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By Jason Watson, CPA
Posted Friday, November 3, 2023
Before we get into the exciting world of automobiles, home offices and traditional business expenses, let’s explore the concept of depreciation. How it works, how it can help, and how it can bite. There are three basic types of depreciation available to small business owners-
- MACRS (or other suitable schedules)
Section 179 of the tax code allows you to instantly depreciate assets up to $1,160,000 (for the 2023 tax year).
Not all property qualifies for Section 179 depreciation, namely real estate. Some property is considered Listed Property which has special rules and limits, namely automobiles and computers. To deduct Section 179 depreciation, your business must have net income and / or sufficient shareholder basis to absorb it, otherwise whatever is unused is carried forward to later years.
Bonus depreciation is also enhanced. It was 50%, but it now 100% for 2018 thru 2022 tax years, and then 80% for 2023, 60% for 2024, 40% in 2025 and 20% in 2026. There are all kinds of rules and interplay between Section 179 and Bonus depreciation.
Now that bonus depreciation is coming back down to earth, Section 179 is becoming sexy again. Even during the good ol’ days of 100% bonus, there were times where Section 179 depreciation yielded a better overall strategy especially given the interplay with Section 199A.
MACRS is not a depreciation schedule designed for bourbons. Frankly, bourbon shouldn’t be sitting around long enough to depreciate… or spoil as us accountants would say. At our office, Maker’s Mark seems to deplete long before it depreciates or spoils. All kidding aside, MACRS is Modified Accelerated Cost Recovery System which is the default depreciation schedule for most property. So, if you do not use Section 179 or Bonus depreciation, you will be utilizing MACRS depreciation (generally speaking). You can also elect other suitable schedules too but those choices and justifications get more complicated.
If you really want to complicate things, Generally Accepted Accounting Principles (GAAP) does not recognize accelerated depreciation. Therefore if you have audited financial statements, there will be a difference between “book” depreciation and “tax” depreciation. 99% of the small businesses out there don’t have audited financial statements (or the need for them). But you might run across this if you are buying or selling a business. WCG also does business valuations for divorce cases or economic damages lawsuits, and the “book” to “tax” and vise-versa becomes an important valuation component.
Tax Planning with Depreciation
We are shocked every time a client walks into our office demanding to pay fewer taxes. We smile and tell them that they are the only one. Most people want to pay more taxes, so we find it refreshing when someone wants to pay less. Yes, we’re kidding.
Tax planning with depreciation must be carefully considered. Everyone wants the bird in the hand versus the two in the bush. We get it. But let’s run through some scenarios which might expand your thinking and horizons.
Let’s say you buy a piece of equipment for $200,000 and you deduct the whole thing in the first year using Section 179 depreciation. If your marginal tax rate is 12%, you saved yourself $24,000 ($200,000 x 12%). Nice job. In the next year, your business is growing and you find yourself in the 22% marginal tax rate but you don’t have any depreciation left, so no savings.
Here is a table illustrating Section 179 depreciation-
|Allowed %||Depreciation||Tax Savings|
|Year 1, Savings at 12%||100%||200,000||30,000|
|Year 2, Savings at 12%||0%||0||0|
|Year 3, Savings at 22%||0%||0||0|
|Year 4, Savings at 22%||0%||0||0|
|Year 5, Savings at 24%||0%||0||0|
|Year 6, Savings at 24%||0%||0||0|
Here is the exact same scenario using MACRS as your depreciation schedule (as opposed to using Section 179)-
|Allowed %||Depreciation||Tax Savings|
|Year 1, Savings at 12%||20.00%||40,000||4,800|
|Year 2, Savings at 12%||32.00%||64,000||7,680|
|Year 3, Savings at 22%||19.20%||38,400||8,448|
|Year 4, Savings at 22%||11.52%||23,040||5,069|
|Year 5, Savings at 24%||11.52%||23,040||5,530|
|Year 6, Savings at 24%||5.76%||11,520||2,765|
That is a $4,300 difference! However, this is overly simplified comparison given that $200,000 spans at least two marginal tax brackets. We used this dramatic disparity to drive home the point that you might be leaving money on the depreciation table.
Also, we concede that the time value of money is not at play in these examples. If you take your $30,000 tax savings and invest it wisely, it will outperform the lost tax savings. At a 6% rate of return compounded annually the savings are $10,147 compared to $4,300. But, this means you must invest it and not spend your tax savings on a cruise boat.
Before you call your tax accountant and franticly decline the Section 179 depreciation method, consider your income projections. The illustrations above only prove a point if your marginal tax rate is increasing. If you are experiencing an exceptionally good year, and the next few years will have less taxable income, then perhaps using the instant depreciation benefits of Section 179 make sense. Plan! Plan! Plan!
Tax Planning with Depreciation Recapture
Please understand that depreciation is a tax deferral system rather than a tax avoidance system. Huh? When you sell or dispose of an asset, you might have to pay tax on the portion that was depreciated.
For example, you buy a $200,000 piece of machinery and use Section 179 depreciation to deduct the entire $200,000 in the first year. Five years later you sell the equipment for $150,000 because you slapped some new paint on it and you are a shrewd negotiator with your buyer. You will now have to recognize $150,000 of taxable ordinary income. Yuck. But there is a silver lining- depreciation recapture is taxed at your marginal tax rate up to a maximum of 25% tax rate. So, you could have depreciated your asset during 37% marginal tax rate years just to pay it all back at 25%. Bonus. Tax planning is a must! How many times have we mentioned that?
You can kick this depreciation recapture can down the road with a Section 1031 exchange (also referred to as a like-kind exchange). Perform your favorite internet search on this topic- way too involved to explain here except that a Section 1031 exchange allows deferral of depreciation recapture and capital gains. And if you think you know what a 1031 exchange is, try learning about a reverse 1031 exchange- where you buy the replacement property first. Yup. It exists.
Keep in mind that 1031 like-kind exchanges are now limited to real property with the recent tax reform.
What if you think you can be clever, and not deduct depreciation on your asset? IRS is way ahead of you. Way ahead. There is a little known rule called the allowed versus allowable rule and it can bite you in the butt. And it’s not a nibble, it is potentially quite the bite, like Jaws-size (“You’re gonna need a bigger boat”).
Several Tax Court rulings will have a statement similar to “Tax deductions are a matter of legislative grace.” Nice. When have you ever felt the grace of a legislator as you pay taxes? Never. At any rate, let’s extend this statement a bit, and one can infer that tax deductions are not required to be taken which is completely true. And some tax planning can involve not taking tax deductions on tax returns in certain cases (seems weird, but there are narrow examples).
But the IRS assumes that you have deducted depreciation expense in the past so when you dispose or sell your asset, you MUST recapture depreciation even if you didn’t deduct it in the past. That is a big Yuck. We commonly see this when taxpayers own rental properties and prepare their own tax returns. Tax preparation is a profession, not a hobby. Yeah, we said it! We have to, it’s our chosen profession.
There are ways to fix this of course. One way is using Form 3115 Application for Change in Accounting Method. This form is used for a variety of things, and one of the things is to bring your depreciation current through a Section 481(a) adjustment. One of the problems with slapping a whole bunch of depreciation in one tax year is revenue and expense matching- this is one of the cornerstones of accounting principles, so these adjustments need to be detailed correctly. And with rental properties specifically, you might get into passive loss limit problems.
By the way, you can opt out of depreciating real property in Canada. Who knew?
We digress. Back to the chapter’s topic- Tax Deductions, Fringe Benefits!
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