The law generally still lets you claim six months' worth of the depreciation in the year you put business property into service, regardless of when in the year you make the purchase. Even if you buy on the last day of the year, you can earn a substantial depreciation write-off. This midyear convention works against you, of course, if you buy your business property early in the year. Even if you buy in January, for example, you still get only half a year's worth of depreciation for the first year of ownership.
But you can trip yourself up if you buy too much business property at year-end. If the cost of assets put into service during the final three months of the year exceeds 40% of the total cost of business property put into service during the year, the half-year convention is replaced by a midquarter convention. That means depreciation is calculated as though each asset was put into service in the middle of the calendar quarter during which it was first used.
A year-end purchase would earn just six weeks' worth of depreciation, then, instead of six months. However, triggering the midquarter convention rule would also boost write-offs for property put in service early in the year. Assets placed in service during the first quarter would earn 10 1/2 months' worth of depreciation rather than six months'.
You need to keep records establishing the cost of the property you depreciate and, if there is a split between business and personal use, evidence supporting the business percentage you claim. When figuring the depreciable business cost—or basis—include any sales tax paid. Because the IRS has a special eye on computers and cellular telephones, your records of business and personal use must be particularly good. Keep a log book near the computer, for example, and have every user sign in, noting the date, the time use begins and ends, and the reason for using the computer.
In the aftermath of the September 11 terrorist attacks, Congress approved legislation providing for an extra 30% first-year depreciation deduction for business equipment purchased after September 10, 2001, and before September 11, 2004. Then, in 2003, the lawmakers boosted the bonus to 50% in hopes of fueling the economic recovery. That special break ended at the end of 2004, so business assets purchased in 2005 are not as privileged, tax wise. However, as 2005 drew to a close, Congress revived a limited version of 50% bonus depreciation for businesses that invest in equipment and structures in the "Gulf Opportunity" zone — the area devastated by Hurricane Katrina. Property put in service between August 28, 2005 and the end of 2007 can qualify for this tax break.
Here, too, Congress made a major change in 2003. Section 179 of the law offers the chance for super-accelerated depreciation. Expensing—as this provision is known—permits you to write off immediately a certain amount of business costs that would otherwise be depreciated over five or more years. In 2002, the dollar limit was $24,000 and it was scheduled to rise to $25,000 in 2003. But, to encourage small businesses to buy new equipment — in the hope of kick-starting the recovery — Congress hiked the limit to a nice, round $100,000. This break did not end last year. In fact, an inflation adjustment hiked the limit to $108,000 for 2006. You basically treat qualifying costs as current expenses-fully deductible in the year incurred-just like what you pay out for salaries, office supplies or utilities.
The $108,000 limit applies to qualifying assets put into service any time during 2006. The limit is $208,000 for investments made in the Gulf Opportunity zone.
Expensing won't necessarily let you deduct the full cost of a new business car, however. Under the "luxury car" rules the biggest first-year write-off for a business car purchased in 2006 is $2,960. Regardless of how much your new car costs, the biggest first-year depreciation allowed is $2,960. There is an exception to this rule, though if your business vehicle weighs between 6,000 pounds and 14,000 pounds—empty if it's a car or with the maximum load if it's a sports utility vehicle or minivan. A special rule lets you expense up to $25,000 of the cost in the first year. TaxCut will make sure you get the biggest deduction you qualify for.
If you put more than $430,000 of equipment into service in 2006, you gradually lose the right to use expensing. The $108,000 limit is reduced dollar for dollar as expenditures exceed $430,000. In the Gulf Opportunity zone, however, the phase outs start at $1.03 million in 2006.
As noted above, the luxury-car rule sets a limit on the annual depreciation deductions for a business auto. For new business cars purchased in 2006, the first-year limit is $2,960.
Note this: The luxury car rules are relaxed for electric cars. The annual deduction limit is tripled.
