Preface: Without going into all the tax complexities, in the past sometimes the IRS and tax courts have varying historic stances on the tax implications of when an asset is placed in service. Here’s how it works.
Taxes and Equipment Purchases (Segment II)
Credit: Jacob M. Dietz, CPA
Many business owners dislike rendering taxes to Caesar, so getting a tax break in the current year seems beneficial.
Sometimes, however, a business may choose to wait to place assets in service. Why would you wait to take a tax break? The federal tax system uses different rates for different amounts of income, and certain tax benefits phase out at higher income levels. A taxpayer may aim to have income within certain ranges to take advantage of more favorable tax rates or benefits.
The details of the tax system can be quite complex, but without getting into all the details the tax rates range from 10% to 37%. One important thing to note is that the higher brackets only apply to the higher income. Therefore, if someone had enough income to be taxed at the 37% income bracket, not all their income would be taxed at 37%. For example, some would be taxed at 10%. Taxpayers do not need to worry that if they bump up into a higher bracket that suddenly all their income will be taxed at the higher percentage. Nevertheless, if they bump into a higher bracket, they will need to pay the higher percentage on the income that is in that bracket.
Suppose a business placed many assets in service in the current year, but they do not need all the deductions in the current year. The business owners may fear getting pushed into higher tax brackets in the next year.
What can be done to generate deductions next year? The business could avoid immediately deducting all the equipment in the current year. Instead they could depreciate it over the recovery period. That defers some of the depreciation to next year. If the taxpayer does not take all the expense in one year, then it must be taken over a certain number of years. Exactly how many years is beyond the scope of this article, but the government provides guidance. If it is not all taken in year one, expect it to take multiple years to get the deduction. The remainder is not all deducted in year 2. But what if the taxpayer wants to take it all in year 2? Generally, the taxpayer is not permitted to do this unless the asset is placed in service in year 2.
Therefore, if a business has enough deductions in year 1, and not enough in year 2, they may want to wait until year 2 to place the asset in service, if they can wait that long without significantly hindering operations. If all the conditions are met, they may be able to fully deduct the equipment in year 2 if placed in service in year 2.
When is the Asset in Service
It can make a significant difference in your taxes depending on when the asset is placed in service. When is it placed in service? That answer can get complex. One of the regulations states that “Property is first placed in service when first placed in a condition or state of readiness and availability for a specifically assigned function.” Without going into all the complexities, in the past sometimes the IRS and courts have sometimes taken a looser and sometimes a stricter stance on when an asset is in service.