Depreciation’s Many Options
We trust that you are still keeping yourself, your loved ones, and your community safe from the Coronavirus (“COVID-19”) as we approach the Christmas Season. As at the time of writing this article the outcome of the election has not been finally determined. Given the federal expenditures in fighting COVID-19, the election’s final outcome really may not matter in avoiding future higher tax rates. There will be a need for additional federal revenue. With that prospect in mind, this article will discuss tax depreciation with the many options available in its calculation. These varied options provide opportunity for delayed tax planning. Understanding these options may be more critical now than ever before.
What is Tax Depreciation
Tax depreciation is the recovery of the cost of property used in a trade or business or investment property held for the production of income. Depreciation deductions are not allowed for any personal activities or use. The Internal Revenue Code (IRC) Section 168 directs taxpayers to use the applicable and allowable rules for depreciation of their business or investment property.
Before we get into the mechanics of depreciation let us look at the options to simply deduct an acquired asset. Assets may be fully deducted under two options Section 179(“§179”) and /or Bonus Depreciation. Once a decision is made on these options any remaining basis in assets will be available for multi-year depreciation. Remember that the Section 1031 like kind exchange rules only apply to real property. Traded tangible assets must be reported as a sale while the new tangible asset’s cost is subject to full write off or depreciation.
Section 179
The Tax Cuts and Jobs Act (TCJA) enhanced the §179 deduction. For 2020, the limits are to the total amount written off $1,040,000, and limits to the total amount of the equipment purchased $2,590,000. The deduction begins to phase out on a dollar-for-dollar basis after $2,590,000 is spent by a given business thus, the entire deduction goes away once $3,630,000 in purchases is reached. The §179 deduction applies to both new and used business equipment. Because it applies to 15-year property or less, it does not apply to farm buildings, but can be used for single purpose agricultural structures, such as hay or feed barns. A §179 election may be revoked on an amended return without IRS consent. Once the election is revoked, it cannot again be elected for the same tax year. Note §179 deduction is also subject to earn income limitations. It cannot create a loss.
Bonus Depreciation
The TJCA also increased additional first-year depreciation, also called “bonus depreciation”, by increasing the allowable amount to 100%, with a phase-down to sunset in 2026. Under this provision, ranchers can claim an additional first-year tax deduction equal to 100 percent of the value of qualifying property placed into service after September 27, 2017 through December 31, 2022. Congress then reduced the depreciation amount to 80 percent in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026. The bonus depreciation deduction, which is available for new and used property, applies to farm buildings, in addition to equipment. Unlike the §179 expense allowance, there is no limit on the overall amount of bonus depreciation that a rancher may claim.
Trees or Vines
Farmers may choose to deduct 100 percent of the cost of planting trees or vines that bear fruits or nuts in the year of planting. Without this special provision, all tree and vine farmers are required to capitalize planting costs, rather than deduct them. This special provision is only in place through 2026.
Vehicles
The TCJA allows $8,000 in additional first-year depreciation for passenger automobiles and light trucks under 6000 lbs gross vehicle weight (“GVW”) placed in service in 2019 to 2022. If placed in service in 2020, first year depreciation without bonus is $10,000. With bonus it is $18,000.
SUVs with a gross vehicle weight rating above 6,000 lbs. are not subject to depreciation limits. They are, however, limited to a $25,900 §179 deduction for 2020. Depreciation and §179 limits do not apply to SUVs or trucks with a GVW more than 14,000 lbs.
Trucks and vans with a GVW rating above 6,000 lbs., but not more than 14,000 lbs., generally have the same limits as the SUV: no depreciation limitation, but a $25,900 §179 limit. These vehicles, however, are not subject to the §179 $25,900 limit if any of the following exceptions apply:
The vehicle is designed to have a seating capacity of more than nine persons behind the driver's seat;
The vehicle is equipped with a cargo area at least 6 feet in interior length that is an open area or is designed for use as an open area but is enclosed by a cap and is not readily accessible directly from the passenger compartment; or
The vehicle has an integral enclosure, fully enclosing the driver compartment and load-carrying device, does not have seating behind the driver's seat, and has no body section protruding more than 30 inches ahead of the leading edge of the windshield.
Fertilizer and Lime
Under IRC §180, taxpayers engaged in the business of ranching may elect to immediately expense the cost of fertilizer and lime even if benefits last substantially more than one year, rather than to capitalize the expense and depreciate it over the term of its useful life. The election is for one year only. Once made by taking a deduction on schedule F, it may not be revoked without the consent of the IRS. Tax planning option, think before you deduct.
Other Deprecation Considerations
When to start depreciation
Generally, the date when the asset is acquired is an indication of when the property is depreciable. However, the IRC uses the terms such as “placed into service” or “available for service” to provide guidance as to when depreciation is allowed as an expense. The rancher should plan for late equipment purchases to accurately determine when the asset is placed into service.
Example:
Hay baler may be delivered and on the ranch before December 31st, could it have been used if there was no hay to bale? In such a case, the equipment was not placed into service because all of the acres of hay were harvested at the time the equipment was purchased. A possible solution is for the rancher to leave a field to harvest with the newly acquired equipment. A position may be taken that it was “available for use” but why open the issue when a small hay field is an option.
