Understanding Depreciation

Many items we buy for use in business can be expensed in the year purchased. This

means the value of office supplies, some computers and furniture, and other items

needed to operate a business can be placed on the profit and loss statement as an

expense which reduces net income. However, not all items we buy are allowed to be

expensed in the current year and must be capitalized. So, instead of being able to

“write-off” the entire item as an expense, we must put the new asset on the balance

sheet and expense slowly over the life of the asset. This is known as depreciation.

Asset vs. Expense

Items that cost $2,500 or less can be expensed in the current year if a business elects

what is known as the de minimis safe harbor rule under Treasury Regulation §1.263(a)-

1(f)(1)(ii). This allows small businesses to operate without the burden of having to

depreciate most items purchased. These expensed items would reduce net income and allow small businesses to minimize their tax liability in the year the items were

purchased. However, if an item over $2,500 is purchased, it must go on the balance

sheet to be depreciated over the item’s class life. Class lives are defined by the IRS and

mimic the expected useful life of an asset. These lives can be anywhere from 3 years to 39 years depending on the type of asset. There are other items such as real property that must be capitalized and may not be expensed in the current year. Further still, there are items that must be capitalized and may never be depreciated because it is said to have an indefinite useful life (i.e. no wear and tear). Land is an example of such an asset.

Effect on Income

When you are able to expense an asset in the current year versus placing it on the

balance sheet, net income will be lower. Conversely, if you must put that same asset on the balance sheet, net income will be higher because you must expense the asset over time instead of immediately. This is why finding a way to take early depreciation

deductions is so powerful. There is a caveat to this though. Depending on the type of

asset, it is possible that when you sell the asset, you will have to recapture the

depreciation deductions taken in prior years. This is a way for the government to give

you a break early and then reclaim taxes on income it lost in earlier years. Remember,

there is almost never a free lunch.

Bonus Depreciation

For certain assets over $2,500 that must be capitalized that aren’t real property or land, there is the ability to use Section 168(k) of the Internal Revenue Code which allows bonus depreciation in the year you purchase the asset. Known as bonus depreciation, the percentage deduction this provision allows used to be adjusted often. However, the One Big, Beautiful Bill Act permanently made bonus depreciation 100%. This means your large piece of equipment that cost $10,000 can be depreciated in its entirety in the year you purchased it. One thing to think about when you use bonus is that certain states do not conform to federal provision on bonus depreciation and may require you to add back to income the difference between regular state depreciation and federal bonus depreciation for state tax purposes.

Section 179 Expensing

Section 179 of the Internal Revenue Code allows expensing of certain assets in the

current year of purchase. The difference between this and Section 168(k) from an

accounting perspective is that Section 179 allows you to move the cost of the assets to

the profit and loss statement and so those costs as expenses. Section 168(k) would still require you to show the asset on the balance sheet, but you would take depreciation expense against that asset for the full amount of the asset. The balance sheet would then show the full value of the asset netted against accumulated depreciation, beginning the carrying cost of the asset on the balance sheet to zero. Section 179 allows businesses a $2.5 million expensing cap and it cannot create a net loss for the entity. Any excess Section 179 that would otherwise cause a net loss must be suspended and carried forward future year. From a state perspective, the same

conformity issue discussed above for bonus depreciation mat also apply to Section 179.

Conclusion

Depreciation is a powerful tool to help lower net income without disturbing your cash

flow. It is a great year-end planning tool and should be considered as one of the

methods used to help minimize your tax burden. However, depreciation rules are

complicated and cumbersome. We have only scratched the surface here. In addition,

while depreciation is a great way to lower income in the current year, there are

potentially state tax consequences and federal recapture issues because of accelerated federal depreciation. For more information on depreciation and/or year-end planning, please contact us at 571-445-0201 or abs@westhighlandtax.com