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	Scott Wrigley

October 2011

Preparing for the End of First-Year Depreciation Incentives

With federal budget pressures greater than ever, most tax and political observers expect that 2012 limits will signal the end of the large first-year deduction for business taxpayers

The recent recession caused Congress to dramatically increase tax incentives for businesses that make expenditures for capital equipment and certain building improvements. Congress expanded the long-standing Section 179 deduction to the point that it is currently at $500,000 per year. Similarly, Congress added an incentive in the form of 100% bonus depreciation for many new (rather than used) asset additions.

Congress extended these provisions into 2012, but at reduced amounts. With federal budget pressures greater than ever, conventional wisdom holds that these 2012 limits signal the end of the large first-year deductions.

Overview of Bonus Depreciation

From 2008 through most of 2010, the bonus depreciation deduction was 50% of the cost of new assets. For assets acquired and placed in service from September 9, 2010, through December 31, 2011, the deduction moved up to 100%. Congress has also extended the deduction into 2012, but at a lower 50% rate. Current tax law does not extend bonus depreciation after December 31, 2012, and an extension appears unlikely.

To qualify for either 100% or 50% bonus depreciation, the asset's original use must commence with the taxpayer (i.e., it is new rather than used property) and have a depreciable life of 20 years or less. (Virtually all tangible personal property – e.g., autos, trucks, machinery and equipment – has a depreciable recovery period of 20 years or less and, therefore, is generally eligible.)

Further, to be eligible specifically for 100% bonus depreciation, an asset must meet all three of the following requirements:

• It must be qualified property, which includes (a) personal property with a MACRS depreciation period of 20 years or less, (b) certain leasehold improvement property, and (c) certain water utility property. Software that is not required to be amortized over 15 years also qualifies.

• The property must have been acquired between September 9, 2010, and December 31, 2011. However, the acquisition and placed-in-service deadlines are extended to December 31, 2012, for certain assets with longer production periods, such as transportation equipment and aircraft. (Under the extended deadline deal, only the portion of an asset's basis that is allocable to costs that are incurred by December 31, 2012 is eligible for 100% bonus depreciation.)

• The original use of the property must begin no later than December 31, 2011 (or by December 31, 2012, for certain property with longer production periods). In other words, the property must be new (not used) when placed in service.

Self-Constructed Property. The date of acquisition for property that a business constructs for use in its own operations (“self-constructed property”) is deemed to be the date when the taxpayer begins construction.

What if a business began construction of an item of self-constructed property before September 9, 2010? In that case, the business can elect to claim 100% bonus depreciation for components of the self-constructed property. To qualify for the election, the components must be:

• acquired or self-constructed after September 8, 2010; and

• placed in service by December 31, 2011 (December 31, 2012, for certain components with longer production periods).

Restaurant and Retail Improvement Property. Qualified leasehold improvement property is eligible for 100% bonus depreciation if the acquisition and placed-in-service date rules are met. The new IRS guidance clarifies that qualified restaurant property and qualified retail improvement property are eligible for 100% bonus depreciation if (a) they also meet the definition of qualified leasehold improvement property, and (b) the acquisition and placed-in-service date rules are met.

Luxury Auto Depreciation Limits. Claiming 100% bonus depreciation for a new passenger auto, light truck or light van that is subject to the luxury auto depreciation limits will increase the maximum first-year depreciation allowance by an even $8,000.

For new autos that were placed in service in 2010, the maximum first-year depreciation allowance is increased to $11,060. The same $11,060 maximum first-year allowance applies to new autos placed in service in 2011.

For new light trucks and light vans placed in service in 2010, the maximum first-year depreciation allowance is increased to $11,160. For 2011, the maximum first-year allowance is increased to $11,260.

Step Down to 50% Bonus Depreciation. For qualified property placed in service in tax years that include September 9, 2010, Revenue Procedure 2011-26 allows taxpayers to elect 50% bonus depreciation instead of 100%. This bonus depreciation “step-down election” can be made for any class of property placed in service during the tax year that includes September 9, 2010. (Previously, the IRS disallowed bonus depreciation step-down elections.)

Forego Bonus Depreciation. Taxpayers can also elect to entirely give up 50% and 100% bonus depreciation for a particular class of qualified property that is placed in service during the tax year. Making this election could be advisable if your business has an expiring net operating loss or an expiring capital loss carryover, or if you believe that higher tax rates will be paid in future years.

Retroactive Extension of 50% Bonus Depreciation. In addition to establishing the new 100% bonus depreciation break, current law retroactively restored the 50% bonus depreciation break for qualified property placed in service between January 1, 2010, and September 8, 2010.

Because the law did not become effective until December 2010, many taxpayers already filed returns that did not take advantage of 50% bonus depreciation. Revenue Procedure 2011-26 supplies guidance for taxpayers in this situation. The guidance applies only to already-filed returns for (a) 12-month tax years that began in 2009 and ended in 2010 and (b) short tax years that ended in 2010.

Overview of Section 179 Deduction

For most of the past decade, the Section 179 deduction was maximized at just over $100,000. When the recession hit, Congress bumped the limit to $250,000 but later increased the amount to $500,000 for tax years beginning in 2010 and 2011. More recently, Congress indicated that, for tax years beginning in 2012, the Sec. 179 deduction would drop back to $125,000 (although inflation indexing is applied, and the actual number should be in the $130,000–$135,000 range).

Not only will the Sec. 179 deduction shrink beginning in 2012, but fewer small businesses will have access to this write-off. During 2011, the deduction phases out only if a taxpayer's eligible Sec. 179 asset purchases exceed $2 million. Starting in 2012, the phase-out threshold is $500,000 of asset additions.

The Sec. 179 deduction applies to both new and used asset additions. It applies to machinery, equipment, software and, for 2011 only, up to $250,000 of qualified real property improvements. “Qualified real property improvements” include improvements to restaurant buildings and interiors of retail and leased nonresidential buildings.

Farmers can also claim the Sec. 179 deduction on special-use or single-purpose agricultural buildings such as bins, drying systems and livestock barns. However, the deduction is not available for general-purpose agricultural buildings such as machine sheds and shops, nor is it generally available to landlords who purchase or construct assets that are used by a tenant.

Quick Reference Chart

The following table provides a summary of the first-year depreciation incentives that are in the law through 2012, as well as the amounts that are generally expected to be applicable for 2013 and after. The latest legislation from Congress for 2012 seems to signal that these incentives are ending and that the new norm for the Sec. 179 deduction would be $125,000, although adjusted upward for annual inflation indexing.

If you have any questions about either the bonus depreciation deduction or Sec. 179, please contact your Schmidt Westergard tax professional.

If you plan on taking advantage of major purchases or improvements while these large allowances are still in the tax law, we recommend that you prepare a detailed depreciation projection. These depreciation incentives can shelter a significant amount of income, but the eligibility rules can be tricky, and it is important to have an accurate expectation of the deductions that will be coming your way.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.