If you’ve been in business for long, you probably know about the Sec. 179 election you can use to save taxes.
Though you typically can’t use Sec. 179 for real estate assets and you can’t use its “immediate write-off” accounting to create a loss, you can still aggressively use Sec. 179 elections to shelter business income and even wipe out your tax liability.
In a nutshell, the Sec. 179 election lets you immediately write off the costs of most assets rather than depreciate the asset cost over years and years.
Here’s the awkward thing, though: If you’ve been going crazy using Sec. 179 depreciation, there’s a very real possibility that you’ve been misusing it—that you’ve been doing your Sec. 179 elections and depreciation accounting in a way that doesn’t save, but rather costs, you taxes.
The Usual Sec. 179 Approach is Wrong
But let me explain.
Assume that you’ve got a business that makes $100,000. Assume further than you buy a $100,000 piece of equipment that’ll last for, oh, say five years.
The Sec. 179 election allows you to write off the $100,000 of equipment all at once. Boom. And so, on your tax return, your business income shows as zero. And that tax accounting seems good.
You won’t owe any income or self-employment taxes.
But probably you have only made an expensive mistake by using this “write everything off at once” approach.
Note: In 2014, tax laws let you use a Sec. 179 election to write off up to $500,000 as long as you purchased less than $2,000,000 of qualifying property.
The Problem in a Nutshell
The things that goof up people? A couple of boo-boos.
First, people forget to look at the effect of the very low tax rates they pay on those first dollars of income.
And then, second, people miss the relatively high tax rates they pay on those last dollars of income.
For example, even if you are making $100,000 in your business, that first $20,000 or so of income you earn probably doesn’t get taxed at all because of your deductions and personal exemptions.
Using Sec. 179 depreciation to “shelter” that first $20,000 of income that won’t even be taxed clearly produces zero benefit.
And then remember that your first two tax brackets are pretty modest.
After you blow past the point where deductions and exemptions shelter your income, you pay a 10% income tax rate on a chunk of your income (nearly a $20,000 chunk if you’re married) and then a 15% income tax rate on a chunk of your income (nearly a $60,000 chunk if you’re married).
Using Sec. 179 depreciation to shelter income that would otherwise be taxed at 10% or 15% also usually isn’t a very good use of the write-off either.
Keep in mind, too, that tax credits may in fact wipe out the income taxes you pay on income within these bands.
How to Optimize Sec. 179 Depreciation
Once you move beyond the point where deductions and exemptions shelter your income and pass the point where low tax rates make for a light burden, things get interesting.
Why? Well, because where Sec. 179 depreciation really saves you money is when you can use it to shelter your most highly taxed income.
In other words, you don’t want to use $100,000 of Sec. 179 depreciation to drive your taxable income from $100,000 to $0. That’ll only save you maybe $12K of income taxes, albeit all at one time. But that’s wasteful.
What you actually want to do is spread the $100,000 out over, say, five years. In other words, shelter $20,000 of income a year for five years. In this manner, you’ll save only $4,000 or so a year—but you’ll enjoy five years of these savings.
Spreading out the savings, then, means you save more like $20,000 in taxes rather than $12,000. And that’s a lot better deal.
Note: Even if you want to make a time value of money adjustment, you really can’t justify using up all the depreciation at once. Not to get all technical on you, but spreading out the tax savings over a few years may been akin to earning 30% to $40% annually.
Awkward Qualifications about My Accounting
Let me leave you with a handful of closing caveats and comments.
First, note that I’m being a little rough here in my accounting. Basically, I rounded all my numbers to the nearest thousand to make this little post easier to read.
Second, you won’t have perfect flexibility with your depreciation accounting. You will be constrained by tax laws in all sorts of little ways—which will mean that you won’t actually be able to perfectly spread the depreciation out in just the way you want.
Third, you absolutely want to check the numbers or ask your accountant for the specifics of your situation. Usually, you want to smooth your income to save on income taxes. But the particular circumstances you find yourself in matter.
For example, I’m focusing on income taxes here but if you’re over the Social Security threshold ($118,000 in 2015) or happen to be running some clever pension strategy, you might want to connect your Sec. 179 decisions with that other stuff.
And a fourth and final comment: This business about using deductions to smooth your taxable income? That works for all sorts of deductions and not just Sec. 179 depreciation. Just so you know…