Depreciation

Article Dean Dorton

This article was first published in Blood-Horse Magazine

Federal depreciation incentives included with the Tax Cuts and Jobs Act continue to benefit Thoroughbred horse and farm owners. This article provides an in-depth look at the rules surrounding the 100% bonus depreciation, generally the most useful of these incentives to industry participants.

This discussion is intended for those active owners operating their horse and farm activities as businesses that use the cash method of accounting.

The new law significantly expanded bonus depreciation. The percentage that may be currently deducted for tax purposes increased to 100% of the purchase price for qualifying property placed in service through 2022. After 2022, the percentage drops by 20% each year until it becomes 20% in 2026. In addition, the definition of qualifying property was expanded to include assets that have been previously owned but not those being reacquired by the purchaser. Previously, assets used by a prior owner did not qualify.

Common equine assets that may qualify for this 100% write-off include racing prospects (yearlings, 2-year-olds in training), racehorses, broodmares, stallions, equipment, fencing, land improvements, and barns. To qualify, these items must be predominantly used in the United States (which makes sense given the desire to stimulate economic growth in the United States).

A person claiming bonus depreciation is not limited by taxable income. The deduction may be used to create or increase a net loss and there is not a specific dollar amount limitation on an annual basis.

For these reasons it is much more valuable than the Section 179 depreciation, which is limited to net income and also to a fixed annual dollar amount. Bonus depreciation also is not prorated based on the timing of the purchase. So a qualifying purchase made on Dec. 31, if placed in service then, is eligible for the same amount of bonus depreciation as property purchased for the same price earlier in the year.

In order to claim the bonus depreciation, the asset must be “placed in service” during the tax year. For tax purposes, racing prospects may be placed in service either in the fall of the yearling year when training begins or when they begin racing.

Breeding stock may be placed in service when available to be bred, even if the purchaser does not plan to breed the horse until the following year, or when bred. Quite commonly, mares are purchased in the breeding stock sales in the fall and placed in service upon purchase, even though they typically would not be bred in the Northern Hemisphere until the following winter to spring. The same is true for stallions or stallion shares. Once a methodology for placing horses in service is chosen, it should be followed consistently for tax reporting purposes.

However, just because the cash has been paid does not necessarily mean the horse has been placed in service. For example, if shares in a stallion prospect are purchased while the horse is still racing to secure ownership in the stallion, these would not be placed in service until the horse is retired from racing and available to be bred or begins breeding. On the other hand, a horse that has been purchased and placed in service but not yet paid for would be eligible for bonus depreciation.

In addition, some leases might be “disguised purchases” and may enable the lessee/purchaser to currently claim bonus depreciation. So, it is important to look beyond the label on the contract or the time at which cash is expended to determine whether bonus depreciation is currently available.

Those purchasing farms also may currently use bonus depreciation to deduct the purchase price allocable to qualifying items such as barns, land improvements, fencing, and equipment.

This could result in a substantial portion of the purchase price being eligible for immediate deduction. Addressing this allocation prior to purchase via agreement with the seller in the closing documents or by an appraisal that allocates a portion of the purchase price to these depreciable assets is important to maximize potential deductions.

While bonus depreciation is a timing difference, it can be financially meaningful. To illustrate what this is worth to a horse owner, let’s use the following example. If a yearling is purchased for $500,000, this $500,000 may be fully deducted in year 1 (subject to some limitations briefly mentioned later in this article), rather than over an eight-year period. (Yearlings use seven-year lives for tax depreciation, but this is actually claimed over an eight-year period.) This is a federal tax savings of $185,000 if the purchaser is in the highest federal individual tax bracket. By accelerating this deduction versus claiming it over time, the cash savings in this specific example are roughly $30,000 if a 5% rate of return is used.

This cash savings increases if a higher rate of return is used, if the asset is depreciated over a longer life, or as the purchase price of qualifying assets increases.

Opt-out option

Owners may opt out of this immediate write-off by filing an election to do so with their tax return. So why would someone choose to elect out of this bonus depreciation?

If the horse venture is otherwise profitable, an owner might wish to report a net profit for hobby loss rules that shifts the burden of proof to the IRS if profits are reported in two out of seven years.  Additionally, horse owners might prefer to align the related depreciation expense better during the period of time that horses or the farm would produce income in future years.

