Expensing Election Under Section 179

By Melvyn Poswolskyp

In Brief

Whether 'tis nobler to take the benefits of depreciation ...

Taxpayers--both individuals and businesses--can deduct up to $20,000 in expenses in tax year 2000 for purchases of qualifying IRC section 179 property. The allowable deduction amount increases each year.

However, maximizing the benefit of the rules requires close examination and planning. Taxpayers and their advisors need to consider how the property will be used (more than 50% for business use is required) and how it is acquired (for example, spousal transactions are disallowed).

With the right information and circumstances, the numbers will fall into place.

The expensing election under IRC section 179 lets taxpayers fully deduct the cost of an asset in the year of purchase instead of claiming yearly depreciation deductions. A deduction of up to $20,000 is available to taxpayers in 2000 in lieu of depreciation. The expensing election also results in several tax breaks:

* If the expensing deduction creates a business loss (other than through a passive activity), that loss is available to offset other business income and compensation income (W-2 earnings) of the taxpayer that owns the business and the taxpayer's spouse.

* An asset purchased in the last three months of a tax year may be subject to a limited depreciation deduction based on a midquarter depreciation convention; directly expensing the asset can avoid the disadvantageous midquarter depreciation computation.

The expensing election was $17,500 in 1996; legislation that year increased the expensing election as shown below:

Tax YearAmount
2003 and after25,000

The proposed Taxpayer Refund and Relief Act of 1999 (HR 2488) would increase the expensing election to $30,000 beginning in 2000.

Eligible Property

To be entitled to the expensing election, taxpayers must purchase qualifying property used in the active conduct of a trade or business. Tangible personal property, such as automobiles, office equipment, and machinery, is generally eligible. Real estate and structural components, such as central heating and air-conditioning systems, do not qualify.

"Acquired by purchase" does not include purchase from a spouse, ancestor, lineal descendant, certain controlled corporations, partnerships, or other related entities. Property that the taxpayer acquired with a carryover or stepped-up basis usually is not eligible for the expensing deduction. Thus, property acquired by gift, inheritance, tax-free or like-kind exchange, or involuntary conversion will generally not qualify for the expensing election.

Planning Opportunity: A purchase by a spouse from an in-law will qualify the asset for the expensing election. Also, purchases from brothers and sisters qualify for the expensing election.

The taxpayer must use the property acquired in the active conduct of a trade or business, as opposed to using the property in the production of income. Finally, the taxpayer must use the property more than 50% in the active conduct of a trade or business.

Example: Helen purchases a computer for $3,000. Two-thirds of its use is for her business and one-third to manage her investment portfolio. Two-thirds of the cost, or $2,000, qualifies for the expensing deduction. If the fractions were reversed--that is, one-third use in business and two-thirds use for investments--no expensing deduction would be available.

Taxpayers must recapture as ordinary income any expensing deduction they claim on property that they no longer use more than 50% in the active conduct of a trade or business prior to the end of the property's assigned depreciation recovery period. This rule applies when the percentage of business use is 50% or less, or when the asset is sold.

The taxpayer determines the amount to be recaptured by subtracting from the expensing deduction the depreciation that would have been allowable on the expensed amount for any prior tax years and the tax year of recapture. The recaptured income is reported on Form 4797, Sales of Business Property.

To claim the full $20,000 expensing deduction, taxpayers must purchase assets that cost a total of $20,000. Cost does not include the basis of previously owned property traded in for new property.

Example: Harry purchases new equipment for $20,000. He pays $9,000 cash and trades in an old machine with an adjusted basis of $7,000 (fair market value $11,000). His basis in the new equipment is $16,000, but his available expensing deduction is limited to $9,000.

The $20,000 expensing deduction is reduced on a dollar-for-dollar basis when the total cost basis of all qualifying assets placed in service by the taxpayer during a tax year exceeds $200,000. Thus, the availability of the expensing deduction will be completely phased out once new asset purchases reach $219,000 in the 2000 tax year. No carryover of the expensing deduction is allowed, due to the $200,000 asset purchase limitation.

