Use Expensing or Bonus Depreciation to Write Off Assets in First Year
Bonus depreciation (for years prior to 2014) and the expensing election enable you to deduct much of the entire cost of a capital asset in the year in which you acquire it.
There are two important exceptions to the general rule that you can't deduct the entire cost of a capital asset in the year you purchase it:
- bonus depreciation (prior to 2014) and
- the Code Sec. 179 expensing election.
These provisions exist solely to encourage businesses to invest in new assets. Although both were very taxpayper options for a number of years, bonus depreciation is not available after 2013 and the value of the expensing election has been severely reduced.
Act Before 2014 to Claim Bonus Depreciation or Enhanced Expensing
Through 2013, the expensing election annual amount is $500,000, with a $2 million investment limit. This continues the amounts that were in effect in 2011 and delayed the reduction that had been set to occur in 2012.
The American Taxpayer Relief Act of 2012—enacted to avert the "fiscal cliff" crisis—postponed, but did not eliminate the scheduled drop in the expensing election amounts.
For tax years beginning after 2013, the annual dollar limit plummets to only $25,000, while the investment limitation will kick in at a mere $200,000.
The option to claim bonus depreciation was also extended through the end of 2013--but only at the 50 percent level. The 100 percent bonus depreciation available in 2010, 2011 and 2012 has vanished. And, after 2013, the 50-percent deduction vanishes as well.
Choosing Between Bonus Depreciation and Expensing
As a result of these law changes, the decision making process must include not only whether to elect either expensing or bonus depreciation, but also the order in which to utilize the options.
In order to make the correct decision, you need to consider these factors.
- Is the property "used?" Bonus depreciation can be claimed only for new property. So, if the property is only new to you, you can elect to expense the cost, but you can't claim bonus depreciation.
- Did you acquire the property in a like-kind exchange If so, you can only expense the cost of any property that you receive that is in addition to the property exchanged. You can claim bonus depreciation on your basis in the newly acquired property.
- Are you likely to have a net operating loss for the year? The amount that you can expense is limited to the amount of your taxable income for the year, although you can carry over the excess and deduct it from your income in future years. However, bonus depreciation is not limited to your taxable income. You can deduct any amount of bonus depreciation, and if the deduction creates a net operating loss, you can carry that amount back to offset previous year's income and also carry any unused loss forward to deduct against future income.
- Are you engaged in an active business or a passive activity? You can only claim an expensing election for assets that are used in an active trade or business. Bonus depreciation can be claimed for assets used in rental activities and other passive activities, as well as in a trade or business.
Although bonus depreciation and the expensing election may allow you to deduct the entire cost of an asset in the year in which you acquired it, the amount you deduct may have to be "recaptured" when you sell the equipment.
This "recapture" will reduce your gain on the sale of the assets, which could work to your disadvantage by increasing your tax liability in the year of sale. You need to think about your net long-term tax liability, rather than simply focus on short-term savings.
Expensing Election Limitations May Affect Decision
In addition to these factors, the expensing election is limited in several ways, although the limits are still high enough in 2012 and 2013 that they might not affect you.
- There is a maximum amount of costs that can be deducted. For 2012 and 2013, this is $500,000. Beginning in 2014, this amount drops to only $25,000!
- The maximum amount is reduced dollar-for-dollar when your total asset purchases in a year exceed a certain amount. In 2012 and 2013, the dollar-for-dollar reduction is triggered when your total asset acquisitions for the year exceed $2 million. Beginning in 2014, this phase out kicks in when asset acquisitions for the year exceed $200,000!!
- The amount that you can expense is limited by your business income. (This prohibition continues unchanged in 2014.)
There are no such restrictions on bonus depreciation--although 2013 is the last year available to claim it.
Consider the Long-Term Outlook for Your Business. There is one additional, very important consideration: does deducting the entire amount in the year of acquisition make sense long-term?
Even ignoring the possibility you will have to recapture the amount claimed if you dispose of the asset prematurely, claiming a full deduction in the year of acquisition means you give up deductions against income in future years. This can work to your disadvantage.
Claiming a large first year write-off is particularly likely to work against you if your tax rates go up (whether because of legislative changes or you are in a higher tax bracket) and your business income increases (which you hope that it will). It's a good idea to discuss your strategy with a tax professional who can help you work through a number of scenarios to balance short-term versus long-term benefits.
