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Turn depreciation deduction rules upside down

by on
in Small Business Tax,Small Business Tax Deduction Strategies

If you go by the book, you should buy equipment late in the year. Reason: Under the Modified Accelerated Cost Recovery System (MACRS), you can claim a depreciation deduction based on a half-year’s use, even if you use the equipment only for a few days in the year.

Of course, you might not be able to wait that long to replace outdated or obsolete equipment.

Strategy:
Load up on necessary equipment purchases early in the year. Thanks to a little-noticed wrinkle in the MACRS rules, you can come out ahead taxwise if you buy more equipment later. Plus, you’ll have access to the equipment when you really need it.

Here’s the whole story:
Normally, a new business asset is treated as if it were placed in service midyear, regardless of when that actually occurs. This is called the “half-year convention” in tax parlance. For five-year MACRS property, the first-year write-off under the half-year convention is equal to 20% of the cost. The deduction is 14.29% for seven-year property under the half-year convention.

For instance, since computers are five-year property, you can write off $1,000 for a tricked-up $5,000 PC or Mac system, even if it is placed in service as late as Dec 31.

Potential tax trap: If the cost of depreciable assets (not counting real estate) placed in service in the last quarter of the year—Oct. 1 through Dec. 31—exceeds 40% of the total cost of depreciable assets placed in service in the year, depreciation deductions are figured under the “midquarter convention.” So the computer would be treated as if it had been placed in service midway through the last quarter. Using the IRS tables for the midquarter convention, your depreciation deduction would be slashed to just $250 (5% of $5,000).

Frequently, 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 might want to trigger the midquarter convention intentionally. It’s not as crazy as it sounds.

Example: A method to the madness

Let’s assume you don’t qualify for Sec. 179 deductions. Your company needs $20,000 in computer equipment right away, so you buy it this month. The only other business asset you expect to purchase this year is a $15,000 machine that is seven-year property. Typically, you would not buy the machine after Sept. 30 because the cost exceeds 40% of the cost of all business assets placed in service during the year. 

Better move: Buy the machine later this year and place it in service before Jan. 1. Under the IRS table for the midquarter convention, the depreciation deduction is $7,000 for the computer equipment (35% of $20,000) and $535 for the machine (3.57% of $15,000). Total MACRS deduction: $7,535.

Conversely, if you had qualified for the half-year convention, the first-year deductions would have added up to $6,144: $4,000 for the computer equipment (20% of $20,000) and $2,144 for the machine (14.29% of $15,000). That’s $1,391 less.

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