Also, passive investors in the horse business participating via multi-member entities may receive little-to-no-tax benefit by accelerating this deduction and instead create a state withholding tax issue in future years when purse winnings are generated or the horse is sold with no remaining tax basis.

Alternatively, the 100% bonus depreciation may be claimed on certain classes of assets while electing out of others. So, if it makes sense to deduct the depreciation on barns over the standard 20-year life while claiming the 100% write-off on horse purchases, an election could be filed to opt out of the 20-year asset class only.

This is made on a class-by-class basis and not an asset-by-asset basis. Horses should be categorized appropriately when evaluating on a class-by-class basis, given that different types of Thoroughbred horses have either a three-year or a seven-year life.

Property acquired from a related party or via inheritance or gift does not qualify for bonus depreciation. Inventory not yet placed in service, such as typical weanling-to-yearling pinhooks, or weanlings not yet placed in service also are not eligible.

Limitations

As with most other tax incentives, a few limitations that might currently reduce or eliminate this 100% deduction may apply. The tax law created a provision that limits net 2018 losses from all business ventures for individuals, trusts and estates to $250,000 ($500,000 for individuals filing jointly). This limit is indexed for inflation after 2018. Any net business loss that exceeds the limit is converted to a net operating loss.

Bonus depreciation might significantly increase the net business loss generated and cause this business loss to be currently limited. For many industry participants who are affected, this creates a one-year deferral of this excess loss that then might be used to offset all sources of income in the subsequent year, subject to the normal net operating loss carryover rules. So owners faced with excess business losses might still want to currently claim bonus depreciation.

Another item of caution: Many states have decoupled from this favorable bonus depreciation so this may be a Federal tax benefit only, depending in which states a horse or farm owner operates.

As sales season kicks into high gear, this 100% write-off option presents some planning opportunities for those looking to reduce taxable income. It is important to speak with your tax advisors regarding your specific situation prior to making any purchases, but the potential tax benefit of utilizing bonus depreciation could be substantial.

Article Dean Dorton

This is the first in a five-part series that highlights the segments of the newly enacted Tax Cuts and Jobs Act and how it impacts the real estate industry.

We will focus on the following topics:

  1. Cost recovery and expensing of depreciable assets
  2. 20% deduction for qualified business income
  3. Excess business losses and net operating losses
  4. Business interest expense limitations
  5. Like-kind exchanges, rehabilitation credit, and qualified opportunity zone gain deferral

In our first installment, we will discuss highlights of the Act and how it impacts capitalization and cost recovery of assets.

First, let’s discuss a section of the Act which may impact assets placed in service during the 2017 tax year.

Bonus depreciation

Prior to September 27, 2017, new assets with modified accelerated cost recovery system (MACRS) lives of 20 years or less were eligible for 50% expensing in their first year in service. For assets acquired and placed in service after September 27, 2017, bonus depreciation has been expanded to include used assets (as long as the use is original to the taxpayer) and increased to 100% expensing. This means certain assets can be fully expensed in their year of purchase. Please note that assets that had a written binding contract prior to September 27, 2017will not be eligible for 100% bonus depreciation. Assets purchased from a related party or controlled group, or received through gift or inheritance, are not eligible for bonus depreciation.

Bonus depreciation at 100% of cost will be available for assets placed in service from September 27, 2017 to January 1, 2023. Then it will be phased out over the period from January 1, 2023 to December 31, 2026 and will be fully eliminated after December 31, 2026. Taxpayers will still be able to elect out of bonus depreciation if they choose.

States will have to decide whether they will follow the changes to federal depreciation rules. If they do not follow the federal law, then there will be adjustments for state purposes to be considered in tax planning.

The next two changes only impact assets placed in service after December 31, 2017.

Section 179 expensing

The Section 179 election allows for 100% expensing for eligible assets up to certain annual limits. The limit for expensing annually increases to $1 million for eligible assets placed in service after December 31, 2017. Section 179 expensing is limited based on the amount of total assets placed in service. This “phasedown” has been increased to $2.5 million after December 31, 2017. This election is only allowable up to net taxable income.