If you use your car for both business and personal driving, the luxury-car cap is reduced to reflect your personal use. Say the business/personal split is 75%/25%. Your first-year depreciation deduction would be limited to $2,220, which is 75% of $2960.
See the following topics for more information about vehicle depreciation.
Under current law, business autos have a five-year depreciation life, but because of the accounting procedures used the write-offs actually stretch over six years. Generally, no matter when during the year you purchase depreciable property, the law gives you credit for half a year's worth of depreciation. Because you can't get more than half a year's worth the first year, you are forced to extend write-offs into the sixth year to depreciate the full business cost. The car has to be depreciated even more slowly if it was not used more than 50% for business.
See Recordkeeping for information on rules regarding personal vs. business use.
All the work of figuring depreciation deductions for a business vehicle may seem pointless because, — the law sets a dollar limit on your depreciation write-offs anyway. The $2,960 first-year limit is what would be allowed on a $14,800 business vehicle (20% of the value). The second year deduction cap for a car put into service in 2006 is limited to $4,800; third year — $2,850; fourth and all subsequent years — 1,775. If you use your car 75% for business and 25% for personal driving, your luxury car limits are reduced to 75% of these figures.
To figure your depreciation deduction if you're not capped by the luxury car rules — or to see how much those rules pinch your write-off — you first must find your car's basis. That is its value for tax purposes and starts out, easily enough, at what you pay for the car, you may include the sales tax in the basis and therefore write off the business portion in your depreciation deductions.
Finding the basis is much more complicated if you trade in one business car for another, particularly if you use the auto for personal as well as business driving, as is almost always the case.
First, consider the simpler calculation: trading in a car used 100% of the time for business for another used 100% of the time for business. The tax basis of the new car is the adjusted basis of the old one—generally that's what you paid for it minus the depreciation deductions you claimed in previous years—plus the extra money you had to pay on top of the trade-in value.
Say you bought a car for $20,000, claimed depreciation deductions totaling $8,060 over the first two years, and traded it in on a new car in the third year. If the new car cost $10,000 more than the trade-in value of the first car, its basis would be $21,500, which is $10,000 plus the $11,500 adjusted basis ($20,000 - $8,060) of the old car.
Now consider the more prevalent scenario: trading in one mixed-use car for another. The basis of the new car would be the adjusted basis of the old one—its cost minus whatever depreciation deductions you have claimed—plus the amount you paid in addition to the trade-in value, minus the difference between the depreciation claimed and what you could have claimed if the old car had been used 100% for business. Whew! The result of this convoluted calculation is to pull down the starting basis of the new car to the same level as if you had used the trade-in 100% for business.
Once you know your basis, you can calculate your depreciation deduction. Under current law, business autos have a five-year depreciation life, but because of the accounting procedures used the write-offs actually stretch over six years. Things are complicated — but in a way that's favorable to taxpayers. In most cases, cars that are used primarily for business qualify to be depreciated at the accelerated pace shown in the table below, which pulls most of the depreciation into the early years:
Here's another twist. The above schedule uses what's called the mid-year convention to give you credit for half a year's worth of depreciation, no matter when during the year you put the car into service. But there's an exception to that rule. If more than 40% of all the depreciable property you buy during the year is purchased in the final three months, the write-off for each asset is figured assuming it was put into service in the middle of the quarter in which it was purchased.
If you buy a new business car in October, November or December and its depreciable basis is more than 40% of the total basis of all the property purchased during the year, for example, your write-off would be greatly reduced. You would qualify for just 5% depreciation for the first year, rather than 20%. Keep that in mind if you consider buying a new car late in the year. Buying before October 1 could mean a much larger depreciation deduction for the year.
Fortunately, you have TaxCut to figure the maximum allowable depreciation deduction for your business car.
See Recordkeeping for information on rules regarding personal vs. business use.
