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Move quickly to collect big depreciation write-offs

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in Small Business Tax,Small Business Tax Deduction Strategies

The enhanced Sec. 179 deduction is a tax bonanza for small business owners. You can write off up to $250,000 of new business assets placed in service in tax years beginning in 2009.

But remember:
The Sec. 179 deduction is limited to the amount of annual taxable income from the business (calculated before the deduction). If 2009 has been a down year—like it has for many small business owners—your allowable Sec. 179 deduction may be miniscule or nonexistent. That generally means you must write off costs under the regular depreciation rules.

Strategy: Buy new assets soon and place them in service before Oct. 1 (assuming your business uses a calendar tax year). Otherwise, you can fall into a tax trap that will result in a reduced depreciation deduction.

If you beat the Oct. 1 deadline, you can benefit from the equivalent of a half-year’s worth of depreciation—regardless of the amount of your taxable income.

In any event, you may still qualify for the 50% “bonus depreciation” deduction for certain assets placed in service in calendar year 2009. This includes new property with a cost recovery period of 20 years or less.

Here’s the whole story: Under the Modified Accelerated Cost Recovery System (MACRS), business assets placed in service anytime during the year generally are 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, a special tax rule is triggered if the cost of business assets placed in service during the last quarter of 2009—Oct. 1 through Dec. 31—exceeds 40% of the cost of all assets placed in service during the year. (Note: Real estate is not counted for this purpose.) As a result, your depreciation deductions for all assets placed in service during the year are figured under the “midquarter convention.”

How it works: The depreciation deduction 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). For instance, a business that places equipment in service during the last three months of the year is entitled to only 1½ months’ worth of depreciation.

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

If you’ve been putting off purchasing business assets due to slow cash flow, you may want to get in gear.

Case study: The benefit of buying by Oct. 1

Let’s say your company buys a new machine costing $50,000 on Oct. 15. This is the only equipment it purchases in 2009. Because your company has no taxable income for the year, it does not qualify for a Sec. 179 deduction.

First, you can write off 50% of the cost as bonus depreciation, or $25,000. Using the MACRS depreciation tables, the remaining $25,000 cost is depreciated over a seven-year period. Normally, the first-year deduction would be $3,572 (14.29% of $25,000), based on the half-year convention, for a total of $28,572 ($25,000 + $3,572).

But your company falls into the depreciation tax trap. Reason: More than 40% of the cost of the annual cost of business assets placed in service in 2009—actually, 100% in this case—is placed in service in the last quarter.

Thus, your company must compute its depreciation deduction using the midquarter rule. Result: The deduction is reduced to only $892 (3.57% of $25,000) for a total of $25,892, or $2,680 less ($28,572 – $25,892).

Just a few days can make a big tax difference. For instance, if you buy the machine and have it operating by Sept. 30, you’ll be able to preserve the bigger deduction for 2009. If you simply don’t have the funds on hand and don’t want to finance the purchase, you might wait until 2010.

Tip: If you claim a Sec. 179 deduction, the cost of those assets is removed from the last-quarter calculation. This might bail you out of the last-quarter tax trap, assuming no problem with the taxable income limitation (see box).

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