My vendor tells me that when I buy lots of their equipment, I get a huge tax deduction if I do it before the end of the year, so I should act now. Is this true?
When you start shopping for equipment, many vendors and lenders will throw this tax law at you in order to encourage you to spend money. Section 179 is definitely a valuable tax benefit, but its value may be overstated for a startup. Nevertheless, you should be aware that this law exists.
The main difference between section 179 and MACRS (traditional depreciation) is that for section 179, you take the tax deduction in the year you placed the equipment in service; for MARCS you spread the deduction out over three to seven years, or longer. Whether it is advantageous to elect section 179 or MACRS depends on two things: your marginal tax rate, and the time value of money. I will discuss some scenarios later on in this post.
First, let’s go over the Modified Accelerated Cost Recovery System (MACRS), which is the traditional system of depreciating property in the United States. When you depreciate property, you are allowed to deduct a certain amount of the property’s value from your practice’s annual income. Normally, if you don’t elect the Section 179 deduction, you would depreciate your property through the MACRS schedule.
Depending on the type of property, you can depreciate over a certain allowed length of time, known as the recovery period. For example, office furniture and medical equipment have a 7 year class life, office machinery, computers, electronic medical equipment such as your OCT, IOL master, and visual field have a 5 year class life. For those of you who are slumlords, residential real estate has a 27.5 year depreciation period, commercial real estate has a 39 year depreciation period. The amount you can depreciate each year is based on the following chart:
You can see that the annual depreciation percentage is weighted heavily toward the early years of the class life, which is more beneficial for the property owner. You can find more information on depreciation on IRS Publication 946. The above chart is from this publication, table A1 on page 70.
Section 179 is a special tax law put into place in 1958 to encourage small business spending. Under this law, you would be able to deduct the entire value of newly purchased property in the first year of service, instead of nibbling away through the MACRS depreciation schedule. Qualified properties include: machinery, computers, software, office furniture, vehicles, or other tangible goods. In 2008, Section 179 allowed businesses to write-off capital equipment purchases up to $250,000, with the deduction phased out on a dollar-for-dollar basis on purchases exceeding a total of $800,000. This meant that the allowed total deduction would be reduced by the amount exceeding $800,000. For example, if you purchased $900,000 in equipment, you would be allowed to deduct only $150,000 ($250,000-$100,000 over $800,000). This threshold as incorporated into this law to make sure that only small businesses benefited. The maximum allowed deduction was originally scheduled to go down to $25,000 in 2011, but every time there is a recession or the government wants to encourage government spending, the annual amount business are allowed to depreciate under section 179 increases.
The Small Business Jobs and Credit Act of 2010 increased the Section 179 deduction limit to $500,000 with the phase out beginning at $2 million for 2010 and 2011. In addition, it reinstated the 50% bonus depreciation as well, which would allow you to depreciate 50% of the value of all purchases greater than $500,000, but less than $2 million. Any amount greater than $2 million would be depreciated over the normal MACRS schedule. In addition, leasehold improvements and other 15 year qualified real estate also became qualified expenses for the Section 179 deduction for up to $250,000.
The Tax Cuts and Jobs Act of 2017 (Trump tax plan) again increased the section 179 deduction limit to $1,000,000 and the phaseout limit to $2,500,000. It is unlikely that a small potatoes solo ophthalmologist would need to buy that much equipment, but this increased limit might be beneficial to a small group practice opening a new satellite office. The TJCA also expanded the definition of qualified property eligible for section 179 to include among other categories improvements to nonresidential real estate property such as roofs, heating, ventilation air conditioning, fire protection, and alarm and security.
In order to qualify for a given year’s Section 179 deduction, all your equipment has to be put in place for service by year’s end. Just making a purchase does not make you eligible. Also, your equipment needs to be used for business purposes for over 50% of the time.
So hypothetically if you bought a OCT for $50,000, and put it in service in 2018, under the five year class life MACRS you could deduct $10,000 in 2018, $16,000 in 2019, $9600 in 2020, $5750 in 2021 and 2022, and $2900 in 2023. The tax savings would depend on your marginal tax rate in each individual year.
