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The theory behind depreciation expense is that when you buy a fixed asset, it's used to earn income over a length of time longer than a year and should be expensed over a period of years. This is the basis of the matching principle--the timing of recognizing revenue should match that of recognizing its attached expenses.
Then the IRS gets involved and logic goes out the window! This is where the concepts of book and tax depreciation arise. Book depreciation is based on the company's estimates of actual asset life, and is usually as simple as dividing cost by estimated life to determine the yearly amount to expense until the asset is fully depreciated on the financial statements. Most small businesses use tax depreciation for their internal bookkeeping.
The Internal Revenue Code (IRC) requires taxpayers to expense capital equipment purchases and buildings over their lifetimes and not in the year they are purchased. However, there is an exception to this under code section 179 whereby, as long as there is taxable income to offset, a certain amount of equipment purchased during the year can be written off all at once; this doesn't apply to buildings.
The amount of tax depreciation allowed is arbitrary and set by the Code under the Modified Accelerated Cost Recovery System (MACRS). The depreciation percentage allowed is front-loaded or "accelerated" in the first few years. Non-real estate asset classes have depreciation schedules such as three, five, seven, 10 and 15 years. For example, office furniture is considered seven-year property and is written off over that length of time. (Automobiles have their own set of rules and limitations that will be the subject of a future article.) Residential real estate is depreciated over 27.5 years and non-residential real estate is depreciated over 39 years. Land is never depreciable because it doesn't wear out.
The Section 179 Expense election mentioned above is a great way to save tax and also match revenue and expense. Please keep in mind that it may not be a good idea to use it if you have a loss for the year and that you must make the election in the year the equipment is purchased.
If, for example, you pay cash for a $3,000 computer, you may want to write it off entirely this year. If you depreciate the computer over the five years allowed, you may pay tax on income generated and fully spent this year but that's not fully deductible on your tax return. In other words, you're allowed to determine the amount you want to expense so you can match your cash outflow. So if you had financed the computer purchase and only paid $500 this year and plan to pay the $2,500 balance in the future, you might not want to expense the entire purchase price this year. Why? It means you'll be paying off the loan with income generated in future years with no offsetting expense.
Whether or not to make large fixed asset purchases before year end is another planning opportunity, but requires a lot of consideration. For example, I have a plumber client, a calendar year taxpayer, who needed a new truck for his employee. He had the choice of purchasing it and placing it in service at the end of December or the beginning of January. We considered pending tax law changes, rate changes, taxable income from the business and other aspects of his personal return before we made our decision: to purchase the truck in the current year since we expected his business income to decrease because of the economy and because he had a large upcoming college tuition bill.
There is also a complicated rule, the Mid-Quarter Convention, that reduces the amount of depreciation you can take if most of your assets are purchased in the last quarter of your tax year. This is something you and your tax professional should consider when discussing the timing of your purchases. When buying large assets, there are many traps to fall into, so involve your tax professional before you write the check
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