Depreciating and Expensing Long Term Asset Costs

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Special tax rules apply to purchases of long-term property four your inventing business--this is property with a useful life of over one year--for example, buildings, equipment, machinery and office furniture. As a general rule, the cost of long-term property you buy for your inventing business is not currently deductible in a single year. Rather, it must be deducted over several years, a process called depreciation. However, a special provision of the tax law called Internal Revenue Code Section 179 permits you to deduct up to $500,000 of your long-term property purchases in the year you make them, rather than having to depreciate them over several years. Tax pros call this “first year expensing” or “Section 179 expensing.”

EXAMPLE: Gary is working to invent a special bed that vibrates to awaken its owner. This year he spends $8,000 for a special sleep monitor he uses to help to test his bed. After perfecting his invention, he buys $10,000 worth of bed-making machinery, and spends $7,000 for a photocopier, fax machine and computer he uses to help market the bed. All $25,000 in expenses are currently deductible under Section 179.

It’s up to you to decide whether to use Section 179 to take a current deduction for depreciable assets. You always have the option of depreciating the property instead -- this means you deduct a portion of the cost each year over several years. Most taxpayers do take the full amount of the Section 179 deduction because it gives them as large a tax reduction as possible for the current year. However, in some cases, you may be better off in the long run using depreciation instead of Section 179. This may be so if you expect to earn more in future years than you will in the current year. This is because the value of a deduction depends on your income tax bracket. If you’re in the 15% bracket, a $1,000 deduction is worth only $150. If you’re in the 30% bracket, it’s worth $300. So spreading out a deduction until you’re in a higher tax bracket can make sense.

You may also prefer to use depreciation rather than Section 179 if you want to puff up your business income for the year. This can help you get a bank loan or help your business show a profit instead of incurring a loss -- and therefore, avoid running afoul of the hobby loss limitations.

Property that Can Be Expensed

You can use Section 179 to deduct the cost of any tangible personal property you buy for your business that the IRS has determined will last more than one year -- for example, computers, business equipment and office furniture.  Special rules apply to cars.You can’t use Section 179 for land, buildings or intangible personal property such as patents, copyrights and trademarks. Software you purchase separately is intangible property and thus cannot be expensed under 179. However, the software that comes with a computer you buy and is included in the price, may be expensed along with the computer.

If you use property both for business and personal purposes, you may deduct under Section 179 only if you use it for business purposes more than half the time. The amount of your deduction is reduced by the percentage of personal use. You’ll need to keep records showing your business use of such property.

EXAMPLE: Lucy buys a computer. She uses it 80% for her inventing business and 20% to play video games. She can deduct 80% of the cost of the computer under Section 179.

If you use an item for business less than half the time, you can’t use Section 179. Instead, you must depreciate the property, deducting the cost over several years. 

Annual Expensing Limit

There is a limit on the total amount of business property expenses you can deduct each year using Section 179. In 2011, the limit increased is $500,000. The Section 179 limit will shrink to $125,000 in 2012 and $25,000 in 2013 and later. The dollar limit applies to all your businesses together, not to each business you own and run. You do not have to claim the full amount. It’s up to you to decide how much of the cost of property you want to deduct. But you don’t lose out on the remainder; you can depreciate any cost you do not deduct under Section 179.

Depreciating Long-Term Business Property

You don't have to use Section 179 expensing if you don't want to. If you don't want to expense an asset, or it doesn't qualify for expensing, you must use depreciation instead. Depreciation is used to deduct the cost of any asset you buy for and use in your business that:

  • wears out, decays, gets used up, becomes obsolete or loses value from natural causes, and
  • has a determinable useful life of more than one year; the IRS, not you, determines an asset’s useful life.

Depreciation can be used for tangible business assets -- for example, buildings, equipment, machinery and office furniture. The cost of intangible property such as patents and copyrights can also be deducted over time. This is called amortization. Land cannot be depreciated because it doesn’t wear out -- you can’t depreciate something that could last forever.

You must depreciate the cost of major repairs that increase the value or extend the life of an asset -- for example, the cost of a major upgrade to make your computer run faster. However, you may deduct normal repairs or maintenance in the year they’re incurred as an ordinary and necessary business expense.

Mixed Use Property

If you use property for both business and personal purposes, you can take depreciation only for the business use of the asset.

EXAMPLE: Carl uses his photocopier 75% of the time for personal reasons and 25% for his inventing business. He can depreciate 25% of the cost of the copier.

Keep a diary or log with the dates, times and reason the property was used to distinguish between the two uses.

Depreciation Period

Depreciation begins during the year you place a depreciable asset in service in an active trade or business. Under these rules, you cannot take any depreciation deductions until your inventing business has passed through the start-up phase and is functioning as a going concern.  An asset is “placed in service” when it is ready and available for use in your business, whether or not it’s actually used. Ordinarily, this is when you buy it. For purposes of calculating your first year’s depreciation, you usually treat an item as being placed in service on July 1. This means you get one-half of the first year’s depreciation, regardless of the exact date you placed the property in service. However, the rules differ if you buy over 40% of your depreciable property for the year during the last three months of the year.

The depreciation period lasts for the entire estimated useful life of the asset. The tax code has assigned an estimated useful life for all types of business assets, ranging from 3 to 39 years.

Bonus Depreciation 

  In an ongoing effort to help jumpstart the faltering economy, business owners have been allowed to claim first “bonus depreciation” for qualifying personal property. Using bonus depreciation, a business owner can deduct a specified percentage of a long term asset’s cost the first year it’s placed in service. For 2008, 2009, most of 2010, and 2012, the percentage you can claim is 50%; that is, you can deduct 50% of the cost of the asset in the first year, with the remaining cost deducted over several years using regular depreciation and/or Section 179 expensing. However, for assets placed in serviced during September 8, 2010 through December 31, 2011, the deductible first-year percentage is 100%, meaning the entire cost of the asset can be deducted the first year, without limit. This has never been possible before, and likely never will be again.   Bonus depreciation is optional—you don’t have to take it if you don’t want to. But if you want to get the largest depreciation deduction you can during the year that you buy long-term personal take advantage of it whenever you can.

by: , J.D.

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