Computers have a five-year tax life, but it takes six years to deduct your full business costs, thanks to an accounting procedure that basically gives you half a year's worth of depreciation the first year, regardless of when during the year you put the machine into use. Since you get only half a year's depreciation the first year, you need to tack an extra year on at the end to recover your full cost. (There's an exception to this "midyear convention" that comes into play if you put more than 40% of new business property into use during the last quarter of the year. In that case, the first year write-off for each piece of property is figured as though it was put into use in the middle of the quarter in which it was purchased.)
The rules for depreciating business software differ depending on whether it is bought as part of a package with computer hardware or purchased separately. In the first case, the value of the software is depreciated at the same rate as the hardware—over six years using the rapid-depreciation schedule. When purchased separately, however, the cost of depreciable software is usually written off over three years, and the mid-year convention does not apply. Thus, if you buy software in December, you deduct one-thirty-sixth (2.78%) of the cost that year, one third of the cost in each of the two succeeding years, and the remainder of the cost in the fourth year. Another exception: if you can show that the software has a useful life of one year or less, you can deduct the full cost in the year you buy it.
Office equipment like typewriters and copy machines has the same five year tax life as computers. However, office furniture, such as chairs, desks and file cabinets, has a seven-year tax life.
See Recordkeeping for information on rules regarding personal vs. business use.
Office furniture, such as chairs, desks and file cabinets, has a seven-year tax life. And it takes eight years to deduct your full business costs, thanks to an accounting procedure that basically gives you half a year's worth of depreciation the first year, regardless of when during the year you put the property into use. Since you get only half a year's depreciation the first year, you need to tack an extra year on at the end to recover your full cost.
(There's an exception to this "midyear convention'' that comes into play if you put more than 40% of new business property into use during the last quarter of the year. In that case, the first year write-off for each piece of property is figured as though it was put into use in the middle of the quarter in which it was purchased.)
"Listed property" is the term used for depreciable assets that Congress has put on a special list for special scrutiny by the IRS. Basically, this includes things Congress worries you might use for personal as well as business purposes—a car, computer, cellular telephone, boat, airplane and photographic and video equipment. (If a computer or photographic or video equipment is used exclusively at your regular place of business, however, it is not considered listed property.) There are special restrictions on the depreciation of listed property if business use does not exceed 50%. TaxCut knows the rules.
Because the IRS has a special eye on computers and cellular telephones, your records of business and personal use must be particularly good. When you file your return, you will be asked flat out, on Form 4562, whether you have written evidence to support your write-off. Keep a log book near the computer, for example, and have every user sign in, noting the date, the time use begins and ends, and the reason for using the computer. If the reason is not personal, cite the specific business or investment project.
If you write off the cost of a business car, you'll need a logbook recording your trips as well as evidence of the costs you incur. If you have rental property, you need another folder for all income and expenses.
Special rules apply to computers, apparently growing out of congressional concern that the tax law was too heavily subsidizing the purchase of many home computers. If you use your home computer in connection with your job, for example, it's almost impossible to write off its cost. To qualify for an employee-business-expense deduction, the computer must be required by your employer. If you're simply encouraged to take work home from the office, that's not enough.
If you pass that test or have your own business, your depreciation deductions turn on the business/personal breakdown of use. If business use does not exceed 50%, you are stuck with straight-line depreciation that severely limits your deduction. And, whether or not you pass the 50% test, of course, your depreciation is based on the business proportion of the computer's cost.
When figuring whether you meet the 50% requirement, don't count time spent using your computer to keep track of your personal investments. Only time spent on your business counts. If business use surpasses 50%, though, you can then add in investment time for purposes of determining what percentage of your cost is deductible.
If business use exceeds 50% when you first buy the computer but later falls below the threshold, the tax law "recaptures" some of your earlier depreciation. In the year personal use predominates, you have to report as income the difference between the depreciation you claimed in earlier years and what you would have been due using the slower straight-line schedule designed for mostly personal machines.
