It usually takes more than just your brains and hard work to make a business run. You need equipment, from technology-based items (e.g., computers and cell phones), to furniture (e.g., desks, file cabinets, and chairs), to industry-specific items (e.g., carpentry tools and heavy machinery). For tax purposes, all of these items are viewed as “equipment” for which special tax treatment may be claimed. Today, the tax law encourages investments in equipment as a means of spurring the economy by allowing an immediate deduction for purchase costs if certain conditions are met.
In this post I discuss 2009-2010 tax deduction specifically; Equipment purchase for your small business. As usually, it comes with case example.
Specific issues covered in this post are:
- How Much Of Your Cost You Can Deduct?
- What Equipment Is Deductible
- Conditions for First-Year Expensing
- Conditions for Depreciation
- Conventions [Special Depreciation Rules]
- Tax Planning Tips for Equipment Purchase
- Equipment Purchase Tax Pitfalls
- Where to Claim the Equipment Purchase Deduction
How Much Of Your Cost You Can Deduct?
You can deduct as an ordinary business expense amounts you pay for equipment used in your business. However, tax law dictates when and how much of your cost you can deduct. Three sets of rules come into play:
- First-year expensing – Up to $250,000 can be deducted in the year the equipment is placed in service. Higher dollar limits apply for equipment placed in service in certain distressed areas; a lower dollar limit applies for vehicles weighing more than 6,000 pounds.
- Bonus depreciation – Fifty percent of the cost of equipment may be deducted if purchased and placed in service in 2009. There is no dollar limit on bonus depreciation, but it applies only to new property. Qualifying property includes equipment and certain leasehold improvements.
- Depreciation. A percentage of the equipment’s basis is deducted over a set term (a recovery period fixed for various types of assets). There is no dollar limit on depreciation.
What Equipment Is Deductible
Equipment purchases are not limited to machinery; the term “equipment” includes just about any type of property other than real estate.
Examples of equipment:
- Answering machine
- Cell phones
- Desk accessories
- Desk chairs
- Farming equipment (see later in this chapter)
- Fax machines
- File cabinets
- Floor models and displays
- Musical instruments for musicians
- Software purchased off-the-shelf
- Tools of your trade
- Vacuum cleaner
Different conditions apply to the different ways in which you can write off equipment purchases. You can combine these write-offs to maximize your deduction.
In June 2009, you purchase a reconditioned machine costing $300,000 (assume the machine is classified under the tax law as five-year property and this is your only purchase for the year). You can deduct a total of $260,000 ($250,000 + $10,000):
- First-year expensing of $250,000.
- Regular depreciation of $10,000 ([$300,000 ? $250,000] × 20 percent).
- Bonus depreciation does not apply because the property is not new.
The rules on depreciation are quite complex, and a complete discussion is well beyond the scope of this post. Here you will gain an overview of the rules that apply.
More Resource: To learn more, see IRS Publication 946, How to Depreciate Property.
Conditions for First-Year Expensing
There are three basic conditions for claiming first-year expensing:
- You must elect it – You must elect to claim first-year expensing (also referred to as a Section 179 deduction because of the section in the Internal Revenue Code governing the deduction).
- Your total equipment purchases for the year cannot exceed a set dollar amount – To qualify for the election, your total equipment purchases for the year cannot exceed a set dollar amount. For 2009, you can claim the $250,000 expensing deduction only if your total purchases are no more than $800,000. The dollar limit phases out on a dollar-for-dollar basis so that no expensing deduction can be claimed if total purchases exceed $1,050,000. Note: Higher dollar limits apply in certain designated areas.
- Your taxable income must at least equal your expense deduction – Your first-year expensing deduction cannot be more than the taxable income from the active conduct of a business. Taxable income for this purpose means your net income (or loss) from all businesses you actively conduct. If you are married and file a joint return, your spouse’s net income (or loss) is added to yours. Taxable income also includes Section 1231 gains and losses (from the sale of certain business property) and salary or wages from being an employee. Taxable income must be reduced by the deduction for one-half of self-employment tax and net operating loss carrybacks and carryforwards.
