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Depreciation deductions: Go against the grain

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in Small Business Tax,Small Business Tax Deduction Strategies

Under Section 179, you can currently deduct up to $250,000 of assets placed in service in tax years beginning in 2010. But not every business can benefit from Section 179 (see box below). You may have to write off assets over the regular depreciation period.

Strategy: Time equipment purchases to suit your needs. Usually, you’ll fare better tax-wise by placing assets into service before Oct. 1. But, surprisingly, you might maximize your deductions after the Sept. 30 deadline.

It all has to do with a special tax rule for assets placed in service in the last quarter of the year.

Here’s the whole story: Under the Modified Accelerated Cost Recovery System (MACRS), business assets placed in service anytime during the year are generally treated as if they had been placed in service on July 1 for depreciation deduction purposes. It doesn’t matter when the assets are actually placed in service. This is called the “half-year convention.”

However, if the cost of business assets (not counting real estate) placed in service during the last quarter of the year—Oct. 1  through Dec. 31—exceeds 40% of the cost of all assets placed in service during the year, depreciation deductions for all the assets are figured under the “mid-quarter convention.” In this case, depreciation is calculated as if the assets were placed in service at the halfway point of the quarter during which they were first used. For instance, a business placing equipment in service during the last quarter of the year is entitled to only 1½ months depreciation.

Conversely, equipment purchased in the first quarter of the year may be entitled to 10½ months depreciation (1½ months for the first quarter and nine months for the next three quarters).

In most cases, you should steer clear of the last-quarter tax trap, but that’s not always the case.

Example: As the owner of A&B Corp., a calendar-year corporation, you’re contemplating the acquisition of new computers costing $20,000. The usual first-year write-off for five-year property, such as computers, is 20% of the cost. So A&B is entitled to a $4,000 deduction (20% of $20,000) if it places the computers in service before Oct. 1. If it waits until after Sept. 30, the deduction under the mid-quarter convention is only 5% of the cost (see chart below). Therefore, A&B’s deduction would be limited to $1,000 (5% of $20,000) if it moves too slowly.

But suppose A&B already purchased the computers in the first quarter of the year. It also needs to buy a $10,000 machine that is seven-year property. The first-year deduction for seven-year property is normally 14.29% of the cost. If the machine is placed in service in the third quarter—before Oct. 1—the deduction is $1,429 (14.29% of $10,000). So A&B can deduct a total of $5,429 ($4,000 + $1,429) of depreciation for the year.

Better move: A&B places the machine in service in the fourth quarter. Under the IRS table for the mid-quarter convention, the depreciation deduction is $7,000 for the computer equipment (35% of $20,000) and $357 for the machine (3.57% of $10,000). Total MACRS deduction: $7,357.

By going against conventional wisdom, A&B can deduct $1,928 more ($7,357 – $5,429).

Note that this example doesn’t take “bonus depreciation” into account. Currently, bonus depreciation generally isn’t available for assets placed in service after 2009, but this tax break might be revived by year-end legislation.

First-year depreciation for mid-quarter convention

Type of property

Placed in service in 1Q

Placed in service in 2Q

Placed in service in 3Q

Placed in service in 4Q

Five-year property

35%

    25%

   15%

  5%

Seven-year property

25%

17.85%

10.71%

3.57%

 

 

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