Section 179 Deduction, Bonus Depreciation and Depreciation Recapture

By Chris Holt, Solid Rock Realty Advisors, LLC

Using the Section 179 deduction with the purchase of machinery and equipment is an effective way for farm and ranch owners to reduce their taxable income.  However, many people don’t fully understand the significant impact depreciation recapture can have on their taxes when they sell their machinery and equipment.  

What is Section 179?

Section 179 of the IRS tax code allows businesses to deduct the full purchase price of qualifying equipment from their gross income in the current tax year.  

This deduction is an incentive created by the U.S. Government to encourage businesses to buy equipment and invest in themselves.

What is bonus depreciation?

Bonus depreciation is a tax incentive that allows a business to immediately deduct a large percentage of the purchase price of eligible assets, such as machinery, rather than write them off over the “useful life” of that asset. Bonus depreciation is also known as the additional first year depreciation deduction.

How bonus depreciation works

When a farm or ranch owner purchases machinery or equipment, the cost, for tax accounting purposes, has traditionally been spread out over the useful life of that asset. 

This process is known as depreciation. 

What’s the difference between section 179 and bonus depreciation?

Bonus depreciation is offered some years, and some years it isn’t. For 2019, it is being offered at 100 percent.  The most important difference is now both new and used equipment qualify for the Section 179 deduction, as long as the used equipment is “new to you,” while bonus depreciation has only covered new equipment only until the most recent tax law passed. 

In a switch from recent years, the bonus depreciation now includes used equipment.

The Section 179 deduction limit has been raised to $1 million with a total equipment purchase maximum of $2.5 million.  

This was a significant increase from the 2017 Section 179 tax deduction which was a $500,000 deduction limit with a threshold of $2 million in total purchases.

The 100 percent bonus depreciation amount will remain in effect until the end of 2022 when the following phase-down will occur: 80 percent for property placed in service after Dec. 31, 2022, and before Jan. 1, 2024; 60 percent for property placed in service after Dec. 31, 2023 and before Jan. 1, 2025; 40 percent for property placed in service after Dec. 31, 2024 and before Jan. 1, 2026 and 20 percent for property placed in service after Dec. 31, 2025 and before Jan. 1, 2027.

What is depreciation recapture?

Depreciation recapture is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that a taxpayer had used to offset their taxable income.  

Since depreciation of an asset can be used to deduct ordinary income, any gain from the sale of the asset must be reported as ordinary income, rather than capital gain which is taxed at a lower rate.  

Calculating depreciation recapture

The first step in calculating depreciation recapture is to determine the cost basis of the asset. The cost basis is the price that was originally paid for the asset. 

The adjusted cost basis is the original cost basis minus any allowed or allowable depreciation expense incurred.  

For example, if business equipment was purchased for $10,000 and had a depreciation cost of $2,000 per year, its adjusted cost basis after four years would be $10,000 – ($2,000 x 4) = $2,000.

The depreciation would be recaptured if the equipment is sold for a gain. 

If the equipment is sold for $3,000, the business would have a taxable gain of $3,000 – $2,000 = $1,000. 

It is easy to think a loss occurred from the sale since the asset was purchased for $10,000 and sold for only $3,000. 

However, gains and losses are realized from the adjusted cost basis, not the original cost basis.

Charitable remainder trust for equipment sales

Fortunately, a tool does exist for reducing taxes on the sale of equipment.  By setting up a charitable remainder trust (CRT) and selling your machinery or equipment through the CRT, you may be able to totally defer the tax you may have otherwise paid.  

With a CRT, you are essentially trading your asset for a lifetime income stream. This tool is typically used by those who are downsizing their operation or transitioning into retirement.

Chris Nolt is an independent, fee-only registered investment advisor and the owner of Solid Rock Wealth Management, Inc. and Solid Rock Realty Advisors, LLC, sister companies dedicated to working with families around the country who are selling a farm or ranch and transitioning into retirement.  

To order a copy of Chris’s new book: Financial Strategies for Selling a Farm or Ranch, visit Amazon.com or call Chris at 800-517-1031