It is common for customers to consider purchasing equipment at the end of the year to claim a tax deduction. Since this is one of the more arbitrary aspects of both accounting and taxes, a little thought is in order. Bottom line: we need to think about the timing of depreciation so that the tax deduction helps the most.
To begin the discussion of depreciation, we will focus only on equipment and ignore the additional issues with vehicles, real estate, and financial accounting differences that may arise.
Equipment can be depreciated when it is owned by both of us and put into service. Ownership seems straightforward until one realizes that an equipment lease can be treated as a purchase if the redemption amount at the end of the lease is small. This type of “lease” needs to be evaluated by your tax advisor and may need to be treated as a purchase and loan rather than lease payments.
Depreciation cannot be taken until the equipment has been placed in service, that is, when it is ready to use – not when it has been paid for. A good example of this is the purchase of a pivot in the fall. A simple test to be considered placed in service is whether the power is connected and the pivot is moving. If the pivot is set up but the power is not connected, it is not ready to use and cannot be depreciated in the current year.
Having overcome the hurdles of ownership and service, we now have a tax management tool. Since depreciation is an estimate of value lost over time, there are several ways to make that estimate. The IRS got tired of arguing with taxpayers about the right method long ago, so standardized methods were put in place. Politically, Congress views depreciation provisions as a practical means of adjusting economic policy, which leads to some changes over time.
The base system is the modified accelerated cost recovery system (MACRS), which spreads the cost of equipment over several years and allows for half-yearly depreciation in the year of service. The MACRS system is front-loaded, with most of the deduction occurring in the first few years of operation.
Although it is advanced, MACRS spreads the depreciation deduction over a period of time, but if we want an immediate deduction for the current tax year, we need other options. Leave it to Congress to give us two options for accelerating the deduction:
- Bonus expiration: This allows 60% of the equipment cost to be deducted in the first year for purchases made in 2024. Bonus depreciation is currently phasing out and will decrease by 20% each year through 2027. Unless we opt out, bonus depreciation is the default for federal taxes, but it has some problems. All assets of the same type must use bonus depreciation if it is elected, which limits our ability to decide how to manage depreciation on a per-asset basis. Many states do not follow the IRS, so bonus depreciation may not be beneficial to us at the state level.
- Article 179: The second way to accelerate depreciation is to use the Section 179 deduction. If we choose not to take bonus depreciation, we can instead choose Section 179 as a deduction for each individual asset up to the full cost of the asset. This allows us to legitimately fine-tune the outcome of the return. Section 179 deductions have their own problems such as a limit on the total amount we can use each year, no tax loss can be incurred, and there are also states that do not follow the IRS code.
Mix and match options
Finally, we have the option to combine bonus depreciation, Section 179 deductions, and regular MACRS depreciation on one tax return to get closer to our goal. It can be a mystery, but let’s talk about how to use these options.
First, a band-aid of tax deductions won’t fix a bad management decision. Let’s make sure we buy the right equipment at the right price that makes business and financial sense even without the tax deductions. If you only think about the tax deduction in the current year, it can lead to cash flow problems in subsequent years. Also, you can’t deduct your tax liability 1:1. Spending $4 to save $1 isn’t always the best choice.
We start by setting up normal MACRS depreciation without additional accelerators. Then we consider this year’s income level and the expected income, equipment purchases, and tax targets for the coming years.
In a high income year, it is obviously better to use both bonus depreciation and Section 179 to reduce our net income. However, if we have a bad year due to low snow cover and dry reservoirs, a deduction in the current year may be a good choice. With lower income next year, depreciation may not help us as much, and we may save some working capital.
If we don’t have any special equipment plans in the future, taking advantage of all of our depreciation up front with bonus depreciation or Section 179 will allow us to get by without a large depreciation expense for several years. We may have to pay taxes in a higher tax bracket, but are short on cash because of equipment loan payments that are still ongoing.
One thing to keep in mind is that depreciation rules often just defer income into the future. For example, if we opt for the full Section 179 deduction for a $400,000 tractor in 2024, we save on our tax bill in 2024. However, in the next few years, we have no depreciation deduction, resulting in higher taxable income. However, if we sell the equipment for $300,000 in 2027, the entire amount is taxable because there is no longer a deductible tax basis for this fully depreciated asset. In fact, that deduction decision in the first year resulted in higher taxable income in subsequent years. This is where thinking about the timing of depreciation can be important.
With MACRS depreciation, bonus depreciation and Section 179, we have tools to manage the timing of equipment depreciation to get the most benefit. We just need to think beyond the current year to get the best result.
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This article is for information purposes only. Readers should consult their own professional advisors for specific advice tailored to their needs. The information contained in this article is subject to change without notice.
