Is your accountant telling you that the upcoming end of the tax year (for calendar year filers) is time to buy equipment to save money? It’s not as cut and dried as that, so I again this year issue my annual warning about the downside of this practice. I say it’s time to review any upcoming purchases, but don’t be panicked into spending now because you may regret it later.
According to http://www.section179.org/section_179_deduction.html (www.Section179.org) the 2012 deduction limit is $139,000. This is the amount of new or used equipment (or software) you may purchase, put into service, and write off as a direct deduction to your income this year. What’s bad about that? Nothing is bad, specifically. What’s bad is the way you pay for the equipment. If you purchase equipment and pay cash for it in 2012 then, by all means, take the deduction. But if you borrow money to buy the equipment, you need to realize that Section 179 saves you no money in the long run.
Huh? In simple terms, when you buy equipment you may depreciate (recapture your investment) according to the Internal Revenue Service’s Modified Accelerated Tax Recovery System (MACRS), which means you offset income over time. In real simple terms, should you purchase $100,000 in equipment and write it off over five years (it’s more complicated than this), then you would depreciate about $20,000 per year (more in early years and less in later years). So, if you pay cash, you are out $100,000 in year one and write off only $20,000 in year one. Then your year two through five depreciation deductions eventually catch up and you have deducted $100,000 over a five year period.
But if you borrow the money in year one ($100,000) and deduct the entire $100,000 in year one while only paying out $20,000 in cash, then your year two through five payments of $20,000 have no offsetting expense deductions leading one to exclaim, “If I’m making all this money, how come I have no cash?”
So if you pay cash, deduct it this year using Section 179. If you borrow money for the equipment, then you are better off matching your depreciation deduction more closely with when the cash goes out.
The panic to buy equipment at the end of the year often results in us buying equipment we don’t need or which hasn’t been proven.
Here’s a further explanation from my 2011 alert: Section 179 Accelerated Depreciation in the U.S. does just that. It does allow you to accelerate or move your depreciation deductions you would take during out years to this year, but it provides no additional deduction. Over time, you have exactly the same tax effect.
OK, you might be thinking, what is wrong with taking the depreciation this year instead of waiting? Follow the cash to find out.
If you pay little or no money down to purchase $50,000 of equipment this year, you probably can deduct the amount as an expense and reduce the amount of income tax paid this year. “Well, isn’t that saving money?” No, because there’s always next year.
Next year you still have to repay the loan (cash out) but you have no offsetting expense deduction (depreciation). So we get upside down in our car payment, so to speak. We pay out $12,500 of cash to repay the loan in out years and have $0 of expense deductions, which means we are paying more taxes in out years, precisely when we have less cash because of the payments. Had we delayed the deduction, our depreciation expense deduction would roughly offset the cash out.
What should we do? Again, follow the money. If you pay cash for equipment, then take the Section 179 deduction. If you finance, however, you are usually better off deducting depreciation normally. That way you will have fewer of those confusing moments when the accountant says you made a lot of money, yet you are wondering where in the world is the cash.
A synopsis of Section 179 from Section179.org may be found at http://www.section179.org/section_179_deduction.html