A faster deduction for certain capital assets

By Jonathan W. Kaplow, CPA, Houston, Texas.

One of the golden rules of tax accounting for businesses is to defer the payment of taxes for as far into the future as possible. One way to do this is to take every tax deduction as early as possible. If you buy depreciable property such as a piece of machinery, office furniture or a computer system, you’ve paid out funds for that investment in its first year of use either by using existing cash or by incurring debt that must be repaid with interest. In general, the IRS requires companies to depreciate a capital asset over its depreciable life, typically five to seven years for many commonly used business assets, receiving a part of their investment back each year.

Section 179 changes

Many small businesses, however, can take advantage of what is known as the section 179 deduction. Section 179 of the Internal Revenue Code allows businesses to elect to deduct the cost of a limited amount of eligible property purchased for use in a trade or business in the year the property is placed in service instead of writing off the property’s cost over its depreciable life. A 2003 tax law increased the amount of the deduction from $25,000 to $100,000 for 2003 through 2005, with this amount indexed for inflation for years after 2003. In 2004, the expanded deduction of $100,000 (indexed for inflation) was extended through 2007. The section 179 deduction decreases to $25,000 in 2008, unless Congress revises current regulations.

The inflation adjusted limits are $105,000 for property placed in service in 2005, and $108,000 for property placed in service in 2006. By electing to charge the property’s cost to expense, a business can receive a larger deduction on its taxes in the first year of the property’s use. Considering the time value of money, businesses usually are much better off with this expense deduction: They pay lower taxes, retaining more funds for additional business use.

The limitations of Section 179

The deduction is subject to certain limitations. For example, businesses can claim a full deduction for eligible property only if the total cost of all qualified section 179 property placed in service during the year does not exceed an investment limitation. The inflation adjusted investment limit is $420,000 for 2005 and $430,000 for 2006. The allowable section 179 deduction is reduced by $1 for every dollar that the total cost of all qualified section 179 property placed in service during the year exceeds the investment limit for the year. This provision ensures that the primary benefit of the deduction goes to small businesses, rather than to large corporations that may invest millions of dollars in eligible property each year. Note that the investment limit drops to $200,000 in 2008 when the maximum section 179 deduction drops back to $25,000. The 2008 amounts are not adjusted for inflation.

Another restriction prohibits companies from using section 179 deductions to make their income go negative. Excess deductions (those that reduce income below the zero point) can be carried forward for an unlimited number of years to a year when the company has positive income and then applied at that time. For flow-through entities such as partnerships or S Corporations, the section 179 expense deduction flows through to the partner or shareholder. Note that the business income limitation applies at the business level and again at the partner or shareholder level.

Special provisions

A special provision has been made for businesses situated in certain distressed communities that have such designations as empowerment zones (40 in all across the United States), renewal communities, the New York City Liberty Zone, and all of the District of Columbia. Businesses located in these areas are allowed to claim up to an additional $35,000 (a total of $140,000 for 2005) for qualifying assets under the section 179 deduction. For purposes of the investment limit explained above, businesses can take into account only 50 percent (instead of 100 percent) of the cost of qualified zone property placed in service during the year when figuring the reduced dollar limit for costs that exceed the investment limit for the year. Businesses in the Gulf Opportunity Zone impacted by Hurricane Katrina are eligible for up to $100,000 in additional deductions for qualifying assets acquired after Aug. 27, 2005, beyond the $105,000 limit for 2005. The investment limit for the year (explained above) for qualified section 179 Gulf Opportunity Zone property is increased by the smaller of $600,000 or the cost of qualified section 179 Gulf Opportunity Zone property placed in service during the year.

Qualifying for Section 179

To qualify as section 179 property, the property must be new or used tangible personal property acquired by purchase for use in a trade or business. Tangible personal property is any tangible property that is not real property. It includes machinery and equipment; property contained in or attached to a building (other than structural components), such as refrigerators, grocery store counters, office equipment, printing presses and signs; gasoline storage tanks and pumps at retail service stations; and livestock. Note that certain other tangible property (except buildings and their structural components) qualifies as does single-purpose agricultural (livestock) or horticultural structures; storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum; and off-the-shelf computer software.

