If property you acquire to use in your business has a useful life that extends substantially beyond the year it is placed in service, you generally cannot deduct the entire cost as a business I the year you acquire it. You must spread the cost over more than one tax year and deduct part of it each year. This method of deducting the cost of business property is called depreciation. Business property you must depreciate includes the following items.
- Office furniture
- Buildings
- Machinery and equipment
As with most things in the U.S. tax code, there is an exception to every rule. Rather than depreciating property over several years, Section 179 of the tax code allows a business to expense in the year of purchase qualifying property used more than 50% in the active conduct of a trade or business and acquired from an unrelated party. The Section 179 election is made on an item-by-item basis for qualifying property by completing Part 1 of Form 4562. The total amount of purchases that you can use the Section 179 deduction for changes from year to year.
So, why is this important to you? Used properly, depreciation and Section 179 can help you decrease your tax liability. The federal government has created a chart that lists the average lifespan of all major categories of assets. Let's take the case of computer equipment which has an asset life of five years. You have the choice when doing your tax return to write off the entire cost of the computer in the year you bought it or deduct part of it over five years. First, the tax return is prepared normally using the standard depreciation to arrive at a net profit. If you had a great year and need additional deductions this year to bring down your tax liability, use the Section 179 to accelerate the expense. However, if you had a lousy year and expect next year to be a lot better, then it is probably best to push the deductions into future years when you will need them more.
Let me also point out that because of depreciation and amortization, your taxable profit will be different from your fiscal net profit. In the accounting/tax world, this is known as book income vs tax income. Also be aware that when using the Section 179 deduction, you may have to recapture part of the deduction if you sell the asset before the end of lifespan listed in the asset table. A good tax advisor on your team can help you make these decisions. I mention them here so that you can make better informed decisions as to when to acquire new assets for your business.
Another recent change to the depreciation rules is know as the Safe Harbor rule. Although the depreciation rules state that you must add to the depreciation tables anything that has a life-span of more than one year - the IRS realized that this can really make the number of depreciable items huge. So they created this Safe Harbor rule that states if the item is less than $2,500, you are allowed to direct expense it. Not only does this cut down on the amount of paperwork you have to do, it also means that you don't have to worry about recapturing depreciation should you decide to sell it in the near future.
Be sure to add a de Minimus statement to the return stating that you are using this Safe Harbor rule. Your tax advisor can help you file it properly.