You own a sole proprietorship that shows a $5,000 profit for the year, and your deduction for one-half of self-employment tax is $383. Your spouse works as an employee with a salary of $50,000. Your taxable income for purposes of figuring your first-year expensing deduction is:
$5,000 – $383 + $50,000 = $54,617
Conditions for Depreciation
Depreciation is a method for recovering your investment in property over a period of time fixed by law, called a recovery period. You apply a set percentage (based on the property’s recovery period) to the property’s basis (generally its cost) to arrive at your annual deduction. These percentages may be found in IRS Publication 946.
In 2009, you place in service a copier machine (five-year property) for which you do not claim any first-year expensing or bonus depreciation. Assume the cost of the machine is $8,000. Your depreciation percentage for the year that five-year property is placed in service is 20 percent, so your depreciation deduction is:
$8,000 × 20 percent = $1,600
Different types of property are classified by their recovery periods:
- Three-year property, such as: taxis, tractors, racehorses over two years old when placed in service, and breeding hogs
- Five-year property, such as: cars, trucks, copiers, assets used in construction, and breeding and dairy cattle
- Seven-year property, such as: office fixtures and furniture, fax machines, assets used in printing, assets used in recreation (e.g., billiard tables), and breeding horses and workhorses.
Note: There are also 10-year, 15-year, and 20-year types of property as well as realty (27.5 years for residential realty and 39 years for nonresidential realty such as office buildings, strip malls, and factories).
Conventions [Special Depreciation Rules]
Special depreciation rules, called conventions, come into play to determine your write-offs for the year:
- For property other than realty – A midyear convention makes a hypothetical assumption that the property has been placed in service in the middle of the year. As a result of the midyear convention, five-year property is depreciated over six years.
- For property other than realty – A mid-quarter convention applies. If you place in service more than 40 percent of all your equipment purchases for the year in the final quarter of the year, a special rule dictates the amount of depreciation you can claim for each item placed in service during the year. This special rule is called a “mid-quarter convention” and generally operates to limit write-offs (although in some cases it may enable you to take greater deductions than under regular depreciation rules).
- For realty – A midmonth convention assumes that the property has been placed in service in the middle of the month it is actually placed in service. The midmonth convention is built into the depreciation rate tables applied to realty.
Equipment Purchase Tax Planning Tips
The amount of your write-offs does not depend on whether you pay cash for the equipment or finance your purchase. If, for example, you finance your purchase, you may wind up deducting more in the first year than you pay out of pocket.
In December 2009, you buy a machine for $25,000, financing it over five years at 8 percent interest. In 2009, you can claim a first-year expensing deduction of $25,000, even though you have not yet paid a penny.
Decide whether to make the first-year expensing election and/or forgo bonus depreciation. Generally, if your current income is modest but you expect it to increase in coming years, it may be preferable to forgo the deduction now in favor of using it against future income that would otherwise be taxed at higher rates.
Equipment Purchase Tax Pitfalls
Special rules apply to so-called “listed property”, which includes cars, computers and peripherals not used at a regular business establishment, and cell phones. You cannot use first-year expensing or accelerated depreciation unless business use of a listed property item is more than 50 percent of total use.
You buy a cell phone that is used 75 percent for business and 25 percent for personal purposes. Since business use exceeds 50 percent, you can use first-year expensing or accelerated depreciation for the portion of the phone (75 percent of its purchase price) used for business.
If you sell or cease using property for which first-year expensing has been claimed, you may be subject to recapture. This means you’re required to report a portion of the previous write-off as income in the year of the disposition of the property. Discuss this rather complicated matter with a tax adviser.
Where to Claim the Deduction
You figure your deduction for equipment purchases on Form 4562, “Depreciation and Amortization“. You enter the amount of your deduction on the line provided for this write-off on Schedule C (or Schedule F).
If you are claiming depreciation this year on an item placed in service in a prior year and you do not have any new items to report, you do not have to file Form 4562. Simply attach your own schedule to the return showing the amount of depreciation you are claiming this year. Note: You cannot claim a deduction for equipment purchases if you file Form 1040A or 1040EZ.
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