Specifically excluded are land and land improvements such as buildings and other permanent structures and components that are real property (not personal property); certain property leased to others by noncorporate lessors; certain property used predominantly to furnish lodging; air conditioning and heating units; property used predominantly outside the United States (with some specific exceptions); property used by certain tax-exempt organizations (except property used in connection with the production of income subject to tax on unrelated trade or business income); and property used by governmental units or foreign persons or entities (except property used under a lease with a term of less than six months).

Property that is acquired for the production of income, such as investment property, rental property (if renting property is not the taxpayer’s trade or business) and property that produces royalties, does not qualify. If the property is used for both business and nonbusiness purposes, it qualifies only if it is used more than 50 percent for business in the year it is placed in service. The cost of the property is multiplied by the percentage of business use to determine the amount of the section 179 deduction that will be allowed.

The section 179 deduction can be claimed for passenger automobiles including trucks, SUVs and vans, but it is very limited in accordance with the special depreciation limits often referred to as the “luxury car limits.” Effective for vehicles placed in service after Oct. 22, 2004, the section 179 expense deduction is $25,000 for any heavy SUV and certain other vehicles that are four-wheeled vehicles primarily designed or used to carry passengers over streets, roads or highways, and are rated at over 6,000 (but not more than 14,000) pounds of gross vehicle weight.

The section 179 expense deduction is treated as depreciation for recapture purposes. Therefore, gain on the disposition of section 179 property is generally treated as ordinary income to the extent of any section 179 expense and regular depreciation claimed on the property. In addition, the business may have to recapture a portion of the section 179 deduction taken if the business use of the property falls to less than 50 percent during any year of the property’s regular depreciation period.

Strategic use of Section 179

Businesses should look at their potential section 179 deductions strategically. For example, small companies may want to complete key equipment purchases before 2008, when the cap on deductions declines. Also, amounts that are not claimed as section 179 expense can be depreciated in accordance with the regular tax depreciation rules. Therefore, it may make sense to elect regular depreciation if the business (or its partners or shareholders in the case of a partnership or S Corporation) will be in a higher tax bracket in the future. If the business plans to sell the asset at a gain in the future, it may not make sense to claim the section 179 expense. The company may be in a higher tax bracket in the year it sells the property (and recognizes ordinary income on the recapture) than the year it purchased the property.

Employing the section 179 deduction is a choice the business must make; it is not automatic. The deduction can be implemented by completing and attaching part 1 of IRS Form 4562 to the taxpayer’s original tax return for the year (including a late-filed original tax return) or to an amended tax return filed by the due date of the original tax return (including extensions).

The section 179 deduction can provide a substantial measure of financial relief for small businesses struggling to keep up with America’s rapidly changing economic environment. With the funds that become available more readily through this deduction, businesses can extend their budgets and other resources to become more competitive in their marketplace.

The following information is provided to you by third parties for informational purposes only and shall not constitute tax or legal advice. Microsoft Corp. has not checked or verified any of the information provided and makes no representations or warranties as to its accuracy. Each individual’s tax situation is unique, and you should check with your accountant or other tax professional for particular advice on your situation.

About the author

Jonathan Kaplow has a bachelor of science from Cornell University (1979) and an MBA from the University of Michigan (1984). He is a CPA certified to practice in Texas and is a member of the American Institute of Certified Public Accountants.

Before establishing his own CPA firm in 1993, Kaplow held various management positions with American Airlines in Dallas, Texas, and served as controller for a publicly held company located in Houston, Texas.

Kaplow’s firm specializes in providing accounting, tax and payroll services to small businesses in the Houston, Texas, area. These services include assisting clients with the preparation of accurate financial statements to enable them to improve their operating performance, as well as preparing a large number of business and individual income tax returns. His firm strives to provide an overall level of service consistent with his objective of serving as his clients’ most-trusted business advisor.

Jonathan W. Kaplow, P.C.
Certified Public Accountant
6430 Richmond Ave., Suite 470
Houston, TX 77057-5938
(713) 789-4718 phone
(713) 266-7392 fax
E-mail: kaplow@kaplowcpa.com
Web site: http://www.kaplowcpa.com

Note: This information is provided to you by third parties for informational purposes only and shall not constitute tax or legal advice. Microsoft has not checked or verified any of the information provided and makes no representations or warranties as to its accuracy. Each individual’s tax situation is unique and you should check with your accountant or other tax professional for particular advice on your situation.