Property Can Be Placed in Service Any Time During Year
The amount of regular depreciation you can claim is based on a number of rules regarding when you place property in service during the course of the year. These rules do not apply to either bonus depreciation or to the expensing election. As long as you start using your newly purchased business equipment before the end of the tax year, you get the entire expensing deduction for that year, whether you started using the equipment in January or December. The same is true for bonus depreciation.
If, toward the end of your tax year, you're thinking about purchasing equipment that you can expense, you may do well to complete the purchase and start using the property before the end of the year if you can benefit from deducting the property's cost on your current year's tax return.
However, if you expect your taxable income to be much higher in the following year, you may want to hold off on the new equipment until the beginning of the next tax year.
Bonus Depreciation Boosts First-year Deduction
Bonus depreciation speeds up your ability to deduct the cost of an asset in the year it is acquired. Bonus depreciation gives taxpayers a "bonus" by allowing them to claim a much larger first-year depreciation deduction that would normally be available for that class of assets.
For qualified property acquired and placed in service after 2011 and before 2014, the amount of bonus depreciation is 50-percent of the property's basis.
Bonus depreciation is deducted after the basis is reduced for any amounts claimed as an expensing election but before taking the normal annual depreciation deductions allowed for such assets. The adjusted basis of the assets (the cost less the expensed amount and bonus depreciation) is then depreciated over the life of the assets.
Anne purchases a new $1,500 computer for use in her business. (Computers are 5-year MACRS property) She claims a $600 expensing allowance. This reduces her basis for depreciation to $900.
She claims the 50 percent bonus depreciation, which is $450 (($1,500 − $600) × 50%).
She then computes her regular MACRS depreciation deductions are computed on the remaining depreciable basis of $450. Her regular first-year MACRS allowance is $90 ($450 × 20% (first-year table percentage).
Thus, on her tax return, Anne claims a $740 deduction. The remaining $760 is depreciated over the class life of the computer.
You May Be Able to Expense Entire Cost of Assets
Small businesses can elect to expense up to $500,000 of the cost of new or used depreciable business assets purchased and placed in service in 2012 and 2013. Plus, because the overall investment limitation is $2 million in 2012 and 2013. Most small businesses will not need to worry about hitting the investment limitation. In addition, special rules allow up to $250,000 in qualified leasehold, restaurant and retail improvements to be expensed through 2013.
Remember: these amounts drop steeping after 2013. Beginning in 2014, the amount amount is only $25,000 and the overall limitation is only $200,000. Plus, the opportunity to expense qualified leasehold, restaurant and retail improvements is gone.
If you fully take advantage of the Section 179 expensing deduction, you can get a significant, up-front reduction in the out-of-pocket cost of a needed piece of business equipment. For example, in 2013, if you are a sole proprietor in the 25 percent tax bracket, the net cost of buying a $100,000 piece of machinery is $75,000 when you take into account the $25,000 tax savings that results.
Ideally, you make the expensing election on your original tax return for the period, on Form 4562, Depreciation and Amortization. However, if you don't claim it on a return filed before the due date, for tax years beginning in 2003 through 2013, you can change your mind later by filing an amended tax return after the due date.
Among the Business Tools are Form 1040 and Form 4562. They are in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.
What Property Can Be Expensed?
To qualify for the expensing election, the property must be:
- tangible personal property;
- purchased by you;
- actively used in your business;
- depreciable (that is, the type of property for which a depreciation deduction would be allowed.
New or used property qualifies. The property must be newly purchased new or used property. You can not elect to expense the cost of property you previously owned but recently converted to business use.
Used property (newly purchased by you) can qualify for the expensing election. This contrasts with the rule for bonus depreciation. Only new property can qualify for bonus depreciation. If you acquire used property, your option for deducting the cost in the first year is limited to the expensing election.
Property must be purchased. You must have purchased the property in order to expense the cost. This means that property you acquire by gift or inheritance does not qualify. In addition, you have to acquire the property from an unrelated party. You can not expense the cost of property you acquire from related persons such as your spouse, child, parent, or other ancestor or descendant, or another business with common ownership.
Property must be depreciable. You can not expense the cost of acquiring land for your business. Eligible types of property include property that is not a building or a structural component of a building, but is an integral part of manufacturing, production, or extraction, or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services; or a research or storage facility used in connection with any of these processes.
