February 24, 2017
The federal income tax system of “depreciation” is incredibly confusing. Generally speaking, the depreciation system is intended to require businesses to deduct the cost of long-term assets over the life of those assets. However, there are countless acronyms, constantly changing tax rules, including retroactive changes to tax laws, and complex procedures for making changes to depreciation on existing assets that conspire to make this a challenging tax area.
Instead of describing each and every nuance and detail of our current depreciation system, I would like to highlight a few key points:
1) Consider Section 179 expensing first
For many businesses, the majority of fixed asset purchases can be fully written off in the year they are purchased under the “Section 179” rules. However, this deduction is limited based on your business income (you generally can’t create a loss using this deduction), and there are certain types of property that don’t qualify (for example - most real property, property outside the U.S., and property acquired by gift, inheritance, or from a related party).
2) Evaluate bonus depreciation
Congress passed legislation in December 2015 that extended “bonus” depreciation through 2019. This depreciation works as you might expect – it allows you to take a certain percentage (50% for 2017, 40% for 2018 and 2019) of depreciation as a “bonus” up-front when you acquire the asset. The remaining cost of the asset is depreciated over the normal period. This accelerated depreciation can be very valuable, particularly with certain assets that may have been deductible over longer periods – such as 15 year land improvements. Generally, bonus depreciation is applied automatically to qualifying assets – you need to elect out of the depreciation by asset class if you don’t wish to utilize it. Also keep in mind that there are many assets that don’t qualify for this deduction. For example, used assets, many real estate assets, and foreign assets are not eligible. Make sure you also consider the state income tax consequences of taking bonus depreciation – many states add it back as an adjustment to taxable state income.
3) Make sure you properly “segregate” major project costs
For many large real estate construction or rehab projects in particular, a cost segregation project by a qualified engineer may be valuable. Certain portions of a larger project may be subject to preferential depreciation. For example, don’t automatically depreciate an entire commercial building over 39 years, as there are likely some significant components that can receive far more advantageous treatment.
4) Know what category of business activities the asset is used in
There are specific and extensive rules that can provide for different depreciable lives, dependent upon the type of business activity that you conduct. For example, machinery and equipment is typically depreciated with a7 year life – but if you are a wholesaler, retailer, or a personal or professional service provider, you fall into Class 57.0 (Rev. Proc. 87-56), and these assets are generally subject to only a 5 year depreciable life.
5) Understand what the asset depreciable life is
Once you know what industry class rules may apply, you can determine the depreciable life of the type of asset that you purchased. For instance, computers are generally depreciated over a 5 year life, while office furniture & fixtures are usually depreciated over 7 years.
6) Apply the right depreciation method
The vast majority of assets are depreciated under the Modified Accelerated Cost Recovery System (MACRS). Under this system, different depreciation methods are used depending on the life and type of property. For example, most vehicles are depreciated of 5 years using the MACRS “double-declining balance” method. Essentially, this means that you’ll deduct double the depreciation up front, and this percentage drops as time elapses. However, most real estate is depreciated using a “straight-line” method, meaning an equal tax deduction is taken for each year during the life of the asset.
7) Don’t assume the goal is to maximize up-front depreciation
Usually, the “time value of money” principle would tell you that a dollar today is more valuable than a dollar in the future. This is often true in the tax world, but not always. For example, if your business income is lower than normal in 2017, it may be in your best interest to selectively consider deferring deductions to maximize your lower tax brackets. In this case as an example, perhaps you elect out bonus depreciation for assets with a three-year life, since you’ll be recovering these deductions over the next few years.
8) Don't be afraid to fix previous mistakes
Did you incorrectly depreciate assets in prior years? Carefully consider an "accounting method change" on Form 3115 to fix these errors. Many depreciation changes are considered automatic, and don't require special IRS consent - and they can be filed with your tax return. As an extra benefit, any addbacks to your income from an accounting method change are generally taken over 4 years, while any deductions can be taken immediately.
Far too many taxpayers and tax professionals do not pay enough attention to complex and rapidly changing tax depreciation rules. Don’t make this mistake – make sure to spend sufficient time to carefully evaluate your asset purchases, and understand how to maximize the benefits of your depreciation deductions.
The world of tax depreciation is deceptively complicated, make sure to consult with your tax advisor on the specifics of your situation. This article is intended to serve as general guidance, and should not be construed as specific tax advice for your situation.
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