Must depreciate correctly
The terms “allowed” and “allowable” have been used in the context of calculating the depreciation expense for ranch businesses. IRS rules provide methods to calculate the depreciation that are for “ordinary and necessary” business or investment activities based on the rancher’s elections. These are “allowed” as expense deductions against business or investment income for the tax year being reported by the rancher. To not take the proper depreciation is a bad answer. Upon the disposition of an asset the IRS generally takes the position that the depreciation foregone would have been “allowable” – and as such, the taxpayer must reduce the cost of the property as if depreciation would have properly been taken and gain is recognized in that year. Making the correct elections is very important
What to depreciate
If an item of property qualifies for both §179 and bonus depreciation expensing, the §179 expensing amount is computed first, and then bonus depreciation is taken based on the item’s remaining income tax basis. Note for fiscal taxpayers, §179 expensing is based on when the taxpayer’s tax year begins, whereas bonus depreciation is tied to the calendar year. To simply state the options, expensing under §179 is an “election in” however the presumption of the depreciation rules is that the rancher uses bonus depreciation, thus it is an “election out” of using bonus depreciation. The election not to use bonus depreciation is made on a class by class basis and affects all assets purchased within the class. Think hard and review/do your multi-year tax plan before making this decision. Ranchers cannot modify their bonus depreciation choices on an amended return.
Modified Accelerated Recovery System (MACRS)
Once the elections under §179 and bonus depreciation are made any remaining basis of assets will be subject to the regular tax depreciation rules. Since January 1, 1987, taxpayers have been using the depreciation system the MACRS which was enacted as part of Tax Reform Act of 1986. This system is applicable to most tangible personal property which taxpayers use in their business or investment activities. There are two sub-systems taxpayers may use to depreciate property. Either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) may be used by the taxpayer. The General Depreciation System provides for a choice between three methods to calculate the annual allowable depreciation. The recovery-periods for GDS using the class life system are: 3-, 5-, 7-, 10-, 15-, 20-, 25-, 27.5-, and 39-years. Three GDS methods are listed below.
200 percent-declining balance method allows the farmer/rancher to “load” depreciation in the first half of the class life and then converts to straight-line values. The conversion to straight-line occurs when the allowable deprecation is greater when compared to the declining balance calculation. For assets falling in the 27.5- and 39-year asset classes, straight-line calculations are used.
150 percent-declining balance method is like the 200 percent-declining balance method, except that the depreciation calculations are not as large in the early part of the class life before converting to straight-line values.
Straight-line method simply divides the cost of the depreciable property by the appropriate class life resulting in the allowable yearly depreciation amount.
The ADS option provides a rancher an opportunity to choose a longer life over which to recover the cost of tangible business property. ADS requires the use of straight-line depreciation over lengthened class lives, thus, slowing down the cost recovery of personal property used in business. The class lives under ADS are: 3-, 4-, 5-, 6-, 7-, 10-, 12-, 15-, 20-, 25-, 30-, and 40-years.
The Tax Cuts & Jobs Act modified MACRS to provide that ranchers will use the 200 percent DB method for assets placed into service after December 31, 2017, unless they elect to use another option. Ranch assets with a 15-year or 20-year GDS life continue to be depreciated using the 150 percent DB method. To elect to use the 150 percent DB method, farmers enter 150 DB in column (f), Part III of Form 4562. To elect to use straight line, farmers enter SL in column (f), Part III of Form 4562. To elect to use ADS, farmers complete line 20 in Part III of Form 4562. These elections must be made on timely return (with extension) however, ranchers may make a late election on an amended return within six months of the due date.
IRS rules allow for the full recovery of personal property used in the course of trade or business over its depreciable life, however, there are rules called “conventions” that apply depending on when an item is purchased/placed in service. Thus, three conventions were established to create “fairness” when calculating depreciation amounts for the first year. They are as follows
Half-year, the rancher is allowed one-half of the first year’s calculated depreciation. Therefore, an asset within the five-year recovery life will be depreciated over six years in which the sixth year captures the “last half” of the first year’s depreciation not taken at that time.
Mid-quarter convention is triggered when the rancher purchases 40 percent or more of his or her depreciable assets in the fourth quarter of the business’s tax year. When mid-quarter convention is required, the depreciation of assets acquired by purchase begins with a mid-quarter adjustment based on the quarter in which they were acquired.
Mid-month convention is applicable to cost recovery of residential and non-residential (commercial) buildings. As discussed earlier, 27.5- and 39-year assets use straight-line method to calculate allowable depreciation. Therefore, the mid-month calculation is one-half of the first month’s depreciation amount.
Summary
As previously stated in our other resent articles, significant amount of effort will be required to accomplish good tax compliance and planning this year because of the Secure Act, the CARES Act and the November election. Businesses should clearly communicate with their tax professionals about all of their property purchases through the course of the tax year. This will help prevent errors of over or under-reporting the asset deductible expenses and help provide flexibility in arriving at optimum tax planning. Explore year end options. Nobody knows when new tax legislation might be enacted and what the new rules may be. As discussed in last month’s article. the CARES Act has created uncertainty in the deductibility of a number of expenses. With the many alternative elections available for deducting expenditures, time should be taken this year to get a good look at your 2021 year’s operations. Your tax adviser should be able to help you develop a good multi-year tax strategy to minimize you overall tax liability.