For most business owners faced with questions on how to depreciate their fixed assets, usually the most common response is to expense as much as possible using Section 179 and then depreciate the remaining portion using MACRS. This makes sense and usually saves considerable tax in the current year; however, you might want to put some more thought into that question the next time your CPA calls when working on your tax return as there are some additional considerations that you should be aware of:
Like a ghost, recapture can come back and haunt you and the great deduction you took a few years may end up costing in the end with a higher tax rate on the gain from sale of the asset. Capital gains rates are great right now (although that may be changing after the elections), but if you sell personal property that you took 179 depreciation on, you will end up with ordinary income rather than the capital gain you were hoping for. The formulas are complex and it is something you would have to sit down with a CPA or accountant to discuss fully and apply it to your specific circumstances, but the bottom line is that you need to consider how long you will be holding a fixed asset when you are deciding on depreciation. If you are planning on selling the asset after a few years, MACRS depreciation could be a better route to go in the long run.
2) The “Next Year”
Life is great in a tax year when you have a big 179 depreciation deduction, but what about the “next year”? Lets say you had a good year and made a healthy net income, so in December you bought a ton of new equipment, or maybe a new commercial van that still qualifies for Sec 179 (maybe the above pictured truck over 14,000 GVW). April comes and you get a big refund and your safe harbor estimated tax payments are nice and low – life is good.
You have another good year and get to December, but the problem is that you do not need much new equipment because of all you purchased last December and trading for a new vehicle using a 1031 exchange will have minimal impact. Luckily, you realized the problem from reading my blog and called your CPA before year-end to get your 4th quarter estimated tax payments adjusted; however, this is not often the case. For most, the “next year” can be painful – especially for those who file closer to October 15th. Estimated tax payments are always based on 100% of the prior year tax liability less withholdings (110% if AGI is over $150k), and so if Sec 179 depreciation lowers you taxable income by $50k, you will be paying estimates based on that reduced amount. Then the next year if business net income was the same but you only have $10k in Sec 179 deductions, your taxable income is going to be $40k higher – which can result in large amounts due with the return since your estimates were based on the reduced income from the prior year. The next thing you know you are learning about installment agreements. 😦
3) Shareholder Basis Issues
If you are an S-Corp and you max out your 179 depreciation deduction ($125k for 2007, $250k for 2008 due to the Economic Stimulus Act), you could end up with a large loan to shareholder balance on your tax return. This results mainly because most smaller S-Corporation owners take distributions based on cash flows and book net income; however, deductions like Sec 179 cause a distortion of net income on the tax return and a timing difference (as an asset that would have been depreciated over 5 years is now expensed completed in the current year). If taxable net income is much lower than the book income that the distributions were based on, then you can end up with distributions in excess of your debt basis to the point where you have reduced retained earnings to zero and the excess distributions become a loan to shareholder account that technically you should be charging regular interest on (unless you want to take the excess distributions as capital gain). The banker will then look at your return and see that you owe the company a large sum, and even though they understand Sec 179 and timing differences, they still do not like seeing this account when renewing a loan. It is definitely something to consider if you have similar circumstances and you have to face renewal every year.
Bottom line – think before you 179 and always look to the “next year” and beyond.