Eligible Section 179 property is tangible personal property, computer software and a newly created “qualified real property”. The inclusion of qualified real property will greatly expand the ability to expense fixed asset additions. Qualified real property includes the newly created qualified improvement property (discussed below), as well as certain structural improvements to the nonresidential real property. This includes roofs, HVACs, fire protection and alarm systems, and security systems. Qualifying property has also been expanded to include certain depreciable personal property used to furnish lodging (e.g., beds, refrigerators, ranges, et cetera). There has been no change related to residential rental property’s ability to take Section 179 on tangible personal property.

Qualified improvement property

Previously, there were three types of qualified improvements to real property—qualified leasehold improvements, qualified restaurant improvements, and qualified retail improvements. All three definitions varied and had different implications for the ability to currently expense improvements. The new law provides for a single qualified improvement property. This property is any improvement to the interior portion of a building placed in service after the original building is placed in service, and is effective for assets placed in service after December 31, 2017. Qualified improvement property has a 15-year recovery period (20-year ADS period), which means it will be eligible for the 100% bonus depreciation from January 1, 2018 through December 31, 2022, as well as Section 179 expensing.

We have not discussed the interaction of the new cost recovery options with the tangible asset regulations that were issued in 2014 that provided guidelines on capitalization of assets versus expensing as repairs. These will need to be considered when making elections related to 100% bonus expensing versus Section 179 expensing. There will also be interaction with the 20% deduction for qualified business income and the limitation on interest expense, which we will discuss in further detail in our next installment.

Read All Tax Cuts and Jobs Act Articles

Article Dean Dorton

In our second installment on the new tax law, we will focus on depreciation-related provisions.

Many of you may have previously benefited from bonus depreciation and Section 179 expensing — tax incentives that have allowed businesses to accelerate deductions quicker than regular depreciation. The new law has increased, extended and modified these tax incentives.

Most of the changes are effective for years beginning after December 31, 2017, but there are some changes that are retroactive to September 27, 2017.

Changes to bonus depreciation

For qualified property acquired and placed in service after September 27, 2017, the new law increases the amount eligible to be immediately expensed to 100% of the purchase price. Additionally, the definition of qualified property is expanded to include used property. Note that used property is eligible for bonus depreciation only if it is the taxpayer’s first use of the property. Meaning, if a business purchases a used piece of equipment, and it is the first use of that piece of equipment for the acquiring business, then the property would qualify for bonus depreciation.

For most qualified property, bonus depreciation will begin phasing-down from 100% expensing starting on January 1, 2023. The phase-down schedule is as follows:

  • 100% for property placed in service after Sept. 27, 2017 and before Jan. 1, 2023
  • 80% for property placed in service during calendar year 2023
  • 60% for property placed in service during calendar year 2024
  • 40% for property placed in service during calendar year 2025
  • 20% for property placed in service during calendar year 2026

It is important to note qualified property that was acquired on or before September 27, 2017, but placed in service after this date will not qualify for 100% expensing under the new law. Property won’t be treated as acquired after September 27, 2017 if a written binding contract was entered into for its acquisition on or before this date. Instead, the pre-Tax Cuts and Jobs Act law on bonus depreciation will be applicable.

Both the old law and new law allow for businesses to elect out of bonus depreciation and depreciate qualified property under regular depreciation rules. For a taxpayer’s first taxable year ending after September 27, 2017, a taxpayer may also elect to use the 50% bonus depreciation rate instead of 100%.

Changes to Section 179 expensing

For taxable years beginning after December 31, 2017, Section 179 expensing is increased to $1,000,000 on up to $2,500,000 of qualifying purchases. Section 179 expensing begins phasing out dollar for dollar for each qualifying purchase over $2,500,000. Unlike bonus depreciation, Section 179 expensing is limited to net trade or business income which means it cannot create a tax loss.

