Update on Basic Fixed Asset Considerations for Your Business
Fixed asset considerations are often neglected because taxpayers do not understand how to properly handle them for tax purposes. Proper fixed asset operations are essential to maximize your tax benefit and to prevent audit issues with the Internal Revenue Service (IRS). Improper tax classification of fixed assets can lead to IRS audit issues where the tax deduction can be disallowed for the open statutory period and any years going forward.
This updated article will touch briefly on seven key fixed asset tax considerations and cover the basics of each operation.
Section 179 or Bonus Depreciation (if applicable)
The first consideration is whether you will apply section 179 expensing to any qualified asset. Generally you can expense a certain amount of fixed assets instead of capitalizing them and depreciating over their class life. In 2015, section 179 expensing was permanently set at $500,000, with a 2 million investment limit before phase out of the 179 deduction with indexing to inflation starting in 2016. Usually a taxpayer will take 179 when they would otherwise have taxable income and want to reduce that income in the current tax year at the expense of future tax deductions for the depreciation. Bonus depreciation allows for 50% of the cost basis of the asset to be taken as depreciation in the first year with the balance of the cost basis being taken over the asset’s class life. Bonus depreciation is a tax device used by Congress to try and spur asset purchases and is mandatory unless you opt out for an entire class of assets. Bonus depreciation was extended through 2019 but the percent of deduction goes down. For 2015-2017 the percent of deduction is 50%, then down to 40% for 2018 and 30% for 2019- the final year before expiration of the deduction.
Placed In Service
The placed in service date is not the same as the purchase date. The placed in service date is the date generally when the asset starts being used by the trade or business. The tax deduction can be timed based on when the taxpayer will get the maximum benefit.
Classification of Property/Recovery Period
The IRS has set guidelines on the period over which the asset should be depreciated. The classification/recovery period (or class life) is supposed to represent the general useful life of the asset before it wears out or is obsolete. The guidelines for class life are complex and open to interpretation.
Your cost basis in the asset is the purchase price plus any other costs to place the asset in service. You do not include any amounts expensed under section 179, or any percentage of the asset that is not used in a trade or business.
This classification determines how much depreciation you take in the assets first year. Most assets get a half year of depreciation in the first year no matter when you place them in service. There are many exceptions to this general rule, including real property (which starts depreciating half way through the month the asset is placed in service), and the mid quarter convention for when more than 40% of your fixed assets are placed in service in the last quarter.
Most taxpayers use the "MACRS" (Modified Accelerated Cost Recovery System) to depreciate fixed assets for tax. It allows for accelerated depreciation (accelerated versus straight line) so the taxpayer gets more deprecation during the first few years of the assets life than the last few years. There are different methods for assets placed in service in the past (pre 1986), Alternative Minimum Tax depreciation, or depreciation for real property (commercial or rental).
Certain property (mostly automobiles) has special depreciation rules as a subset of the other depreciation rules. Generally, they get less depreciation early on and have to take longer to fully depreciate the asset (most people sell or otherwise dispose of the asset before it is fully depreciated).
Fixed assets, like most tax topics, are very complicated and require consideration of many factors (not all of which are listed above). Making a mistake on how you assign a class life, or assign the placed in service date can open you up to an audit adjustment by the IRS if you are unlucky enough to have your fixed assets examined. If you have any questions on these topics you should consult your tax advisor.