At the end of the year, calendar-year business owners may want to begin thinking about the tax considerations relevant to making equipment purchases. Timing is critical because the year in which the equipment is purchased and is available and ready for use will likely play a significant role in determining the amount of allowable depreciation and, therefore, tax liability for a given year.
Conventional wisdom suggests that a taxpayer may not begin to depreciate an asset as “placed in service” until it is put to actual use. However, it is well established that a taxpayer may begin to depreciate an item as “placed in service” when the taxpayer has acquired the item and it is ready and available for use.
Taxpayers considering whether to acquire and place in service equipment in a given year face several choices that will impact the amount of the depreciation deduction. Among those choices are two key decisions: when to purchase and how much to spend. These two issues will generally determine the amount of the depreciation deduction.
Depreciation Rules
A taxpayer will generally apply the half-year convention, unless the mid-quarter convention applies. Under the half-year convention, the taxpayer is generally entitled to take one-half of the depreciation deduction in the first year, regardless of when the property was placed in service during the year.
Example
A taxpayer buys five-year property costing $5,000 in September. Assuming the taxpayer is using the straight-line method of depreciation, he is entitled to a depreciation deduction of $500 in year 1 ($5,000/5 = $1,000/2 =$500). However, if the aggregate costs of property placed in service during the last three months of the taxable year exceed 40% of the aggregate costs of property placed in service during the taxable year, the applicable depreciation convention for all property is the mid-quarter convention. This simply means a smaller deduction for depreciation.
Example
A taxpayer purchases $20,000 of seven-year property in August and places it in service. In October, the taxpayer makes an additional $20,000 purchase of seven-year property. Because more than 40% of the total costs of all property placed in service during the year occurred in the last quarter, the taxpayer must use the mid-quarter convention to compute all depreciation deductions for the taxable year. Assuming the taxpayer used the straight-line method of depreciation, he would be entitled a depreciation deduction of $1,428.57 under the mid-quarter depreciation method. Depreciation would have been $2,857.14 (assuming straight-line depreciation) if the taxpayer had planned the timing of asset purchases to avoid the mid-quarter convention. Thus, to avoid the application of the mid-quarter convention, taxpayers generally time the acquisition of property so that they may apply the half-year convention.
Alternatively, a taxpayer may want to consider postponing the purchase until the beginning of the next year. This may result in an increased tax bill this year. However, with careful planning, a taxpayer might be able to time the purchase in order to maximize the tax benefits. An example of such circumstances would be when a taxpayer does not need the equipment immediately and does not have enough income in the current year to fully utilize the depreciation deduction.
Another option to consider to avoid the mid-quarter method may be to expense some property under Section 179, if the property qualifies. In fact, all qualified property may be expensed under Section 179 as long as the cost of the property does not exceed the limit set by the Internal Revenue Service.
Section 179 Deduction
In 2013, the limit is set at $500,000. So you can expense up to $500,000 in 2013. This amount phases out when more than $2,000,000 worth of assets are put into service.
Example
A taxpayer purchases $250,000 of seven-year property in May and subsequently purchases $600,000 of three-year property in November. Without making a Section 179 election, the taxpayer would be subject to the mid-quarter convention (40% x $850,000 = $340,000 and $600,000 is more than $340,000). However, in making the Section 179 election, the taxpayer may choose the property to apply the election. In this instance, to avoid application of the mid-quarter convention, the taxpayer should apply the 179 election to the later acquired property. Doing so reduces the cost of property acquired in the last quarter below 40% of the total costs of all property placed in service during the year (Property 2 – $600,000 – $500,000 = $100,000; 40% x $700,000 = $280,000).
Planning Tip
In the above example, the taxpayer purchases seven-year property early in the year and three-year property later in the year. Unless there is a business need to make the purchases in this order, the taxpayer should consider making the purchases in reverse order, especially if there is a chance that the mid-quarter convention might apply. By reversing the order of the purchases, the taxpayer will get the full benefit of the recovery period of the seven-year property, the full Section 179 expensing election on the three-year property and avoid application of the mid-quarter convention.
Special Depreciation for 2013
In addition to the above tax benefits, there is a special 50% depreciation deduction for property acquired and placed in service from January 1, 2013 to December 31, 2013. The bonus deduction is to be taken on the adjusted basis of the cost of the property after any Section 179 expensing. To take advantage of this bonus depreciation, the following requirements must be satisfied:
- The property must be acquired during 2013. If a binding contract to acquire the property existed prior to January 1, 2013, this property is exempt from the special depreciation.
- The property must be placed in service during 2013.
- The property must be new.
- Types of property that qualify are section 168 property (with a recovery period of 20 years or less), off-the-shelf computer software, water utility property and qualified leasehold improvement property.
No 2013 update has been released as of this publication. The total depreciation amount for a business passenger vehicle is $11,060 per the Small Business Jobs Act of 2010 (SBJA), and the maximum depreciation limit for business trucks and vans is $11,160. This is in effect until the end of 2012.
Example
In July 2013, a taxpayer buys and places in service five-year property costing $5,000 that qualifies for the bonus depreciation and chooses not to expense any of the property under Section 179. The taxpayer may take $2,500 as the bonus depreciation (50% x $5,000= $2,500). Assuming the taxpayer is using the straight-line method and half-year convention of depreciation, he is entitled to a depreciation deduction of an additional $250 in 2013 ($2,500/5= $500/2= $250). The total depreciation deduction for 2013 would be $2,750 ($2,500 + $250).
Example
In June, a taxpayer bought and placed in service five-year property costing $750,000. This property qualifies for both Section 179 expense and the bonus depreciation deduction. The taxpayer chooses to expense the maximum $500,000 under Section 179. Therefore, the remaining $250,000 would be the adjusted basis. She would take $125,000, as the bonus depreciation deduction, as well as $12,500 using the straight-line depreciation method (125,000/5 = 25,000/2 = $12,500). In the end, the total deduction for 2013 from Section 179, bonus depreciation, and depreciation, would be $637,500 ($500,000 + $125,000 + 12,500).
Special depreciation is set to expire after 2014.
Final Tip
To take advantage of the special depreciation deduction for 2013, a taxpayer planning to purchase new assets at the beginning of 2014 may consider purchasing the assets before year end if possible. This may be beneficial depending on the cost of the property and other acquisitions during the year.
For additional tax consulting regarding asset acquisition, contact Henssler Financial at 770-429-9166 or experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
