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Tax considerations for major purchases

Brandon Hendrickson Published on 29 October 2012

Every year about this time, I inevitably get asked the following or similar question: “Should I buy that truck this year to save taxes?” The answer to this question is almost always: “It depends.” The idea behind this tax planning strategy is fairly simple – buy business equipment or other depreciable property before the end of the year, rather than next year, and get up to 100 percent expensing to offset business income for this year.

The trick is making sure the equipment is something the business really needs and not just a way to reduce taxes. It is never a good idea to let the tax code make business decisions but, if asset purchases are planned in the next six to 12 months, it is worth looking to see if accelerating these purchases makes sense.

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Special depreciation methods
There are two ways to accelerate expensing of equipment purchases available for the 2012 tax year. The first one is commonly known as Section 179 expense, which refers to the tax code section that allows for it.

The second one is often called special or bonus depreciation. Both can provide the same desired result, but each has different rules to keep in mind when deciding how best to utilize them.

Code Section 179 provides an election to treat specific amounts of new or used qualifying property as a current expense in the tax year it is placed in service. This expense is treated as depreciation and can be applied on an asset-by-asset basis.

The election to expense can be made for some or all of a particular asset and assets to be expensed can be cherry picked. Qualifying property is tangible personal property subject to current depreciation rules, including off-the-shelf software, acquired by purchase for use in the active conduct of the taxpayer’s trade or business.

Generally speaking, assets (new or used) purchased for a farming activity will be considered qualifying property.

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In 2012, there is a $139,000 limitation on elected expense that is reduced dollar for dollar for each dollar of qualifying property placed in service above $560,000. This basically means the ability to elect Section 179 expense phases out between $560,000 and $699,000 in qualifying asset additions.

The ability to deduct Section 179 expense requires income; it cannot create a net operating loss (NOL) or reduce income below zero.

It is important to note that without action from Congress, Section 179 expense for 2013 is reduced to a $25,000 limit phasing out between $200,000 and $225,000 of qualifying property placed in service.

Bonus depreciation applies to all new property purchases unless a choice is made to elect out. To qualify for bonus depreciation an asset must be new in the year placed in service with an asset class life of 20 years or less. Essentially, all new assets purchased for a farming activity will qualify for bonus depreciation.

Bonus depreciation is generally 50 percent of the asset cost with the remainder being depreciated under regular depreciation rules. Unlike Section 179 expense, bonus depreciation is applied and elected out of by asset class. For example, all five-year asset class lives will be treated the same.

There is no limit to the amount that can qualify for bonus depreciation and bonus depreciation can create an NOL or take income below zero. Section 179 expense is applied prior to bonus depreciation. Bonus deprecation tax provisions are set to expire at the end of 2012.

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Planning
There are a couple of things that need to be considered before making a decision to accelerate equipment purchases in order to accelerate depreciation. The first is the future expectation of profits and second is potential increases or decreases in tax rates.

Predicting the future can be a difficult task but good tax planning requires some expectation of how things might unfold in the future. Tax rates have historically been fairly predictable but, lately, this is not the case. There has been a lot of discussion lately on tax rates by both political parties but very little in the way of action in Congress.

It is a good idea to run numbers with what will be the rates if Congress does not change anything and numbers with what is expected to happen. Many experts say higher tax rates are inevitable and, in at least one case, this looks to be true. There is a new Medicare tax on unearned income coming on the books in 2013.

Medicare tax on unearned income
A 3.8 percent Medicare contribution tax will be imposed on the lesser of an individual’s net investment income for the tax year or any excess of modified adjusted gross income for the tax year over a threshold amount of $200,000 or $250,000 if jointly filing.

This tax was added by the Health Care and Education Reconciliation Act of 2010. The new tax applies to all tax years beginning after 2012. Net investment income, to which the new 3.8 percent Medicare tax will apply, includes interest, dividends, annuities, royalties, rents and other gross income derived from a passive activity.

Gains from the sale of property not used in an active business and income from invested working capital are treated as investment income as well.

The tax does not apply to nontaxable income, such as tax-exempt interest or veterans’ benefits. The tax does apply to capital gains income, including gain from the sale of a principal residence, unless the gain is excluded from income under Code Sec. 121, and gains from the sale of a vacation home.

While income from farming activities will generally not meet the definition of net investment income, and therefore not be subject to the new 3.8 percent Medicare tax, other non-farming income may meet this definition and will need to be considered as part of the overall tax planning process.

Tax planning in today’s uncertain environment is very difficult. The decision to accelerate asset purchases in 2012 does not have a simple one-size-fits-all answer. The flexibility that Section 179 expense and bonus depreciation offer makes it fairly easy to manage income between years and the 2012 tax year might be the last year this flexibility is available.

However, accelerating equipment purchases at the end of 2012 has the effect of borrowing tomorrow’s deductions for use today. This can provide very favorable tax results but if tax rates go up, whether by statute or increased income, tomorrow’s deductions might be more valuable tomorrow. PD

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