this decision, and they may not be considering (or even be aware of) how this will impact their passive investors.
Additionally, this is not the normal way this works in other states, so if you’re investing in a company that is outside of New York, there’s a reasonable chance that the company’s manager (and even their tax counsel) don’t know that New York has this weird rule that can end up costing you a lot of New York tax despite the fact that the investment generated a loss for federal tax purposes.
What should you do about it?
A few things:
- If you’re responsible for making the decision as to whether or not to take bonus depreciation, make sure to review the possible impact of this decision as it relates to all of your investors
- When making an investment, speak to management about their plans for bonus depreciation and consider referencing it in the operating/investor agreement
- If you are managing a deal and want to ensure investors that they won’t get burned by this but still want to take bonus depreciation, consider including something in the Tax Distributions section of your operating agreement that references this
- Talk to your CPA about how this might affect you before the decisions have been finalized!
A final note: this New York phenomenon can happen with other types of loss limitations at the federal level, not just passive losses, such as limitations on excess business losses.
This is a complicated area of the tax code, and you should always talk to your tax advisor about your specific situation before making any tax-related decisions.