Property eligible for Section 179 expensing includes tangible personal property, computer software and qualified real property. Under the new law, qualified real property has been expanded and includes:

  • Qualified improvement property (defined below)
  • Certain structural improvements made to nonresidential real property placed in service after the date such property was placed in service including:
    • Roofs
    • Heating, ventilation and air-conditioning property (HVACs)
    • Fire protection and alarm systems
    • Security systems

Changes to depreciation provisions for nonresidential real property

In an effort to simplify the tax code, the new tax law condenses the improvement categories (leasehold, retail, and restaurant) which were eligible for special depreciation deductions under the old law into one category called “qualified improvement property”. Qualified improvement property is defined as any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. The definition excludes the enlargement of the building, any elevator or escalator, or the internal structural framework of the building.

Qualified improvement property qualifies for a 15 year recovery period using the straight-line method for regular depreciation and is eligible for both bonus depreciation and Section 179 expensing.

The changes noted above are effective for property placed in service after December 31, 2017.

Other changes

There are many more changes made to depreciation-related provisions under the new tax law that we will not detail in this article. Some of these changes include:

  • An increase in the annual caps on luxury automobiles depreciation
  • Specific changes to depreciation of farm property:
    • 200% declining balance method can be used for certain farm property, and
    • farm equipment is now eligible for a 5-year cost recovery period
  • Shorter ADS recovery period for residential rental property
  • Limitations on the use of bonus depreciation for certain businesses with floor plan indebtedness

All of these noted changes are effective after December 31, 2017.

Read Previous Article: Employee Benefits

Article Dean Dorton

In order to take advantage of two important depreciation tax breaks for business assets, you must place the assets in service by the end of the tax year. So you still have time to act for 2016.

Section 179 deduction

The Sec. 179 deduction is valuable because it allows businesses to deduct as depreciation up to 100% of the cost of qualifying assets in year 1 instead of depreciating the cost over a number of years. Sec. 179 can be used for fixed assets, such as equipment, software and leasehold improvements. Beginning in 2016, air conditioning and heating units were added to the list.

The maximum Sec. 179 deduction for 2016 is $500,000. The deduction begins to phase out dollar-for-dollar for 2016 when total asset acquisitions for the tax year exceed $200,000,000.

Real property improvements used to be ineligible. However, an exception that began in 2010 was made permanent for tax years beginning in 2016. Under the exception, you can claim a Sec. 179 deduction of up to $500,000 for certain qualified real property improvement costs.

Note: You can use Sec. 179 to buy an eligible heavy SUV for business use, but the rules are different from buying other assets. Heavy SUVs are subject to a $25,000 deduction limitation.

First-year bonus depreciation

For qualified new assets (including software) that your business places in service in 2016, you can claim 50% first-year bonus depreciation. (Used assets don’t qualify.) This break is available when buying computer systems, software, machinery, equipment, and office furniture.

Additionally, 50% bonus depreciation can be claimed for qualified improvement property, which means any eligible improvement to the interior of a nonresidential building if the improvement is made after the date the building was first placed in service. However, certain improvements aren’t eligible, such as enlarging a building and installing an elevator or escalator.

Contemplate what your business needs now

If you’ve been thinking about buying business assets, consider doing it before year end. This article explains only some of the rules involved with the Sec. 179 and bonus depreciation tax breaks. Contact us for ideas on how you can maximize your depreciation deductions.

Article Dean Dorton

With most of 2016 behind us, you may want to consider some year-end tax-saving ideas. Before acting on these, note the following:

  • Most strategies do not apply universally, but only in specific circumstances.
  • Many strategies should take into account not just the current year’s impact, but future years’ projected impacts as well.
  • Strategies that reduce your current year regular federal income tax may not reduce your overall federal income tax due to the alternative minimum tax.

Section 179 and bonus depreciation — Businesses should consider these tax breaks related to fixed asset acquisitions:

  • Section 179 depreciation deduction. In 2016, individuals and business entities can elect to deduct up to $500,000 of qualifying business property cost in the year the property is placed-in-service. The deduction is reduced dollar-for-dollar for qualifying property cost greater than $2,000,000. Note that this deduction is available only to the extent of positive business taxable income.
  • Special “bonus depreciation” allowance. For 2016, an additional depreciation deduction is permitted for qualifying property in the year it is placed in service. This bonus depreciation is a deduction of 50% of the qualifying property’s cost.