If you use a cellular telephone in your business, it has a seven-year tax life but it is covered by the 50% business-use requirement that stands between computers and rapid depreciation. If business use of the phone does not exceed 50%, you must use a ten year depreciation schedule compared with the seven-year schedule for mostly-business phones.
More important than sluggish depreciation, though, is that failure to use your computer or phone mostly for business means forfeiting the chance to "expense" part or all of the business cost. Expensing would allow you to write off the full business cost in the year of purchase, rather than gradually depreciating it over time.
The law lets you depreciate rental property, claiming deductions that are supposed to reflect how the building is being "used up.'' You depreciate your basis in the building. The basis is basically what you paid for the property minus the value of the land. Depreciation is a key to many real estate investments because even if rental income fails to cover all out-of-pocket expenses, the tax savings of depreciation—by sheltering other income from the IRS—can make up much, if not all, of the difference.
How fast you can depreciate property depends on when you put it into service. Before 1987, buildings could be depreciated over 19 years (never mind the fact that a building would probably last much longer) using a method called the Accelerated Cost Recovery System (ACRS). It was "accelerated'' because the write-off schedule bunched bigger deductions in the earlier years.
The law now demands that you use the straight-line method and stretches the write-offs over 27.5 years for residential real estate. For commercial property put into service between January 1, 1987, and May 12, 1993, the depreciation period is 31.5 years. For commercial non-residential property put into service on or after May 13, 1993, it's 39 years. (If you had a binding contract to buy or build commercial property before May 13, 1993, and it was put into service before January 1, 1994, you still get to use the 31.5 year recovery period.) Note this: If you placed a building into service when a more generous depreciation schedule was allowed, you continue to use that schedule. Note this: gasoline station/convenience store combinations can be depreciated over 15 years.
For new investments, the first-year depreciation deduction depends on the month you put the property into service and is based on what accountants call the midmonth convention. Regardless of what day of the month you start depreciating the building, you get credit for half of the first month. Put a rental house into service on July 1, for example, and your first-year depreciation write-off would be for 5 1/2 months—half of July plus the rest of the year.
Figuring how much depreciation you can write off is fairly simple. You begin with the depreciable basis—which is the cost of the building itself. (You can't depreciate the value of the land.) Divide the basis by either 27.5, 31.5, or 39—depending on the type of property and when it was put into service—to find the annual depreciation amount. Divide that by 12 to get the monthly figure, and multiply that amount by the number of months it was available for rent, whether or not you actually had a tenant. TaxCut depreciation worksheet handles the number crunching.
On a residential property with a $100,000 basis, a full year's depreciation would be $3,636 ($100,000 divided by 27.5). One month's worth would be $303. Thanks to the midmonth convention, the first-year depreciation deduction for a property put into use anytime in July would be $1,667 ($303 multiplied by 5.5). If you put the property into service in December, the first-year write-off would be just $150.
After the first year, you deduct 3.64% of your basis for residential property each year until the final year when the write-off would be slightly smaller depending on the first-year deduction. For commercial property, the full-year write-offs would be either 3.17% or 2.56% of basis, depending on whether you're depreciating the property over 31.5 or 39 years. GoZone eligible residential and commercial property can take a bonus depreciation after 8-27-05.
Remember this about depreciation: Each deduction you take reduces your adjusted basis in the property. When you sell the property, it is the adjusted basis that is compared to the sales proceeds to determine your profit on the sale. Thus every dollar you deduct as depreciation shelters a dollar of profit until you sell.
There's a twist here, too, thanks to the change in the 1990s that reduced the tax rate on capital gains. Before that, profit that was the result of straight line depreciation was taxed just like other profit—as a long-term capital gain subject to what was then a top rate of 28%. So does such depreciation now enjoy the new 15% capital gain rate? Not quite. Instead, a 25% rate applies. And, as under the old law, gain attributable to accelerated depreciation claimed on property put into use before 1987, can still be recaptured as ordinary income. . .and hit by rates as high as 35%. TaxCut will sort through the rules for you.