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Need new equipment? Flip buying strategy on its head

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in Small Business Tax,Small Business Tax Deduction Strategies

Sometimes, you come out ahead in the tax world by going against the grain. Take depreciation deductions, for example.

Under the Modified Accelerated Cost Recovery System (MACRS), “the book” is to buy equipment late in the year in order to claim a half-year’s deduction. However, your situation may call for drastic measures.

Strategy: Replace worn-out or obsolete equipment right now. If you load up on such purchases early in the year—and purposely “flunk” a tax-law test later on—you’ll come out ahead.

Here’s the story: Normally, business assets (other than real estate) that you buy are treated as if they were placed in service halfway through the year, regardless of when that actually occurs. That’s commonly called the “half-year convention” in tax lingo. For five-year MACRS assets, the first-year write-off is 20 percent of the cost; it’s 14.29 percent for seven-year assets.

For instance, since computers are five-year assets, if you buy a $5,000 computer and place it in service in December, you normally can write off $1,000 of depreciation (20 percent).

But there’s another wrinkle: If the cost of assets placed in service during the last quarter of the year exceeds 40 percent of total assets for the year, depreciation deductions are figured under the “mid-quarter convention.”

In other words, the computer would be treated as if it had been placed in service midway through the last quarter. Using the IRS tables for the mid-quarter convention, your depreciation deduction for the PC is reduced to just $250 (5 percent times $5,000).

Usually, business owners will buy just enough equipment before the fourth quarter to avoid this tax trap. However, if you need to replace equipment early in the year, you can trigger the mid-quarter convention on purpose. Sound crazy? Like a fox.

Example: Early bird gets the worm

Say your company needs $20,000 in computer equipment, so you buy it in February. The only other asset you expect to buy this year is a $15,000 machine that is a seven-year MACRS asset.

In the usual situation, you wouldn’t buy the machine after September because that would exceed 40 percent of all depreciable assets placed in service during the year. And you don’t want to trigger the last-quarter tax trap.

Unconventional advice: Buy the machine after September and place it in service before Jan. 1. Under the mid-quarter convention, the depreciation deductions of $7,000 for the equipment (35 percent times $20,000) and $535 for the machine (3.57 percent times $15,000) add up to $7,535.

Conversely, with the half-year convention, the first-year deductions would have totaled $6,144. That’s $4,000 for the computer equipment (20 percent times $20,000) and $2,144 for the machine (14.29 percent times $15,000). That equals $1,391 less than the deduction you can claim using the unconventional strategy.

Final tip: If your plans go awry before the end of the year, you can fall back on the Section 179 expensing deduction to bail you out. For 2006, the maximum deduction allowed is $108,000, regardless of the time of year any of the equipment is placed in service.

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