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Sidestep year-end tax trap on depreciation

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in Small Business Tax,Small Business Tax Deduction Strategies

At this point, it’s anybody’s guess if the Section 179 allowance will be increased this year. Small business owners can’t count on it so they might have to take regular depreciation deductions.

Strategy: Buy qualified property before Oct.  1. Otherwise, if you place an overabundance of property in service during the last quarter of the year, you could fall into the tax trap.

It all has to do with the way depreciation deductions are calculated under the Modified Accelerated Cost Recovery System (MACRS).

Here’s the whole story: Absent the Section 179 expensing deduction, the MACRS generally treats property placed in service at any time during the year as being placed in service on July 1 under the “midyear convention.” Therefore, your business can effectively benefit from a half-year’s deduction, even if property is placed in service late in the year.   

However, if the property placed in service during the last quarter exceeds 40% of the cost of all assets placed in service during the whole year—excluding any amounts for real estate—your depreciation deductions for all property placed in service during the year (except for real estate) are figured under the “midquarter convention.”

How it works: The depreciation deduction for the property is based on the equivalent of one-half of the quarterly period the property is placed in service (plus a full amount for any subsequent quarters). Say you place property in service in any of the last three months of the year—October, November or December—you’re entitled to only 1½ months’ worth of depreciation. Conversely, property placed in service 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 following three quarters). This could significantly reduce the deduction for year-end purchases.

Example: Your company buys seven-year business property in October costing $100,000. Under the midyear convention, the first-year deduction would normally be $14,290 (based on the MACRS tables).

Now suppose this is the only business property your company places in service during the year. Because you now fall into the last-quarter tax trap, your depreciation deduction is computed under the midquarter convention, reducing the deduction to only $3,570. This could be avoided by moving up purchases into September.

Tip: Currently, the maximum Section 179 deduction for 2014 is $25,000, but it could be raised by new legislation enacted later this year.

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