If you elected section 179, you would take the entire $50,000 deduction in 2018. If you were in the 22% bracket, it would be a tax savings of $11,000; if you were in the highest tax bracket of 37%, it would be a tax savings of $18,500. At a hypothetical stock market return of 8% it would take about 6.5 years for $11,000 to grow to $18,500. You can see where I’m heading with this…
So regardless of whether you elect section 179 or MACRS, you get to deduct the $50,000. It’s just a matter of if you do it all at once for cash flow, or “save” the deductions for future years when you’re taxed at higher rates and the deduction is potentially worth more.
Finally, there’s no such thing as a free lunch. Once you sell the equipment, depreciation is recaptured and you pay taxes on it. Otherwise, what’s to stop you from buying a bunch of OCTs, taking the deductions, and selling the OCTs to friends? You report sales on form 4797 and depreciation recapture is taxed at ordinary rates. Say you buy the OCT in the above paragraph in 2018 and sell it in 2021 for $20,000. You depreciated $41,350 of the $50,000 between 2018 and 2021, so your basis in the equipment is $8650. The difference between the sale price of $20,000 and basis of $8650 is $11,350, so you’d pay taxes on the $11,350; if in the highest bracket of 37% it would be $4200 in taxes. If you elected section 179 in 2018 and sold it in 2021, your basis is zero, and you’d pay taxes on the full $20,000, which would be $7400 at 37%. If you sold the equipment at a profit, you’d be taxed at ordinary rates on depreciation recapture but more favorable capital gains rates on anything over the purchase price.
As an aside, the tax geek in me wants to let everyone reading this who leases residential real estate they own, that the depreciation per year is the value of the home minus the value of the land divided by 27.5. (For commercial property such as your office, the depreciation period is 39 years). So say you have a property worth $400,000 and the land is worth $125,000. You would depreciate $10,000 per year. When you sell the house, you pay depreciation recapture of 25% under section 1250. If you held it for five years, you’d deduct $10,000 of depreciation per year against rent. This is like getting a loan from the government and if you depreciate at the highest tax bracket of 37% but “pay it back” at 25% there’s an arbitage. When you sell you pay 25% of $50,000 or $12,500 in taxes for depreciation recapture- unless you bought another rental under a section 1031 exchange and rolled in the depreciation. And there’s a step up basis on death if you want to pass it on to your heirs…
You report depreciation on form 4562. The amount depreciated goes on form 1120 line 20 if taxed as a S corp, or on schedule C line 13 if taxed as a sole proprietor. Page 21 of the instructions for form 4562 has a important table: the depreciation worksheet. To keep good records, for every piece of equipment you purchase enter it on this worksheet. You should keep a worksheet for every calendar year and save it indefinitely, as you may need this information when you sell the equipment. At the end of the year, you can look at the worksheet and take into account your overall tax picture to decide if you want to elect section 179 or MACRS. If you do your taxes yourself, you can just enter the information from the worksheet into TurboTax or the software of your choice; if you use an accountant this worksheet will save them a lot of time and trouble.
This all sounds awesome and everything, but there are still limits to this law. For startups, Section 179 probably won’t hold as much value as the equipment vendors and lenders would lead you to believe. Unfortunately, your Section 179 deduction may not exceed your annual income (including any wage or spousal income). That means that if I buy $200,000 worth of equipment, but I only make $10,000 that year, I can only deduct $10,000 from my income tax return. However, I don’t lose out on the remaining $190,000 in deductions, but instead, it indefinitely carries over to the next year until I exercise all my deductions. Hence, if I don’t make much in my first few years of practice, Section 179 deduction may not be significantly different from traditional MACRS depreciation.
