It’s pretty common for clients to consider buying equipment at year's end in order to write it off for tax purposes. Since this is one of the more arbitrary parts of both accounting and taxes, a little thought is in order. Bottom line: We need to think about depreciation timing for when the tax deduction will help the most.
For the sake of beginning the discussion on depreciation, we’ll only be covering equipment and ignore the additional issues with vehicles, real estate and financial accounting differences that might arise.
Equipment becomes eligible for depreciation when we both own it and it’s placed in service. Ownership seems straightforward until you realize that an equipment “lease” might be treated as a purchase if the end-of-contract buyout is small. That kind of “lease” will have to be evaluated by your tax professional and might need to be treated as a purchase and loan rather than lease payments.
Depreciation cannot be taken until the equipment is placed in service, which means it is available for use – not just paid for. A fall purchase of a pivot is a good example. A simple test for qualifying as being placed in service is if the power is connected and the pivot moves. If the pivot is erected but the power is not connected, it’s not ready to use and no depreciation can be taken in the current year.
Once we’ve cleared the hurdles of ownership and service, we now have a tax management tool. Since depreciation is an estimate of value lost over time, there are different ways to make that estimate. The IRS long ago got tired of arguing with taxpayers over the proper method, so standardized methods have been adopted. Politically, Congress sees depreciation provisions as a handy tweak for economic policy, resulting in some modifications over time.
The base system is the modified accelerated cost recovery system (MACRS), which spreads the cost of the equipment over multiple years and allows a half-year depreciation in the year it is placed in service. The MACRS system is front-loaded, with most of the deduction coming in the early years of service.
Even though it’s front-loaded, MACRS spreads the depreciation deduction over time, but if we want an immediate deduction for the current tax year, we need other choices. Leave it to Congress to give us two options to accelerate the deduction:
- Bonus deprecation: This allows 60% of the equipment’s cost to be deducted in the first year for purchases made in 2024. Bonus depreciation is currently sunsetting and decreases by 20% each year until 2027. Unless we elect out, bonus depreciation is the default for federal taxes, but it has some issues. All assets of the same type must use bonus depreciation if it’s elected, which limits our ability to choose how to manage depreciation by asset. Many states don’t conform to the IRS, so bonus depreciation may not benefit us at the state level.
- Section 179: The second means of accelerated depreciation is using the Section 179 deduction. If we elect out of bonus depreciation, we can instead elect to take Section 179 as a deduction on an asset-by-asset basis up to the full cost of the asset. This will let us legitimately fine-tune the return result. Section 179 deductions have their own issues, such as a limit on the total amount we can use each year, it can’t create a tax loss, and again, there are states that don’t conform to the IRS code.
Mix and match options
Finally, we do have the option to mix and match bonus depreciation, Section 179 deductions and normal MACRS depreciation on a tax return to get closer to our goal. It can be a puzzle, but let’s talk about how to use these options.
First, a tax deduction Band-Aid won’t fix a bad management decision. Let’s make sure we are buying the right equipment at the right price that makes operational and financial sense aside from the tax deductions. Thinking only of the tax deduction in the current year may cause cash flow issues in future years. You also don’t get a dollar-for-dollar deduction on your tax liability; spending $4 to save $1 isn’t always the best choice.
We’ll start by setting up normal MACRS depreciation with no additional accelerators. Now we consider this year’s income levels and future years’ anticipated incomes, equipment purchases and tax goals.
A high-income year obviously favors using both bonus depreciation and Section 179 to decrease our net income, but if we are looking at a bad year due to poor snowpack and dry reservoirs, a current-year deduction might be a good choice. With lower income next year, depreciation may not help us as much, and we can preserve some operating cash.
If we don’t have any particular equipment plans in the future, using all our depreciation up front with bonus depreciation or Section 179 may leave us several years without much depreciation expense. We can find ourselves with taxes to pay in a higher bracket but tight on cash due to the equipment loan payment we are still making.
A good thing to remember is that depreciation rules often just push income to the future. For example, electing the full Section 179 deduction on a $400,000 tractor in 2024 will save us on our 2024 tax bill. However, for the next couple of years, we will have no depreciation deduction, resulting in higher taxable income. If, however, in 2027 we sell the unit for $300,000, the entire amount will be taxable since that fully depreciated asset has no deductible tax basis left. In effect, that first-year deduction decision resulted in higher taxable income in future years. This is where thinking of the timing of the write-off can be important.
Using MACRS depreciation, bonus depreciation and Section 179 gives us tools to manage the timing of equipment write-offs to get the most benefit; we just need to think past the current year to get the best result.
References omitted but are available upon request by sending an email to an editor.
This article is provided for informational purposes only. Readers should consult their own professional advisers for specific advice tailored to their needs. Information contained in this article may be subject to change without notice.
