-By Donovan Thiessen, CPA
When a business orders furniture, equipment, supplies, or inventory, consideration to accounting policies should be part of the equation for management. Expenses for interior improvements, new vehicles, software, repairs and maintenance items, and in general items that have useful lives in excess of one year, can be treated as ordinary expenses and deductible. These expenses can be deducted in the year a payment was made; but the same is not true of capital expenditures. Capital expenses must be expensed over a period of time, anywhere from 3 to 39 years depending on the asset type and its relative useful life. This concept is referred to as depreciation; the cost recovery is over time rather than in the year it was actually acquired and placed in service. This article is a primer on depreciation and related analysis of the tax reform signed into law last year. Depreciation may be treated differently for accounting than it is for tax purposes. We will focus on tax depreciation but also touch on expensing items on your books.
A computer purchased today could be fully expensed as a ‘repair and maintenance’ item. It could be ‘capitalized’ and depreciated evenly over a period of five years. (Five years is the useful life and recovery period for depreciation purposes for a computer. The useful life varies for software, furniture, leasehold improvements, and residential and nonresidential properties etc.). It could be ‘capitalized’ and subject to accelerated depreciation, whereby you take a greater expense percentage in the earlier periods and less in the end. It could be ‘capitalized’ and still fully expensed in the year that you place it in service. This may seem overwhelming for the layman business owner; but you just need to understand that there are options, and you should communicate your ideas to your tax adviser before you make a purchase.
Until three years ago, the decision to capitalize and depreciate an item was less liberal than it is today due to tangible property regulations. Today, companies typically set written accounting standards allowing them to expense from $2,500 to $5,000 per unit. Items up to $2,500 are generally considered a de minimus expense, but larger companies can set the threshold up to $5,000. Items exceeding $5,000 per unit generally require you to depreciate the asset over its useful life.
Depreciation expense for tax purposes has several options that allow the business to accelerate the deduction so that you can take most or all of the expense in the first year that the assets are placed in service. The layers for tax are Section 179 depreciation deduction, bonus depreciation and regular depreciation (accountants may refer to this as MACRS, modified accelerated recovery system).
Internal Revenue Code Section 179 allows a business to expense up to $1,000,000 in assets each year with an election on the entity’s income tax return. This was increased in the recently passed tax reform from $500,000 to $1,000,000 for assets placed in service after December 31, 2017. During a tax year if more than $2,500,000 in assets are capitalized and placed in service, the Section 179 deduction begins to phase out. This deduction is an annual election and the basis of the asset is reduced first by the amount of this deduction. Assets purchased new or used such as computers, furniture, vehicles, software and qualified leasehold improvements generally qualify for Section 179 expensing. This deduction cannot be taken by a Trust and it is limited to taxable income for the taxpayer. In other words, if the current year Section 179 deduction is $20,000, but taxable income before the deduction is $10,000, then the Section 179 deduction is limited to $10,000 and the remaining unused deduction is suspended and available for use in future tax years. If this situation were to actually arise, I might recommend electing $10,000 as Section 179 and allow the remaining $10,000 to be deducted as Bonus Depreciation.
Bonus depreciation (BD) is generally taken by taxpayers after Section 179 is depleted unless there is no taxable income to take Section 179. BD is a mandatory deduction unless you elect not to take it. For assets placed in service after December 31, 2018, new and used equipment that qualifies for BD treatment can be 100% deducted. There are exceptions and limitations depending on the asset purchased, such as vehicles. Similar to Section 179, BD reduces the cost basis of the qualifying assets. Note that the recent “Trump” tax reform increased BD from 50% to 100%, a move that is welcomed by business owners looking to expand and grow.
After taking Section 179 then Bonus depreciation, accelerated depreciation is taken until the assets are fully depreciated. It is possible that for 2018, a taxpayer purchased $20,000 in new furniture and takes all three types of depreciation expense in the same year. Business owners should seek a CPA that is able to accurately maximize and track the deduction and adjusted basis of these assets over time.
One of the most popular purchases over the last few years and one that will undoubtedly be good news for taxpayers are the tax deductions available for purchasers of heavy SUV’s weighing over 6,000 pounds. For vehicles that qualify for this treatment, a taxpayer can first deduct $25,000 as Section 179 expense. Then they can deduct 100% of the remaining basis as Bonus depreciation, all in the first year the vehicle is placed in service. In prior years the first $25,000 was available but BD was limited to 50% of the remaining basis and then approximately 20% of the remaining basis could be deducted in the first year, with the remaining basis deducted ratably over the remaining 5 years. Business owners were already happy with that treatment, but this new change should have them rethinking the type of vehicle purchased. Limitations for passenger automobiles with a Gross Vehicle Weight Rating (GVWR can be found on the driver door panel labels of most cars) weighing less than 6,000 are far more restrictive than buying an SUV with GVWR exceeding that threshold. Vehicles can be new or used but must be new to the taxpayer and first placed in service after 12/31/17.
Depreciation and asset acquisition strategy is a popular item to review before a tax year ends. There are additional details on this subject that cannot be covered in this necessarily brief article; a tax professional may spend years learning the fundamentals and nuances of depreciation. Incidental advice in this article should be considered and discussed with a tax professional and should not be relied upon for tax planning or for defending tax positions.
Donovan Thiessen, CPA is The Accountant. He partners with growth driving entrepreneurs who seek value from, and take action based on their accounting data. You may reach Donovan at firstname.lastname@example.org or 702-324-7421.