Depreciation and Write-offs
Copyright 2010 by Morris Rosenthal - - contact info
Copyright 2010 by Morris Rosenthal
All Rights Reserved
Filing Form 4562 with Section 179 Listed Property (Laptop, Camera, Car, etc)
Warning: These pages are not intended as professional advice. They are presented "as is", reader beware!
First of all, it's important to note that not all business property can be written-off, ie, expensed, regardless of whether it meets the other qualifications for business usage. In general, big expensive things that you may prefer to expense, taking the whole cost off your taxes in the year the item was purchased, must be depreciated over a period of years. For example, real estate that you purchase for a business, whether your business is carried out in the building like a store, factory, or office, or whether your business consists of renting that building (landlord), must be depreciated over decades. The only exception I remember seeing is for some single use farm related structures, or special buildings involved with field operations. Other property that lasts for years that you might normally think would need to be depreciated over time may be written-off, or expensed, in one shot, see IRS Publication 946 for details.
There's no point in filing form 4562 if you don't have to. The basic reasons to file a 4562 is for the sake of deducting amortization or depreciation for business property, to write-off certain property (elect to expense it) under section 179, and to provide some documentation about the business use of equipment. You must file form 4562 if you are claiming depreciation for property you've started using for the business in the current tax year, to continue the depreciation of property put into business service in a previous year, for any vehicle deduction not covered by Schedule C, if you want to take a section 179 deduction, or want to start amortizing any business investment in the current year. If you have multiple business entities, you must file a form 4562 for each one with the deduction listed above.
The main deduction for most businesses is the depreciation of business property. Depreciation is just the government's way of acknowledging that the things you buy for your business have a value that starts at the cost (what you pay for it) and declines with time. When I use the expression "write-off" as the equivalent of the IRS expression "expense", I'm talking about deducting the whole value of the purchase in one shot. But depreciation means that you get to take a partial deduction (a percentage of the purchase price) each year for a number of years, where that percentage may be steady (straight line depreciation) or accelerated (larger deductions in the earlier years). Depreciation isn't limited to real property, like buildings and equipment, you can also depreciate certain intangible property, such as the intellectual property including patents and copyrights.
Section 179 listed property is a red flag list of items that the IRS realizes have dual-use potential, ie, business or pleasure. Common examples of listed property are cars and pick-up trucks weighing less than 6,000 pounds, and basically anything else that moves that you might have fun on outside of business hours. Depreciation for laptops, cameras, an LCD TV or computer , video equipment, stereos are all suspect. Sure, you might have a legitimate business use for these items, but if there's a chance that you're using them for recreation that isn't part of the defined workplace practice, the IRS wants you to keep track of the time and not claim your personal recreation use as a business expense. Cell phones purchased by a business and pretty much any and all personal computer equipment are also on the list. So even if you use your laptop for work all day, if you use it at night to research restaurant and movie listings online (assuming this isn't your business), the laptop would be considered listed property and you are asked to state what percentage of time it is used for work and what percentage of time it is used for play (they better add up to 100%). Note that you can write-off (expense) less than 100% of the cost of listed property its first year, and depreciate the rest later.
The total amount you can deduct is limited by both the maximum amount the IRS is allowing that tax year (probably several hundred thousand dollars) but also by your business income. You cannot have more business deductions than business income in a tax year, and for most people, if you're getting that close to zero, it probably makes more sense to only write-off that part of the property that keeps your income in the 25% or higher tax bracket. Deductions are where a ton of Washington pork politics and special interests are involved, it's pretty easy to see who has the ear of Congress each year by looking at the special industry deductions and exceptions.
As usual, there are exceptions to the exceptions, If your computer or photography equipment, which would normally be considered listed property, is never used for anything other than business activity, or used anywhere other than your regular business location, it's OK. But in an exception to the exception to the exception, if your regular business establishment is your home, ie, you file a Form 4562, your business use of the home has to meet a stricter criteria, set out in section 280A(c)(1). And life gets even more confusing if listed property that you claim is used less than 50% for the business, even if you've been depreciating it over the years and it is just dropping below 50% business use in the current tax year.
So how do you determine how many years to depreciate property over? The IRS pretty much locks it in for property that isn't getting expensed, with the following lifespans (I'm leaving out deductions for stuff like municipal sewer plants and gas pipelines, but I kept the railroads-):
3 year property - race horses ( doesn't matter how old they are when you put them into service) and certain rent-to-own items.
