By George G. Jones and Mark A. Luscombe
The combination punch of Section 179 expensing and bonus depreciation may now be used more effectively than ever, by more small businesses, thanks to the expanded benefits provided under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
While expensing first appeared on the scene in 1982, bonus depreciation only started recently, retroactive to Sept. 11, 2001. Their combined use on assets that qualify under both provisions has made for impressive tax savings.
Now, with the enhanced expensing and enhanced bonus first-year depreciation under the Jobs and Growth Tax Relief Reconciliation Bill immediately in place, planning to maximize individually and simultaneously the benefits of each has grown in importance.
On May 23, Congress passed a four-fold rise in the expensing amount, from $25,000 to $100,000, and a doubling of the maximum amount of qualifying property allowed before triggering a dollar-for-dollar phaseout, from $200,000 to $400,000, retroactive to Jan. 1, 2003, and through 2005. Congress at the same time also provided for a dramatic increase in bonus first-year depreciation from 30 percent to 50 percent, for property acquired after May 5, 2003, and before 2005.
Here are some considerations that may help to maximize these new benefits for your clients.
Section 179 expensing
The Section 179 expensing election is available for tangible depreciable personal property that is acquired by purchase for use in the active conduct of a trade or business. The dollar limitations (both for the maximum deduction and the start of the phase-out) apply to each taxpayer rather than to each trade or business in which the taxpayer has an interest.
Further, no proration of the deduction is required based on the number of days that the property has been in service during the tax year.
In addition to the dollar limitations, the aggregate cost of qualifying property that may be deducted during a tax year is limited to the amount of taxable income generated by the taxpayer’s active trade or business. If the business is showing a loss, however, taxpayers can carry over qualifying deductions to subsequent tax years. To do so, an affirmative election must be made on the return for the loss year, or that carryforward is lost.
Taxpayers also need to remember that, since the changes made by JGTRRA ‘03 are temporary, taxpayers should use any carryover as quickly as possible.
Cherry picking assets. The expense election deduction may be applied against the entire cost or a portion of the cost of one or more items of qualifying property. It is generally preferable to allocate the expense allowance to property with the longest recovery period.
For example, if an item of qualifying 10-year MACRS property and an item of qualifying five-year MACRS property are placed in service, the expense allowance should first be allocated to the 10-year property. The cost of all of the property will then be recovered in the shortest possible period of time.
Selection of the asset used for expensing also should consider the penalty that will be paid in the form of recapture of the expensing benefit as ordinary income in the tax year in which the property is no longer predominantly used in the active conduct of a trade or business prior to the end of the property’s recovery period.
The recaptured amount equals the difference between the MACRS depreciation deductions that would have been permitted and the amount deducted under the direct expense election.
Under the Job Creation and Worker Assistance Act of 2002 (JCWAA), taxpayers are permitted to claim an additional 30 percent first-year depreciation allowance of the adjusted basis of qualified property. The basis of the property and the depreciation allowances in the year of purchase and later years are appropriately adjusted to reflect the additional first-year depreciation deduction.
Thanks to the Jobs and Growth Tax Relief Reconciliation Act of 2003, the bonus depreciation rises from 30 percent to 50 percent for property acquired and placed in service after May 5, 2003, and before calendar year 2005.
Since bonus depreciation is treated as a depreciation deduction, it is subject to recapture as ordinary income under Code Sec. 1245 when property is sold at a gain before its recovery period has ended.
Type of property. In order to be qualified property, the original use of the property must begin with the taxpayer.
Further, to be “qualified property” for purposes of the additional bonus first year depreciation allowance (whether 30- or 50-percent), property must be property to which the general MACRS rules apply and which is: depreciable property that has a recovery period of 20 years or less; computer software for which a depreciation deduction is allowable without regard to bonus depreciation; water utility property; or qualified leasehold improvement property.
Any amount expensed under Code Sec. 179 reduces the adjusted basis of the expensed property for purposes of computing MACRS depreciation deductions, including the first-year bonus depreciation allowance.
Next in the sequence, the adjusted basis of the qualified property is reduced by the amount of the 30-percent deduction (or, if passed, the 50-percent deduction) before computing the amount otherwise allowable as a depreciation deduction for that tax year and any subsequent tax year.
“Bonus” depreciation actually is something of a misnomer, in that it should be considered accelerated depreciation. It reduces the amount of regular depreciation that would otherwise be claimed during each year of the regular depreciation period, other than the first year. Nonetheless, the cumulative depreciation claimed is limited to the asset’s basis, regardless of whether the additional first-year bonus depreciation is claimed.
Not all assets that qualify for Section 179 expensing will qualify for bonus depreciation, and vice versa. First, bonus depreciation is limited to new assets; while used equipment may be purchased for expensing purposes. As a consequence, expensing, up to the dollar limitation if possible, generally should be allocated to assets not also qualifying for bonus depreciation.
Next, Sec. 179 expensing is generally confined to small businesses because of the existence of the dollar limits to the purchase of qualifying property after which the deduction is phased out. Bonus depreciation, on the other hand, is available to any business, although the intent was especially to jump-start capital investment in the small business sector.
Finally, due to congressional manipulation of projected budget costs, the effective dates for each of these tax benefits do not coincide. Under the law prior to JGTRRA ‘03, bonus depreciation sunsets after Sept. 11, 2004.
The new law extends the end date through Dec. 31, 2004. Likewise, under pre-JGTRRA’03 law, $25,000 maximum expensing will sunset in 2012, while the JGTRRA’03 expensing enhancement is scheduled to end after 2005.
Section 179 expensing and bonus first-year depreciation offer a powerful incentive at least to attempt to coordinate the business need for capital purchases of tangible property with the applicable tax rules under each of those provisions. Depending on a client’s tax rate bracket, the tax benefits of first-year writeoffs can effectively maximize the total discount on carefully timed purchases (at carefully considered elections) by more than up to a third of their cost.
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