Section 179 of the IRS code is a deduction that allows businesses to deduct the full cost of qualifying equipment in the year of purchase rather than depreciating the cost over time.
Since a bigger deduction means lower taxable income in the current year, this deduction encourages businesses to invest in their growth through the purchase of new equipment.
What is Depreciation?
Depreciation is when an asset's value decreases gradually over time due to normal usage. When a company buys a piece of equipment, instead of recognizing the expense entirely in the year of purchase, the IRS requires that the expense be taken gradually over the years of the asset's useful life. In the most simple scenario, if a company purchases an asset for $25,000 and it has a useful life of five years, the books would show a capitalized asset for $25,000 and a depreciation expense of $5,000 for each of the first five years of its life. The company may continue to use the asset after it is fully depreciated, but its book value would be zero.
Section 179 Explained
Section 179 is a deduction allowed by the IRS where the full cost of an asset may be taken as an immediate expense, relieving a company's current tax burden. This is instead of the typical tax treatment for a newly acquired asset, which would mean capitalizing the asset and taking smaller depreciation deductions during each year of the asset's useful life. By allowing companies to take advantage of section 179, the IRS is encouraging businesses to invest in their growth by purchasing new equipment and receiving an immediate tax incentive. To elect the deduction, businesses need to fill out IRS Form 4562.
What is Eligible for Section 179?
Eligible property may be new or used and may be leased or purchased outright.
To utilize a deduction under section 179 an eligible property must be:
- Tangible. Physical property like computers, software, equipment, furniture, machinery, and vehicles would qualify. Intangible property such as patents does not qualify, and neither do buildings or land. However, certain improvements attached to buildings, such as security or HVAC systems do qualify.
- Put into use. Eligible property must be placed into service in the year the deduction is claimed.
- Not acquired from a related party. Property may not be purchased from a relative or related organization.
- Used more than 50% of the time for business. If the eligible property has mixed-use, as long as the business usage is greater than 50%, the business portion is eligible for the deduction. Simply multiply the cost by the percentage of business use to arrive at the cost to be used for section 179.
Section 179 offers a fair amount of flexibility. So long as the guidelines are met, businesses may choose how much of the allowed deduction they would like to use, which eligible items they would like to use it on, and how much of the full cost they would like to deduct. This means some depreciation may be saved for future years if desired. For this reason, it's important to consult with an accountant to maximize total savings over time.
Section 179 Limitations
The IRS has a cap that limits the amount of the section 179 deduction that a company can take in a given year. For example, in 2020 the maximum deduction that can be claimed under section 179 is $1,040,000. Furthermore, this amount is reduced dollar for dollar by any qualifying purchases exceeding the IRS cap of $2,590,000.
Additionally, a section 179 deduction can never exceed net income. If the section 179 deduction exceeds net income, the remaining deduction amount can be carried forward and depreciated in future years.
Section 179 used to be known as the SUV loophole or the Hummer deduction since companies would write off the full cost of luxury vehicles as business expenses in the year of purchase. To close this loophole, the IRS imposed certain guidelines for vehicles to be eligible. Vehicles must weigh more than 6,000 pounds, and there is an annual cap on the cost tied to vehicle eligibility. However, certain vehicles that are unlikely to be used for personal use, such as specialized machinery or vans seating nine-plus passengers, still qualify for the full section 179 deduction.
Section 179 Example
Sweet Treats is a commercial bakery with a net income of $850,000 for the tax year 2020. In order to expand the lines of desserts offered, Sweet Treats purchased and began using commercial ovens with a cost of $2,650,000.
Eligible purchases: $ 2,650,000.00
Allowed total purchases (IRS cap): $ 2,590,000.00
Dollar-for-dollar reduction for excess purchases: (subtotal) $ 60,000.00
Maximum deduction amount (IRS cap): $ 1,040,000.00
Less reduction for excess purchases: $ (60,000.00)
Deduction available for Sweet Treats subject to net income (subtotal): $ 980,000.00
Net Income - max deduction allowed (current tax year): $ 850,000.00
Depreciation remaining for future years (deduction above net income): $ 130,000.00
The IRS cap for 2020 is $1,040,000. This is reduced dollar for dollar by purchases exceeding $2,590,000. Since Sweet Treats purchased equipment exceeding this amount by $60,000, the maximum deduction allowed Sweet Treats is $1,040,000 less $60,000, or $980,000.
Since Sweet Treats has a net income of $850,000, Sweet Treats must limit their section 179 deduction to that amount. The remaining amount of $130,000 may be carried over and depreciated in future years.
The IRS offers an additional deduction with the similar idea of encouraging companies to invest in their growth through purchasing equipment. Although bonus depreciation has the same concept and may be used in conjunction with section 179, the rules and applications are different. Businesses should be sure to understand both deductions and plan strategically for the optimal tax benefit over the greatest possible amount of time.