By Larry R. Gearhardt, Director of OSU Tax School
The depreciation deduction (usually MACRS method) for assets used in a trade or business has always been very important to farmers when preparing their income tax returns. In addition to MACRS, the “fiscal cliff” legislation, passed early in 2013, allows two additional cost recovery deductions in the year a depreciable asset is placed in service. Click here to view the IRS news release on the fiscal cliff changes to depreciation.
First, Code Section 179 allows the entire cost of qualifying assets to be deducted in the year they are placed in service, subject to some dollar and income limitations. Second, Code section 168(k) allows 50% of the cost of qualifying property to be deducted as additional first year depreciation (AFYD) for property placed in service in 2012 and 2013. Since MACRS depreciation, Section 179, and AFYD can all be applied to the same asset, whichever method you choose, or a combination of all three, deserves attention as a planning tool to minimize taxes both now and in the future.
Section 179 Property
Many taxpayers are eligible to deduct (in lieu of depreciation) the cost of most tangible personal property used in the active conduct of a trade or business. The taxpayer can elect on Form 4562 to expense the cost of eligible “Section 179 property.” Under the old law, this deduction was limited to $139,000.00 for 2012 and $25,000.00 for 2013. The new legislation increased the amount that can be deducted under section 179 to $500,000.00 for 2013 and $500,000.00 retroactive to 2012. This deduction can be used for both new and used equipment.
“Eligible property” that qualifies for Section 179 includes: Machinery and equipment; Property contained in or attached to a building (other than structural components), such as milk tanks, automatic feeders, barn cleaners, and office equipment; Livestock, including horses, cattle, hogs, sheep, goats, and mink and other fur-bearing animals; Grain bins; Single purpose agricultural (livestock) or horticultural structures; and Agricultural fences and drainage tile. You cannot take the expense for drainage tile if the costs of installation were paid by a government agency. Land improvements do not qualify.
Some limitations apply to Section 179 property. First, the deduction is limited to the taxpayer’s new basis in the property. This means that if eligible property is acquired through a like-kind exchange (such as a trade-in allowance), only the “boot” payment can be expensed. Second, the expense deduction is limited to the amount of taxable income received by the taxpayer from conducting any of his active trades or businesses. This includes taxable income from Schedules C, E, or F. The unused expense deduction can be carried forward and used in following years. The Section 179 expense deduction can be used to offset income, however, the deduction cannot be used to create a “loss” from income. Third, taking the Section 179 expense deduction reduces the basis in the property the same as taking depreciation. If the property is sold before the end of its useful life, the taxpayer will be subject to “recapture” of the deduction.
A taxpayer can elect on Form 4562 not to take the Section 179 deduction, or take a portion of the deduction. If the taxpayer elects to not use Section 179, or a portion thereof, the remainder defaults to AFYD.
Accelerated First Year Depreciation (AFYD)
The new legislation continued into 2013 the additional 50% first year bonus depreciation deduction on qualified property. “Qualified property” is tangible personal property that qualifies to be depreciated under the MACRS method with a recovery period of twenty years or less. This deduction can only be used when purchasing new property and the taxpayer must be the original user of the property. Land does not qualify for depreciation, but buildings and other real property improvements can be. Property used solely for personal use does not qualify. Property that is used less than 50% in the business does not qualify.
If you do not want to take the AFYD and utilize more depreciation in later years, you can elect, for any class of property, not to deduct the special depreciation allowance for all property in such class placed in service during the tax year. Please note that this differs from the Section 179 deduction where you can elect not to take the deduction for various items of property. To make the election, attach a statement to your return indicating the class of property for which you are making the election. If the AFYD is not claimed, the asset will be depreciated over time according to the taxpayer’s common method of depreciation.
The Section 179 expensing election and AFYD are powerful tools to manage income taxes. They do not increase the deduction relating to a purchase; rather, they allow a farmer to time manage purchases and deductions. Section 179 and AFYD allow for a larger deduction in the first year and smaller deductions in future years. Since Section 179 and AFYD can have both a cash flow and income tax effect, it is important for the taxpayer to understand their capabilities and make decisions in consultation with their tax professional.
More information about each of these depreciation methods can be found on the Internal Revenue Site at http://irs.gov