It can also be a single-purpose livestock or horticultural structure, or a petroleum products storage facility that is not a building. Off-the-shelf computer software is eligible for the expensing election, too.
Through 2013, up to $250,000 of improvements to qualified leasehold property, qualified restaurant or qualified retail property can be expenses. However, there are certain rules regarding what qualifies and the carryover period. An air conditioning or heating unit doesn't qualify, however. Neither does intangible property such as a patent, contract right, stock or bond, etc. See "Expensing Possible for Certain Real Property" later in this article. (This option disappears after 2013.)
Business use required. The property must be used more than 50 percent for business. If you want to expense property that will be used partly for personal or family reasons (e.g., a home computer that you use for business about 75 percent of the time, and for personal use the other 25 percent of the time), you can expense only the portion of the property's tax basis that corresponds to its percentage of business use.
Early Disposition of Property Can Trigger Recapture
If, in any year after the year you claimed the expensing election, you either sell the property or stop using it more than 50 percent in your business, you may have to recapture or "give back" part of the tax benefits that you previously claimed. The recaptured amount is equal to the difference between the amount you expensed, and the amount you would have been able to depreciate under the normal rules.
If you think you'll only be using the equipment for a year or two, it may be better to not to make the expensing election and avoid the recapture problem.
Annual Income May Limit Amount Expensed
As noted earlier, three limitations apply to the amount that you can deduct in a year using the expensing election. The amount you can expense is limited by:
- the maximum dollar amount
- the total cost of assets acquired during the year and
- your business income during the year.
In addition, you may need to allocate the amount between other taxpayers under certain circumstances.
Impact of limitations. If you purchase equipment that exceeds these dollar limits, you can depreciate the excess amount under the usual rules.
If your equipment purchases for the year exceed the expensing dollar limits, you can decide to split your expensing election among the new assets any way you choose.
Generally speaking, where you have a choice, it's best to expense those assets with the longest depreciation periods (e.g., seven-year property), so you can claim a quicker write-off for them. If the asset has a shorter depreciation period (e.g., three-year property), expensing it in the first year is not going to make as much of a difference.
Amount Expensed Is Subject to Annual Limitation
There is a maximum amount that you can elect to expense in any given year. For 2010 through 2013, this maximum amount is $500,000. (As noted earlier, the maximum amount is scheduled to drop to $25,000 in 2014.)
In 2013, Bob's Carts, Inc., a company that manufactures electric golf carts, purchases a machine to be used in its business. The machine cost for $425,000. Bob's Carts can expense the entire cost of the machine, unless the investment limitation or the taxable income limitation applies.
If the company waits until 2014 to purchase the equipment, only $25,000 of the cost of the machine can be expensed --the remaining $400,000 will have to be recouped via annual depreciation deductions.
Total Amount of Assets Acquired Can Trigger Limitation
You will not be able to claim the maximum dollar amount if you the cost of property you purchased and placed in service during the year exceeds the "annual investment limitation." (This rule is intended to keep the expensing election targeted toward small businesses.) If this limitation is reached, then the maximum amount of the expensing election for the year is reduced dollar for dollar by the amount spent in excess of the investment limit.
For 2010 through 2013, the annual investment limitation is triggered if the cost of qualified property purchased and placed in service by a business exceeds $2 million. This means that most small businesses do not need to worry about it. Unfortunately, in 2014, the investment limit is scheduled to drop to only $200,000.
Assume the same facts as the example above. In addition to the new $425,000 machine, Bob purchased a second machine for $200,000.
In 2013, Bob does not need to worry about the annual investment limitation because the $625,000 he spent was far below the $2 million limitation threshold.
Unfortunately, Bob waited until 2014 to make the purchase. This means he takes a double hit on the expensing election. First, the maximum he could possibly claim is only $25,000. But, he can't even claim this amount because his total investment is well over the $200,000 limitation in effect in 2014. This means the expensing election is completely phased out when the annual investment exceeds $250,000 total.
Bob must reduce the amount he can expense by one dollar for every dollar he is over the annual limitation--and loses out on any opportunity to expense the assets.
Business Income Limits Expensing Amount
The total cost of property that may be expensed in the first year it is place in service cannot exceed the total amount of your taxable income that you get from the active conduct of any trade or business, including any salary or wages from other jobs you (or your spouse) may have.
