As a business owner, you have certain deductions that can save you on your tax liability. If you’ve been in business long enough, you’ve probably heard of “Section 179” relating to depreciation. What is it exactly?
This special tax election allows business owners to depreciate 100% of the cost of the equipment in the first year rather than spread the depreciation over its useful life, usually 5 year for small equipment. There is a $500,000 limit per year for this election. Let me give you an example:
In 2014, you bought and placed in service $475,000 in machinery and a $25,000 commercial printer for your business. You elect to deduct $475,000 for the machinery and the entire $25,000 for the printer, a total of $500,000. This is the maximum amount you can deduct. Your $25,000 deduction for the printer completely recovered its cost. Your basis for depreciation is zero. The basis for depreciation of your machinery is $25,000. You figure this by subtracting your $475,000 section 179 deduction for the machinery from the $500,000 cost of the machinery.
Though you typically can’t use Sec. 179 for real estate assets and you can’t use its “immediate write-off” accounting to create a loss, you can still aggressively use Sec. 179 elections to shelter business income and even wipe out your tax liability. So, you can’t create a loss, but you can completely wipe away your tax liability using this election.
In summary, the Sec. 179 election lets you immediately write off the costs of nearly all types of assets rather than depreciate the asset cost over years and years.
If you find yourself saying, “Yah. Yah. I use this election every year to save money on my taxes,” you’re probably not using this election to your full advantage. Let me explain….
The Typical Sec. 179 Usage is Dead Wrong!
Let’s pretend you have a business that grosses $500,000 per year. Assume further that you buy a piece of equipment for $500,000 that will last for 5 years.
As we now know, the Sec. 179 election allows you to take all $500,000 as a deduction in the year you purchased and placed the equipment into service. And so, on your tax return, your business income shows as zero. And that tax accounting seems like a good deal.
You won’t owe any income or self-employment taxes, which is always nice. However, you probably made one costly mistake by using this “write everything off” approach.
Here’s The Problem (Finally!)
First, business owners forget to look at the effect of the very low tax rates they pay on those first dollars earned in a given year.
For example, even if you are making $100,000 a year in your business, that first $20,00 or so of income earned probably doesn’t get taxed at all because of your deductions and personal exemptions.
When using the Section 179 election to “shield” that first 20,000 of income that won’t even be taxed obviously doesn’t produce a benefit. Understand that your deductions and personal exemptions are already taking care of that tax from the first $20,000 or so income for you.
And then remember that your first two tax brackets are pretty modest.
After you pass the point where deductions and exemptions shield your income, you pay a 10% income tax rate on a piece of your income (nearly a $20,000 piece if you’re married) and then a 15% income tax rate on a piece of your income (nearly a $60,000 piece if you’re married).
Using Section 179 depreciation to shield income that would otherwise be taxed at 10% or 15% also usually isn’t a very good use of the write-off either.
Keep in mind, too, that tax credits may in fact wipe out the income taxes you pay on income within these parameters as well.
So What Do I Do To Optimize The Section 179 Election?
Once you are past the point where deductions and exemptions shield your income and pass the mark where low tax rates make for a light burden, things get very interesting.
How so? Well, because where this special election really saves you money is when you can use it to shield your highly taxed income.
In other words, you want to spread the $100,000 of depreciation out over, say five years. That way you shield $20,000 over five years. Using Section 179, you would be able to deduct all $100,000 in the first year, saving you about $12,000 in taxes, albeit all at once.
By spreading out the depreciation over 5 years ($20,000/yr.) and lowering your highest-taxed income, you would save about $4,000/yr. for a total of a $20,000 in tax savings rather than $12,000. Even taking into account inflation and the time value of money, you really can’t justify using up all the depreciation at once.
Hopefully a light bulb has gone off in your heard. The immediate gratification of using Sec. 179 and deducting 100% of an asset all within the first year may not be the optimal way for you to use this election.
Let me leave you with a couple closing notes:
First, it’s always a good idea to run this information by your accountant. I absolutely recommend you speak with them about your specific situation and how this would affect you specifically.
For example, I’m focusing on income taxes here but if you’re over the Social Security threshold ($118,000 in 2015) or happen to be running some clever pension strategy, you might want to connect your Sec. 179 decisions with the other strategies you have in place.
Second, my numbers have been rounded for the sake of easy reading. Basically everything was rounded to the nearest $1,000.
UPDATE:
The Limits of Section 179 have been updated in 2015. Here they are:
Total amount written off: $25,000
Total amount of the equipment purchased: $200,000 ($500,000 in 2014)
The deduction begins to phase out dollar-for-dollar after $200,000 is spent by a given business, so this makes it a true small and medium-sized business deduction.
It is important to mention that while Bonus Depreciation (allowing 100% deduction during the first year of use) is currently not being offered (as of 7/6/15), in years past it has been approved at year end for retroactive purchases.
Lastly, although Bonus Depreciation is not available in 2015 – in years when it is available, Bonus Depreciation is useful to larger businesses spending more than the Section 179 Spending Cap (currently $200,000) on new capital equipment. Also, businesses with a net loss are still qualified to deduct some of the cost of new equipment and carry-forward the loss.