Take full advantage of depreciation deductions
If you’re like many other small business owners, you may wait until the end of the year to buy property like equipment and computers.
Strategy: Don’t fall into a depreciation tax trap for property placed in service in the last quarter of the year. This little-noticed tax provision might catch you by surprise if you’re not careful.
It all has to do with the way depreciation deductions are calculated under the Modified Accelerated Cost Recovery System (MACRS). In essence, your deduction will be significantly reduced if the cost of the depreciable property (other than real estate) that is put in service for the fourth quarter exceeds 40% of the total cost of such property placed in service during the tax year. Property for which you claim the Section 179 first-year depreciation write-off is not counted. However, the depreciation reduction rule can come into play if you’ve exceeded the annual Section 179 deduction limit or if properly doesn’t qualify for the Section 179 deduction privilege.
Here’s the whole story: MACRS treats property placed in a service at any time during the year as being placed in service on July 1 under this “midyear convention.” Therefore, your business can effectively benefit from a half-year’s deduction, even if property is placed in service late in the year.
However, if the property placed in service during the last quarter exceeds 40% of the cost of all depreciable asses placed in service during the year-excluding any amounts spend on real estate and amounts for which the Section 179 deduction is claimed- depreciation deductions for all property placed in service during the year are figured under the “midquarter convention.”
Under the midquarter convention, the depreciation deduction of the property is based on the equivalent of one-half of the quarterly period during which the property is placed in service (plus a full amount for any subsequent quarters). For instance, if you place property in service in any of the last three months of the year – October, November or December – your entitled to only 1 ½ months worth of depreciation in the first year of ownership. Conversely, property placed in service in the first quart of the year is entitled to 10 ½ months’’ worth of depreciation (1 ½ months for the first quarter and nine months for the following three quarters).
The midquarter convention rule can reduce your annual depreciation deduction if you place a lot of property in service in the fourth quarter. For simplicity, let’s consider the potential tax consequences without figuring the Section 179 allowance or any bonus depreciation.
Example: Your company buys a seven-year business property in October for $100,000. No other property is placed in service during the year. Under the midyear convention that usually applies, the first-year deduction would be $14,290 under the MACRS tables.
But since this is the only business property your company placed in service during the year, you fall into the last-quarter tax trap. So, your first-year depreciation deduction is computed under the midquarter convention, reducing the deduction to only $3,570. As a result, your deduction is $10,720 less than it would have been if the property had been placed in service on September 30!
To Avoid the trap, ensure that your last-quarter purchases stay below the 40% threshold.