Time To Payback The Benefits of Bonus Depreciation?Written By Rick Reekie
Article Date: 01-01-2006
Copyright (C) 2006 Associated Equipment Distributors. All Rights Reserved.
For some companies, reduction of the tax liability was an interest-free loan the government wants repaid.
Following September 11, Congress enacted the 30 percent bonus depreciation provision to spur capital spending. This provision permitted taxpayers to expense, in the year of acquisition, 30 percent of the cost of new business property. The remaining cost was then eligible for MACRS depreciation. In May 2003, Congress increased the bonus depreciation to 50 percent. This allowed many capital intensive businesses to reduce or "eliminate" their federal tax liability, freeing up cash for investment.
However, for many companies that turn over assets frequently, this benefit may soon reverse when bonus depreciation-eligible property is sold. The reduction of prior-year tax payments resulting from bonus depreciation could be viewed as an interest free loan that will have to be repaid soon without additional tax planning.
For example, let's assume a taxpayer typically averages $60,000 in taxable income. At an 35-percent tax rate, he normally pays $14,000 in taxes on this income. In 2003, because of bonus depreciation, he decided to purchase an additional $100,000 of construction equipment that was sold for $40,000 in 2005. With the bonus depreciation, the taxpayer has increased cash flow by $14,000. In this example, the additional bonus depreciation eliminated his tax liability.
Let's assume the taxpayer did exactly what the government wanted and took the additional cash and reinvested it in the economy by buying new business assets. In other words, the taxpayer didn't save the money. Everyone's happy, at least for the first year. Now, let’s look at the tax impact in 2004:
In the second year, due to the reduced tax basis in the asset because of bonus depreciation, the taxpayer actually has to pay $5,600 more in tax – reducing the benefit of bonus depreciation from $14,000 to $8,400.
From the taxpayer’s point of view, $8,400 is still not too bad. That is until the taxpayer sells the asset on which bonus depreciation was taken.
Because of the depreciation recapture, when an asset is sold for more than the tax basis, the taxpayer has to repay the benefit of bonus depreciation.
Accelerated tax depreciation has always been an interest-free loan from the government to the extent that the asset's actual economic depreciation was less than the allowable tax depreciation. Bonus depreciation simply magnified that by greatly acceleration the allowed tax depreciation. As the examples illustrate, when assets are turned quickly, the benefits of bonus depreciation are short-lived.
However, there is a way to maintain the benefits of bonus depreciation for taxpayers who frequently replace business assets. Through successful implementation of a "like kind exchange" program (LKE), the taxpayer can "indefinitely" defer recognizing the tax gain on disposition for as long as they continue to replace the assets. This is usually for as long as the company remains in business. In effect, KLE turns the temporary timing difference afforded by bonus depreciation into a permanent deferral.
Here's how: For every asset that is sold and replaced, the sold asset is treated as if it had never been sold and it continues to depreciate it its remaining MACRS life. Any additional funds (over the sales proceeds) needed to acquire the new asset are then depreciated under a separate MACRS schedule. To determine depreciation for the exchange group, the two layers are combined. The deferral of the gain on the sale of the asset reduces the basis in the acquired property.
Let's see how the same contractor would fare if he implemented an LKE program. Since, the benefits of LKE are realized when the asset is sold, the tax depreciation for 2003 and 2004 would remain the same.
Instead of having to payback the benefits of bonus depreciation, the benefit is rolled forward into the replacement asset.
From the above, it should be clear that the benefits of bonus depreciation start to reverse in the year following acquisition, unless of course, an LKE program is implemented to retain the benefits.
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