Is a Tax Depreciation Tsunami Coming?
To stimulate the economy in 2008, Congress passed some very generous bonus depreciation deductions for purchasing new equipment. For 2016 and 2017, you can expense half the cost of new equipment purchased and depreciate the balance. For over the road tractors, tax depreciation can be expensed over 4 years; 33.33% the first year, 44.45% the second, 14.81% the third, and 7.41% the fourth year of the original cost (assuming more than 60% of the equipment is placed in service by September 30). For trailers and day cab tractors, tax depreciation is taken over 6 years at 20% the first year, 32% the second, 19.2% the third, 11.52% the fourth, 11.52% the fifth, and 5.76% the sixth year.
Starting in 2018, bonus depreciation will reduce to 40%, 30% in 2019 and 0% in 2020. Currently, with bonus depreciation, you can expense 66.66% of the cost of the tractor in the first year (50% bonus plus 33.33% on the remaining 50%). Trailers you can expense 60% of the cost in the first year (50% bonus plus 20% of remaining 50%).
What is essentially happening on your tax return? You are getting an expense early, which means there will be less to claim in the future and you will have a larger gain when you sell it.
The trucking industry is very equipment intensive and significantly accelerated tax deductions can be built up. A $150,000 over-the-road tractor can create an $88,000 accelerated deduction over book in the first year. In the fifth year, the tax gain on the sale of that equipment will be $48,750 greater than the gain on the book. If you are replacing equipment annually, the extra tax depreciation on new equipment can offset the early depreciation on the older equipment as it is replaced. If you replace equipment in groups every few years, you may have more of a roller coaster effect on your depreciation expense, and taxable income over the years. With just 10 tractors acquired in a year, creates an $880,000 extra tax deduction in the first year.
By 2020, there will no longer be any bonus depreciation (under current law) and there will not be any bonus depreciation to offset the effect of taking early depreciation expense on the older equipment. With progressing tax rates, a roller coaster effect on taxable income could cause a significantly higher overall tax liability than if taxable income were more constant over the years. A tax deduction that offsets taxable income at 15% or 25% could result in a lost deduction in a year when tax rates are 40% or higher.
Companies that have elected to be taxed as a pass-through entity, owners who will pay the income tax may also have increased tax with AMT and itemized deduction reductions as their taxable income increases.
You can plan and manage the potential tax impact by electing out of bonus depreciation and you also have options to use slower tax-depreciation methods as well as electing to use a year longer depreciable life (ADS Life). By trading in equipment, you can roll the book/tax difference into the new equipment and defer its effect. If you sell equipment, any gain will be recognized in that year. If you elect out of bonus depreciation you can use additional first-year depreciation (Section 179) and deduct any amount up to $500,000 in any year that you purchase less than $2,000,000 in equipment and other depreciable personal property. However, section 179 depreciation cannot reduce taxable income below zero.
With modeling tax depreciation over the next 4-5 years using different methods, elections, and lives, you can manage the potential tax-depreciation tsunami and spread the effect over several years to soften the effect and reduce the total taxes you pay. You need to plan 3-5 years ahead, because the decisions that are made today will affect future tax consequences.
These are just some of the factors to consider regarding tax depreciation. Everyone’s individual situation is unique and we would welcome the opportunity to meet with you to discuss your specific goals and objectives. Please contact us at 952-844-2500 or 651-227-9431 to schedule a tax check-up meeting with your BGM tax advisor.
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