5 year property - cars, pick-up trucks, most office equipment (PC, copier, etc), appliances, carpets and furniture, certain R&D or energy related equipment, most farming equipment (but there are exceptions),
7 year property - office furniture (and equipment other than copiers, computers, etc), railroad tracks (for you tycoons), motorsport complexes (see the special interests), everything else that doesn't show up in the other categories!
10 year property - ships, boats, barges, single use farm buildings, fruit and nut trees and vines, smart electric meter (computerized grid stuff to encourage green energy and conservation)
15 year property - qualified leasehold improvements and restaurant properties, qualified retail property
20 year property - multi-use farm buildings
25 year property - residential rental property where at least 80% of the total income is from rental units, property that isn't residential rental property and doesn't have a class life less than 27.5 years, Class life is in Publication 946, table below from Publication 4562.
50 year property - pretty much railroad stuff
I used to break my head over trying to understand the way things are expressed on Form 4562, but in the end, I've always been able to expense all of the property I was claiming in that year, The maximum amount a business could expense was pretty low when I got started as a sole proprietor, less than the cost of a decent new car, but those limits have been pumped up over a hundred thousand dollars for the past couple years in an attempt to encourage business spending. It's the acronyms that tend to make life look more difficult, and the annoying one of the form 4562 is MACRS (Modified Accelerated Cost Recovery System). It's an alternative to straight line depreciation, so with MACRS, you can write-off more of the cost basis of the equipment or property faster. This is usually preferable for because inflation always means that future deductions will be worth less than present deductions, simply because the dollars will be worth less. But if you are just starting a business and have limited profits and you don't absolutely need the cash, a slower depreciation schedule will allow you to write off part of the property cost in the future when you are ideally in a higher tax bracket, making the deduction worth more.
Generally speaking, for a sole proprietor without employees, depreciation is the most complicated thing you are likely to have to deal with in your tax return. Not only are the rules somewhat complicated, but you need to follow up year after year, reducing your cost basis and continuing the depreciation process until the equipment no longer has any value or is no longer used in the business. Then, if you sell the property and you receive more for it than the value you are carrying on your taxes. you're going to owe the IRS some money back. This is called recapture, and any profit you make selling property that you've depreciated to a point lower than the remaining cost basis is treated as regular business income. So how do you calculate the cost basis for property? It's just the cost of the property times the percentage of time it's used for the business. So if you have a computer you paid $1,000 for that gets 80% business use and 20 % personal use, you can depreciate or expense 80% of $1,000, or $800.
Straight line deduction and MACRS depreciation aren't the only choices. There's 200% declining balance, and 150% declining balance, not to mention the Unit of Production Method, the Retirement Replacement Betterment Method, and who knows how many other methods that accountants have convinced the IRS are legitimate. The simplest is straight line, which means you divide 100% by the number of years allowed for the depreciation, and the resulting percentage is what you get to deduct each year (allowing for partial years as described in the next paragraph). The other two standard methods, 200% declining balance and 150% declining balance, are actually simple modifications to straight line, refering to how much the maximum depreciation amount is increased the first year. The IRS examples make it look like the norm is to switch to straight line as soon as the advantage goes out of the accelerated amount,
More complicated is the convention chosen for dealing with partial years, the year the property is put into business use and the year it is sold or disposed of. There are three different conventions, half year (no matter when it's bought, you get credit for half of the depreciation amount allowed a full year), mid-quarter (cuts it up a little finer) and mid-month (the finest gradation, lets you go as high as .9583 of a full year for something placed in service the first month of the fiscal year). By expensing rather than depreciating, I've gotten around from having to fool around with any of these.
Amortization is very similar to depreciation, but it generally refers to less tangible expenditures, like start up expenses and intellectual property. Research and development expenses can go either way, depreciation (or expense) or amortization over five years or more in equal amounts. See publication 535. Most intellectual property must be amortized over 15 years, starting with the month it was acquired or put into service. This includes all sorts of knowledge based assets, copyrights, patents, formulas, etc, goodwill, trademarks, franchise value, liquor license, all sorts of things of value that have an acquisition cost and value).
Planning A New Business | Estimating Business Taxes | Schedule C Deductions | Car Expenses | Freelancer and Contractor Payments | Section 179 Depreciation and Form 4562 | Employee Benefits and Pension Costs | Professional Services, Business Taxes and Fees | Hotel and Travel Expenses | Deducting Food and Entertainment | Inventory and Cost of Goods Sold | Sole Proprietor Statistics | Home Office Deductions | Self Employment Tax | The Self Employed Sole Proprietor