Some accountants will convince you they’re doing a great job by using section 179 to zero out your income. Big mistake- you WANT to pay taxes at a low rate and save some deductions for when you’re taxed in marginally high brackets. With the old tax law, for a single person if you declared a business profit of about $23,700 you could pay zero in taxes (assuming no other job or investment income), with the standard deduction and exemption of about $10,750 and a simple IRA contribution of $12,500 plus a 2% IRA match of $465. OK, I left out that you’d pay about 15.3% in self employment taxes, but I’d love to be taxed at the 15.3% bracket on as much of my earnings as possible…
On the other hand, if you’re well into the highest tax bracket, and expect to be taxed at the highest rate in future years, it makes sense to section 179 most of your equipment purchases, so you get your deduction (and cash back) ASAP rather than spread it out over five to seven years, for the time value of money.
You are allowed to elect to depreciate some equipment under section 179 and other equipment under MACRS the same year. So say you spend $150,000 on equipment for your startup. Depending on how much your practice earns, if your spouse has income, and the time value of money, you could elect to depreciate $100,000 with section 179 and $50,000 with MACRS traditional depreciation- or the other way around, $50,000 with section 179 and $100,000 with MACRS. Because of the time value of money, it usually makes sense to elect section 179 for property with longer depreciation periods, and MACRS for three to five year property.
The two drivers for whether and how much you should elect for section 179 vs MACRS depends on whether you are paying self employment taxes (FICA and medicare taxes of 15.3%, on the first $128,700 of self employment income) as well as whether you are in the phaseout of the pass through deduction.
If you have a spouse that works, say they earn $100,000. The first dollar you earn is taxed at the 22% rate along with self employment taxes of 15.3%. That’s about a 37% rate- the same rate as if you earned over $600,000. So you want to take enough deductions to offset your business income at the 37% marginal rate, but NOT offset your spouse’s wage income taxed at the lower 22% rate!
For a single person, anything up to $38,700 is taxed at 24.6% (9.6% rate taking into account pass through deduction plus 15% self employment taxes). Once you earn more than that it jumps to 32.6% for income up to $82,500 (17.6% rate plus 15% self employment taxes). Then you are taxed at 34.2% up to $128,700 (19.2% rate plus 15% self employment taxes), then it drops to 22% (no more FICA tax but still medicare tax) from $128,700 to $157,000. At $157,000 to $207,000 your pass through phaseout occurs so you’re being taxed at a marginal rate of 50 to 53%! That would be a good year to buy a new exam lane. Once you’re over $207,000 (end of pass through phaseout) your marginal rate drops back down to 35% (32% plus 2.9% medicare tax).
But it’s hard to predict how quickly or slowly your practice will grow, and what your marginal tax rate will be in future years. Plus Congress could change the tax laws and rates at their whim…
So, don’t assume that Section 179 is as awesome as vendors and lenders describe it. In the end, they’re still out to make money from you, and they will use all the best sales pitches to to overstate the value of the deduction and entice you to take the bait. Of course, I think Section 179 may be of great benefit for your practice if you’re five years into practice, are taxed at highest tax bracket, and want to buy a new OCT or furnish an additional exam lane. However, I don’t think you should spend more than your budget because of Section 179. Be aware that this law is out there, but don’t let it be the sole driver of your purchase decisions. Don’t buy equipment to lower your tax burden- buy it because it will help your practice be more productive. And even if you have a tax advantage from waiting to buy equipment in a future year, if you really need that additional exam lane to make your practice run efficiently, go ahead and buy it now.
Going back to the original question, if you are told you need to buy it by the end of the year to get the tax break, don’t listen to the high pressured sales pitch. If you wait until the next year to buy the equipment, you can still elect section 179 the next year- which actually might be advantageous if you’re in a higher marginal tax bracket. Indeed, the mistake I made when I opened up in December was to put all my equipment in service that year. If I had waited six weeks to get my field and OCT delivered, I would’ve been able to section 179 most of that equipment when I was in a 40% tax bracket (25% ordinary rate plus 15.3% self employment tax).
Editor’s note: the original version of this post by Ho Sun appeared October 31, 2010 and has been edited by Howie with 2018 updates and to discuss how marginal tax brackets can drive the decision of MACRS vs section 179 election