Taxes Made Simple

How Depreciation Usually Works

There are several methods that can be used to depreciate capital assets. (“Capital asset” is the term used for an asset that will last longer than a year.) Some of these methods are pretty straightforward, such as “straight line depreciation” in which you deduct an equal amount each year, until the entire cost of the asset has been depreciated. Other methods, such as the “Modified Accelerated Cost Recovery System,” are decidedly more complex, although they allow you to receive a greater percentage of the deduction earlier in the life of the asset.

The good news is that you probably won’t have to learn exactly how any of the depreciation methods work. That’s because you most likely won’t be using them. You’ll be using the “Section 179 Election.” However, if for some reason you find yourself needing more information about depreciation methods, you can find it in IRS Publication 946.

What’s the Section 179 Election?

Under Section 179 of the Internal Revenue Code, you are allowed to expense (deduct) the entire cost of a capital asset in the first year in which you use it for business. The benefit of using Section 179 is obvious: it allows you to get money off your taxes sooner rather than later.

What’s the catch? There are two. First, there are some limits as to the amount of expenditures that you can deduct in one year using Section 179. That said, most of these limits don’t come into play unless you plan on placing more than $125,000 worth of capital assets into use for your business in one year. As you can see, most small business owners needn’t worry. Likely, the only limit you need to worry about is as follows: Your Section 179 election amount is limited to your income from the business in which the asset is used.

The second catch is that, as the law stands right now, the ability to take this election will only last through the end of 2010. Unless Congress passes an extension, as of 2011, we’ll be back to using regular depreciation. Many experts think it’s very likely that Congress will extend the time frame for Section 179 (perhaps permanently), but there is really no way to know for sure. As such, if you’re planning on acquiring a large amount of capital assets for use in your business, it might be a good idea to budget the costs for prior to 2011.

What Is Eligible and What Isn’t Eligible

Almost any asset used for your business qualifies for Section 179. Therefore, it’s easier to simply list what isn’t eligible. The following cannot be expensed under Section 179:

• Property that you lease to others.
• Property used predominantly outside the United States.
• Property used predominantly to furnish lodging (for example, furniture used in the rented rooms at a Bed & Breakfast).
• Air conditioning or heating units.

Property Used Only Partially for Business

If you have an asset that you use partially for your business and partially for personal reasons, you can still deduct part of it under Section 179. As you would expect, the portion you can deduct is equal to the business use percentage for the asset. For example, if you bought furniture for your office worth $3,000, but you use it 10% of the time for personal reasons, you calculate your deduction as follows:
$3,000 x 90% (business use percentage) = $2,700 deduction

Listed Property & Ramifications

Pay attention here. This part is important, because it’s an area where many self-employed taxpayers make mistakes that end up resulting in them owing more taxes than they had planned on. If an asset is categorized as “listed property,” it is subject to special rules and restrictions (explained below) in terms of how it can be depreciated/expensed. The following items are listed property:

• Passenger automobiles weighing 6,000 pounds or less.
• Any other vehicle used for transportation (except for vehicles such as ambulances or police cars for which an explicit exception is made).
• Property generally used for entertainment (examples: cameras and video-recording equipment).
• Cell phones and other similar devices (i.e., Blackberries, Treos, etc.)
• Computers and peripheral equipment, unless used exclusively at a regular business establishment and owned by the person who owns the establishment.

The most important rule regarding listed property is that if it is used 50% or less for business, it is not eligible for the Section 179 election. As such, you’ll have to depreciate it over several years. (The length of time depends on the asset, and can be found in IRS Publication 946.) In fact, you will be required to use the straight line method, which is the slowest of all depreciation methods.

Even if your listed property is used more than 50% for business, you will be required to keep records (a daily log, for instance) to prove that it is used predominantly for business.

In Summary

• If you purchase equipment to be used exclusively in your business, you can generally deduct it in the year you place it into use (using what’s known as the Section 179 election).
• If the equipment is listed property (defined above) and is to be used 50% or less for business, you cannot take the Section 179 election. Instead you must deduct it over a longer period of time. (See IRS Publication 946).
• If the equipment is listed property and is to be used at least 51% for business purposes, you can use Section 179 to deduct the business-use portion of the cost. (For instance, 60% of the cost if you use the equipment for business 60% of the time.)
• If the equipment is not listed property, you can deduct the business-use percentage of the cost, regardless of whether the equipment is used primarily for business or not. (For example, even if it’s used only 30% for business, you can still use Section 179 to deduct that 30% in the first year.)

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