Taxable Income Limitation

The total expensing deduction in each year is limited to the taxable income from the active conduct of a trade or business. Taxable income is computed as usual but without taking the expensing deduction. The amount of any expensing deduction that is not deductible due to the taxable income limitation may be carried forward indefinitely to future tax years and added to the cost of property qualifying for the expensing election placed in service in later years.

Therefore, if the expensing deduction is not allowed due to the taxable income limitation, the taxpayer treats the amount not allowed as a purchase of qualifying property in the carryforward years. The annual limitation and the $200,000 phaseout limitation apply in the carryforward year to determine whether the deduction carried forward into that year is allowable.

Example: In 2000, Julia places in service a machine that costs $24,000. Julia's taxable income for 2000 (determined without regard to the cost of the machine) is $4,000. Julia's maximum expensing deduction is limited to $4,000. She can carry forward to year 2000 the $16,000 not allowed because of the taxable income limitation.

Planning Consideration: The taxable income limitation prevents the use of the expensing deduction to create a loss. A better strategy may be to forgo the expensing deduction and claim regular depreciation deductions, because a loss can be generated through a depreciation deduction. However, once a taxpayer makes the election not to take the expensing deduction, no carryforward deduction will be available.

A carryforward may not be beneficial if the income limitation will apply in future years. The formula in Exhibit 1 maximizes the allowable expensing deduction and provides for depreciation of the remaining balance without exceeding the taxable income limitation.

Married taxpayers filing separate returns are limited to one $20,000 expensing deduction. They can allocate the $20,000 between themselves in any manner they wish. If they do not agree to an allocation, each will be allowed 50% of the cost of the qualifying property, regardless of which spouse actually paid for and acquired the property.

The $20,000 annual limitation applies separately to a partnership and each of its partners and to an S corporation and each of its shareholders. So the partnership or S corporation gets one $20,000 expensing deduction, which is then allocated and passed through to the partners and shareholders. The partners or shareholders add the passed-through amount to any other qualifying assets purchased in computing their own separate $20,000 expensing deduction. (S corporations and partnership rules that limit deductions and losses to the tax basis of the business owner also apply to the expensing deduction.) If the partnership or S corporation purchases assets in excess of the $200,000 limitation, the partners or shareholders lose part of their available expensing deduction.

Tax Trap: A taxpayer that owns more than one flow-through entity or owns a sole proprietorship and one or more flow-through entities is limited to one overall $20,000 expensing deduction no matter how many separate businesses are involved. If such a taxpayer exceeds the annual dollar limitation, the amount of the total flow-through deduction that exceeds this dollar limit cannot be carried forward to future years. However, the owner must reduce her basis in the flow-through entity for the entire amount of the flow-through deduction, including the portion that was not deductible. Thus, by reducing basis, the owner will never be able to deduct the excess amount, even upon selling the interest in the entity.

Planning Opportunity: A taxpayer can meet the taxable income limitation to deduct the $20,000 first-year expensing election by using net income from all actively conducted trades or businesses, including income from gains from the sale of a business asset. Also, wages and salaries as an employee count as business income.

Example: Robert is a sole proprietor operating a business that shows a net loss of $6,500 in 2000 before deducting any depreciation (The business is not a passive activity). Robert buys office equipment of $20,000 during the year. He also works as an accountant and gets a W-2 with taxable wages of $75,000.

* The $75,000 earned as an employee counts in determining the taxable income limitation and allows the full $20,000 expensing deduction.
* Robert can deduct the $26,500 combined loss from his sole proprietorship this year.
* Because the taxable income limit is applied to spouses filing jointly on a combined basis, the salary of one spouse is considered as taxable income allowing a section 179 expensing deduction if the other spouse's proprietorship is operating at a loss. Thus, if Robert's wife was the W-2 wage earner, the $26,500 expensing deduction would still be available.

Taxpayers claiming the expensing deduction must reduce the basis of the property by the amount they deduct for purposes of calculating depreciation deductions on the remaining portion of their basis in the property. The expensing deduction is computed before any depreciation deduction is calculated.