Capital gains and losses — If you have realized net capital gains during 2016, consider realizing capital losses before the end of the year to offset the gains. Remember that net long-term losses can be used to offset net short-term capital gains which otherwise would be taxed at ordinary rates. Also, be aware of the “wash sale” rules if you are inclined to reinvest in a security you sell at a loss.

Self-employed retirement plans — If you have self-employment income and don’t have a retirement plan in place to shelter any of it, you may qualify to use a Self-Employed Plan (SEP). A SEP contribution deduction is allowed for 2016, even if the SEP is created and funded at any time up to the due date, including extensions, of the 2016 income tax return in 2017.

Charitable contributions — Consider funding charitable gifts with appreciated marketable securities held for more than one year, resulting in gains being untaxed and deductions being allowable at the securities’ market values. You may also charge charitable contributions on your credit card; contributions posted to your account before year-end are deductible this year, even if you do not pay the charges until next year.

Annual gifting — You may give your children and others up to $14,000 each in 2016 without any gift tax consequences. This annual exclusion is calculated on a per donee basis and no carryover is allowed for the unused exclusion. Consider making year-end gifts to fully utilize this year’s annual exclusion, and consider making your 2017 annual exclusion gifts (also at $14,000 per donee) early next year.

Required minimum distributions — Individuals with retirement plan accounts (employer qualified plans or IRAs) generally are required to take minimum annual distributions upon reaching age 70 ½. Steep penalties apply to noncompliance, and not all IRA custodians or plan sponsors actively communicate the applicability of the rules to account holders and plan participants.

S Corporation and partnership losses — If your S Corporation will generate a tax loss this year, consider whether you have enough basis in the stock (or in loans you’ve made to the corporation) to take the full loss. If you don’t, additional investments should be considered. Similar considerations can arise in some situations with partnerships expecting tax losses.

Possible elimination or reduction of valuation discounts for family-owned businesses — As reported in an earlier newsletter, the U.S. Treasury has proposed regulations which, if finalized, will have the effect of increasing valuations of noncontrolling interests in family-owned businesses and investment entities for gift, estate, and generation-skipping tax purposes. The proposals are attracting much criticism. A hearing on the proposals is scheduled for December 1. Subsequent courses of action include at least the following:

  • The regulations being finalized as proposed
  • The regulations being finalized with modifications
  • Withdrawal of the proposals followed by further study

Once finalized, the regulations would become law after 30 days. If you are interested in transferring an interest in a family-owned entity, you may want to consider conducting such transactions before the end of the year.

If you have any questions, contact your Dean Dorton advisor or Matt Smith at msmith@deandorton.com.

Article Dean Dorton

…But Should They?

Bonus depreciation allows businesses to recover the costs of depreciable property more quickly by claiming additional first-year depreciation for qualified assets. The Protecting Americans from Tax Hikes Act of 2015 (the PATH Act) extended 50% bonus depreciation through 2017.

The break had expired December 31, 2014, for most assets. So the PATH Act may give you a tax-saving opportunity for 2015 you wouldn’t otherwise have had. Many businesses will benefit from claiming this break on their 2015 returns. But you might save more tax in the long run if you forgo it.

What assets are eligible

For 2015, new tangible property with a recovery period of 20 years or less (such as office furniture and equipment) qualifies for bonus depreciation. So does off-the-shelf computer software, water utility property and qualified leasehold-improvement property.

Acquiring the property in 2015 isn’t enough, however. You must also have placed the property in service in 2015.

Should you or shouldn’t you?

If you’re eligible for bonus depreciation and you expect to be in the same or a lower tax bracket in future years, taking bonus depreciation (to the extent you’ve exhausted any Section 179 expensing available to you) is likely a good tax strategy. It will defer tax, which generally is beneficial.

But if your business is growing and you expect to be in a higher tax bracket in the near future, you may be better off forgoing bonus depreciation. Why? Even though you’ll pay more tax for 2015, you’ll preserve larger depreciation deductions on the property for future years, when they may be more powerful — deductions save more tax when you’re in a higher bracket.

We can help

If you’re unsure whether you should take bonus depreciation on your 2015 return — or if you have questions about other depreciation-related breaks, such as Sec. 179 expensing — contact us.