This article desribes two ways to maximize depreciation deductions, including an example of how the rules are applied.
As a small business owner you will want to be aware of all the tax deductions that are available to you through special depreciations rules. Why? Because, obviously, this knowledge translates into higher deductions, lower reportable income, and less income tax to be paid. The following are two important rules to become familiar with and an example of how those rules are applied:
30% Bonus Depreciation:
In addition to the regular depreciation deduction allowed for the purchase of qualified fixed asset property is a 30% bonus depreciation deduction that has been authorized by the Job Creation and Worker Assistance Act of 2002. It will remain in effect through 12/31/04. The Act requires an additional first year depreciation deduction for qualified property placed in service after September 10, 2001. Notice that I said requires. If you decide you dont want to take bonus depreciation you must elect out of it. If you fail to make the election, the IRS will treat your depreciable property as though you did take the allowed expense. Of course, that will only occur if you happen to get audited.
Section 179 Election to Expense:
The other special depreciation rule you should be aware of is called an IRS Section 179 election to expense. It has been around for quite awhile so you may have already heard of it. It works like this: If you purchase under $200,000 of qualified property, you can elect to expense up to $24,000 ($25,000 in 2003) of that property in one year, instead of three, five, seven, etc., years. For each dollar of investment in Section 179 property in excess of $200,000 in a tax year, the $24,000 maximum is reduced (but now below zero) by one dollar. In other words, if the total investment in Section 179 property is $224,000 or more in a tax year, there is no Section 179 deduction allowed for that tax year.
Keep in mind that leasehold improvements are not qualified property and therefore cannot be expensed in one year under Section 179. Its a good idea to check with your tax preparer regarding specifics. You should also be aware that there is a taxable income limitation for using this deduction. The IRS does not allow for a Section 179 expense to create a loss. However, here is a tip: Income, for this purpose, is defined as aggregate taxable income derived from the active conduct of any trade or business. This means that not only can you use the taxable income from your business but also the taxable income from W-2 wages as an employee. So, if you file jointly and your spouse is an employee, your aggregate income can be used to offset a Section 179 expense.
In addition, if you have more Section 179 expense than you can use in one year, you can carryover the unused amount to the following year. Although, this does not mean that you can carryover an amount that exceeds the $24,000 limit. Another benefit is that there is no limit on the amount of Section 179 expense due to the time of year you make the purchase. For example, if during any tax year the total basis of all property placed in service during the last three months of the tax year exceeds 40% of the total basis of all property placed in service during the tax year, a mid-quarter convention is applied to all property subject to MACRS (Modified Cost Recovery System), instead of a half-year convention.
This means that instead of assuming all your property was purchased on July 1 (half-year) you will have to assume that you will have to assume your purchases were made in the middle of the quarter that they bought. When using regular depreciation this rule can severely limit your depreciation deduction. However, if you buy a piece of equipment as late as December 31, you can write off the entire amount by using the Section 179 election because the 179 election does not apply to the 40% rule.
The following is an example of how to maximize your depreciation tax deduction for your small business:
Look at all your purchases of depreciable property and determine what property qualifies under Section 179. Take as much as you can. If there is still any property left that has not be depreciated, you should use the 30% bonus depreciation first, then the regular MACRS depreciation. To illustrate, lets assume you bought $50,000 of qualified property. After applying the maximum Section 179 expense of $24,000 you will have $26,000 of remaining property to depreciate ($50,000 less $24,000 = $26,000). Then apply the 30% bonus depreciation, i.e., $26,000 x 30% = $7,800. Last, assuming it is all 7-yr property, your depreciation expense will be $2,600.78 ($26,000 $7,800 = $18,200 x .1429 = $2,600.78).
Your total depreciation tax deduction will be:
Section 179 $24,000.00, plus Bonus depreciation $7,800.00, plus 7-yr MACRS $2,600.78, equals $34,400.78.
Thats a pretty good first year write-off for $50,000 in purchases. Understanding these special rules should help when doing your year-end tax planning and, hopefully, save you a little money.