Example: Terry purchases qualifying five-year depreciable property at a cost of $14,000 on June 18. The taxable income and $200,000 limitations do not apply. Terry could claim $10,000 of the $20,000 expensing deduction and depreciate the remaining $4,000 basis ($4,000 * 20% = $800 depreciation deduction).

Planning Opportunity: If several assets are purchased during the year and the half-year depreciation convention applies, claiming the expensing deduction on the assets with the longest recovery periods will maximize depreciation deductions.

Example: Jane's business purchases two assets in 2000: a specially equipped truck that costs $20,000 with a five-year depreciable life and office furniture costing $20,000 with a seven-year depreciable life. Two of her options are shown in Exhibit 2.

Jane elects to claim the expensing deduction directly on Form 4562, Depreciation and Amortization, in the section provided for the tax year in which the property is placed in service. She can also make the election on an amended return filed before the due date (including extensions). Taxpayers can revoke the election only in extraordinary situations and with IRS consent.

Avoiding the Midquarter Depreciation Limitation

Modified Accelerated Cost Recovery System (MACRS) depreciation allows taxpayers to depreciate assets deducting a half-year's depreciation in the first year.

To prevent taxpayers from receiving the benefit of a half-year depreciation for assets purchased at the end of a tax year, a midquarter depreciation convention applies if more than 40% of the total depreciable property is purchased during the last three months of the tax year. This convention requires taxpayers to compute depreciation as if the asset were purchased in the middle of the quarter it is placed in service.

Planning Opportunity: A taxpayer that elects to claim the expensing deduction with respect to an asset purchased in the last three months of the tax year removes that asset from the computation of the 40% limitation. This omission will reduce the amount of assets considered purchased in the fourth quarter when determining whether the midquarter convention applies.

Example: Joe buys $27,000 of assets in June and $22,500 of assets in October. He bought more than 40% of the assets in the fourth quarter ($22,500 / $49,500 = 45.45%).

If Joe elects to deduct the $20,000 expensing election all for fourth-quarter purchases, he is considered to have bought only $2,500 in the fourth quarter and the midquarter convention will not apply ($2,500 / $49,500 = 5.05%) [Treasury Regulations section 1.168(d)-1(b)(4) and PLR 9126014].

Where the midquarter convention applies, taxpayers are allowed considerably less first-year depreciation for assets purchased in the fourth quarter of the tax year. To maximize depreciation deductions, a taxpayer should take the expensing election against the assets purchased in the fourth quarter.

Automobile Depreciation Limitations

The annual dollar limitations on automobiles apply to both the depreciation deduction and the expensing deduction. The combined depreciation and expensing deduction on a purchase of an automobile in 1999 was $3,060.

Example: Ted purchased an automobile for $20,000 in December 1999 to use 100% for business. This is the only asset he purchased during 1999 and a midquarter depreciation deduction computation would be required. The maximum depreciation using the midquarter convention for an automobile, in the five-year property class, would be 5%. A depreciation deduction of $1,000 (5% * $20,000) would be allowed. However, Ted can claim up to $3,060 as an expensing deduction instead of the depreciation deduction.

Alternative Minimum Tax

The expensing deduction is not considered an accelerated method of depreciation and does not result in an alternative minimum tax (AMT) adjustment. Taxpayers with potential AMT tax can reduce the depreciation AMT adjustment and the concomitant potential AMT tax by electing to expense the asset, or part of the asset, instead of claiming an accelerated depreciation deduction.

Consider the Options

Taxpayers can make the expensing election after the tax year-end in any amount up to the annual limitation, $20,000 for 2000. This flexibility gives many taxpayers the opportunity to calculate the benefits of an immediate deduction versus annual depreciation deductions. If a business is carried on by a self-employed individual, partnership, or S corporation operating at a loss, electing the expensing deduction can still result in a deduction against other trade or business income, including wages of both the individual business owner and spouse. *

Melvyn Poswolsky, JD, CPA, is an attorney and CPA with over 20 years of experience in tax planning for business entities and their individual owners; his practice also includes estate planning, estate administration, and the review and drafting of wills and trusts. He can be reached at (516) 935-6666 or poswolsky@pb.net.

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