The way in which taxable income is computed under the expensing rules may especially benefit a small business owner who operates the business in either unincorporated form (a sole proprietorship or partnership) or as an S corporation.
This is because in determining the taxable income limit of such taxpayers, all wages and income are included - even those from another job or separate business activity. Married business owners filing joint returns can also count their spouses' wages and business income.
This means that if your business is facing a loss, you may not get the full benefit of the expensing provision. Costs that are disallowed can be carried forward to the next year, so the fact that this income limitation rule knocks out a portion of your expensing deduction does not mean that it is permanently lost.
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Some Real Property Improvements (Made Before 2014) May Be Expensed
The expensing election traditionally has been available only for tangible personal property used in a trade or business. Improvements to buildings generally cannot be expensed. For example, a restaurant owner can expense the cost of new ovens in the year the equipment went into service. But in most years, improvements to the restaurant building cannot be expensed. These improvements generally have to be depreciated, usually over a substantial number of years.
However, for 2012 and 2013, this expensing prohibition was lifted for improvements to qualified restaurant property, retail property or qualified leasehold property. As a result, the cost of updating and refurbishing a restaurant, retail store or other leased commercial property may be fully deductible in 2012 and 2013 under expanded expensing rules contained American Taxpayer Relief Act of 2012. (This provision resurrects a similar provision contained in the Small Business Jobs Act that had expired at the end of 2011.)
The expensing option is limited to 2012 and 2013 so you must move quickly. Act now to determine if you should undertake renovations on your property. Check with your tax professional if you made improvements to your property in 2012.
Limitations on the carry-over of unused election amounts make planning and forecasting essential. Because the rules surrounding the qualifications and interplay of deductions can be very tricky, it's advisable to work with an accountant to make sure you maximize your savings while minimizing any risks.
What Is Qualifying Property. In order to be eligible for the expensing election, the property must
- be depreciable
- it must have been acquired for use in a trade or business.
- it must be
- qualified restaurant property
- qualified retail improvement property or
- qualified leasehold improvement property.
The cost of new heating and air-conditioning elements can't be expensed. Their cost must be recovered through depreciation.
Qualified Restaurant Property. A building, or an improvement to a building, is qualified restaurant property if more than half of its square footage is devoted to preparing and serving meals. Qualified restaurant property can include a new building, not merely improvements to an existing building as required for retail and leasehold property.
A small cafeteria housed within a larger grocery store is unlikely to qualify as restaurant property due to the square foot restriction. However, if property improvements fail to qualify as restaurant property, the costs may still qualify for expenses as "qualified retail property" or "qualified leasehold property."
Qualified Retail Improvement Property. Improvements made to the interior of a building that is more than three years old and is used as a retail store open to the general public may also qualify for the expensing election. Nonqualifying improvements include those that
- enlarge the building
- add an elevator or escalator
- relate to structural components that benefit a common area, or
- affect the internal framework of the building
Examples of improvements can qualify are:
- electrical systems
- permanently installed lighting
- plumbing systems
- sprinkler and security systems
- ceilings (such as dropped acoustical panels)
- windows, and
- new wall and floor tiles
Qualified leasehold improvement property. Improvements made to the interior of a nonresidential building that is at least three years old and that will be occupied solely by the lessee (or sublessee) may be considered qualified leasehold improvement property. As with retail property, improvements that enlarge the building, add an elevator or escalator, relate to structural components that benefit a common area or affect the internal framework of the building can not qualify.
Reduced Dollar Limitation. As noted above, for 2012 and 2013, the maximum expensing amount is $500,000 of the costs of business property purchased and first used in those years. However, the amount of qualified real property purchases that can be expensed (deducted) is limited to $250,000 in 2012 and in 2013.
The expensing limitation on tangible personal property is $500,000 in 2012 and 2013. This means that, if all the requirements are met, you can expense up to $250,000 of expenses for qualified property improvements and still expense other purchases, up to the $500,000 limitation.
Example: During 2012, Anne, a restaurant owner, purchased new equipment that cost $100,000. She also completely refurbished the dining area of the restaurant, which cost $300,000. These were her only asset purchases, and the taxable income limitation did not apply. The maximum section 179 deduction she can claim for 2012 is $350,000 ($100,000 with respect to the equipment and $250,000 with respect to the qualifying leasehold improvements).
Income Limitation. As under the current rules, the amount that can be expensed is limited to the total amount of taxable income from any active trade or business during the tax year.(Any active trade or business means just that. If you worked as an employee, the wages that you earned are income from an active trade or business. In addition, on a joint return, the spouse's taxable income from a trade or business counts in the total amount of taxable income.)
Special Carryover Rules. If the taxable income rule limits the amount that can be expensed, the unused amount generally is carried forward to succeeding years where it can be claimed as a deduction. However, there is a stricter rule for qualified real property: The unused amount in the preceding years can be carried over to 2013. But, any amount that can not be used in 2013 (including any amounts carried over from earlier years) will be lost as an expense deduction, although those amounts can still be depreciated.
In 2012, Joe, a store owner, renovated his entire store. The cost of the renovation was $150,000, and all of the expenses qualify for the deduction. Joe's total taxable income was $50,000. As a result, Joe can only deduct $50,000 of the expenses on his 2012 tax return, the remaining $100,000 is carried to 2013. In 2013, his taxable income was $125,000. The remaining amount is deductible on Joe's 2013 tax return. However, if his income was only $75,000, then $25,000 of the cost of the renovation would need to be deducted via depreciation.
Allocation or Recapture of Expensed Amounts May Be Necessary
Allocation rules determine how the benefits of the Section 179 expensing deduction are to be split between spouses, certain related corporations, partnerships and their partners, and S corporations and their shareholders. These rules are designed to make sure that a purchase of business equipment in a particular year cannot be used by related parties to gain more than the total allowed for expense deductions.
- Married taxpayers filing separate returns. Married persons filing separate returns are treated as one taxpayer for purposes of the expensing amount ceiling. Unless they elect otherwise, 50 percent of the cost of the property is allocated to each spouse.
- Related corporations. If you operate your business as a corporation, and this corporation controls other corporations, the corporations will be limited to one total deduction amount for business property purchased.
- Partnerships and S corporations. The deduction limit applies separately to the partnership or S corporation itself and to each partner or S corporation shareholder.
In 2013, Sam Smith and Linda Lane form a partnership to operate a bakery. The partnership buys new ovens for a total cost of $135,000. In addition, Lane also enters into a separate business venture, a flower shop, by herself, for which she buys $15,000 worth of cooling units to store fresh-cut flowers.
Assuming the partnership has taxable income that exceeds $135,000, it can elect to expense the full cost of the ovens because the expensing limit for 2013 is $139,000. If it does so, each partner's share of the expensing deduction is $67,500. In addition, Lane can elect to expense the entire $15,000 cost of her equipment, assuming her taxable income derived from the flower shop exceeds $15,000.
Low Business Use Triggers Recapture
To claim the expensing election for a piece of property, you must use the property at least half the time for business purposes. If your business usage drops below 50 percent during some year before the ordinary depreciation period for this property ends, you will have to "give back" or recapture some of the amount you expensed.
To figure the recaptured amount, compare the amount you expensed, and the total amount you would have been entitled to deduct so far under the quickest depreciation method allowed for that type of property. If the amount you expensed was greater, the difference between the two amounts must be reported as ordinary income.
Among the Business Tools are Form 1040 and Form 4797. They are in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.
The recapture is reported on IRS Form 4797, Sales of Business Property, in Part IV at the end of the second page. If the property was listed property, used Column B of Lines 33 through 35. If not, use Column A.
In 2011, Raymond Georges purchased a new computer to use in his boat chartering business. He expensed 75 percent of the $3,000 cost in the year of purchase. He used the computer 75 percent for business in 2011 and 2012. In July of 2013, Raymond decided to buy a new business computer and retired the old one to his family room, to be used for business purposes only 10 percent of the time.
Because Raymond's computer was listed property his allowable depreciation must be computed using the straight-line method, over a five-year recovery period. Raymond's recapture amount would be computed as shown in the chart that follows. Raymond would report the amounts in bold in the right hand column of the chart in Column b, Lines 33-35, of his IRS Form 4797, Sales of Business Property.
|Section 179 expensing election ||$3,000 x .75 = || ||$2,250 |
|Allowable depreciation || || || |
|2011: ||$3,000 x .75 x .10 = ||$225 || |
|2012: ||$3,000 x .75 x .20 = ||$450 || |
|2013: ||$3,000 x .10 x .20 = ||$60 |
|$ 735 |
|2013 recapture amount: || || ||$1,515 |