Analyzing the Tax Cut Deal

President Obama signed a tax bill into law yesterday (Friday) that gives us some clarity on what the tax situation will be for 2011 and 2012.  Here are the highlights of the bill:

• Tax brackets to remain the same, with a 10% bottom rate and a 35% top rate.  Without this legislation, the bottom rate would have increased to 15% and the top rate to 39.6%.
• A "payroll tax holiday" that reduces the amount of FICA withholding by 2% (self-employed taxpayers will see their self-employment tax decrease by 2%).  For a person making $40,000/year, this would equal an $800 savings.  (But the Making Work Pay Credit is expiring, which negates some of the savings.)
• Another "patch" to the Alternative Minimum Tax that will help millions of taxpayers avoid this tax.
• The capital gains and qualified dividends rates remain at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the higher tax brackets. 
• The Child Tax Credit will remain at $1,000 (it had been set to decrease to $500 in 2011).
• You can claim dependent care expenses of $3,000 for one child or $6,000 for two or more children.  These amounts had been set to decrease to $2,400 and $4,800.
• The expanded Earned Income Credit remains in place through 2012.
• The credit available for energy efficient upgrades to your home remains in place through 2012 (it had been set to expire at the end of this year).
• Extension of the American Opportunity Credit for college expenses, and an extension of the "above-the-line" deduction for college expenses.
• Special 100% "bonus depreciation" for purchases of brand-new assets from September 9, 2010, through the end of 2011.
• The estate tax returns with a $5 million exemption per person, and a 35% top rate, retroactive to January 1, 2010.  Estates arising in 2010 will have the option of of using these rules, or using the "old rules" of no estate tax and a reduction in the amount of increase in carryover basis.

Section 179 and Bonus Depreciation for Iowans

Following up on my last post about Section 179 expensing and bonus depreciation:  one other aspect of tax planning for asset purchases is to examine what your state's rules are.  Some states, such as Iowa, do not follow federal guidelines for either Section 179 or bonus depreciation.

For example, in Iowa, Section 179 expensing is capped at $134,000, and bonus depreciation is not honored at all.  If your federal Section 179 expense exceeds $134,000, you'll only be able to deduct $134,000 as Section 179 expensing on your Iowa return; the rest will have to be depreciated.  This means an Iowan  could easily have to track two sets of basis and two sets of depreciation schedules - one for the IRS and one for Iowa.

Iowa isn't the only state that does this.  For example, I prepared an Ohio tax return last year, and they have a strange "5/6" rule on bonus depreciation and Section 179 expensing.  The rule gets its name because you have to add back 5/6 of the bonus depreciation amount as income on your Ohio tax return.  And for Section 179 expensing, you have to compare the amount of Section 179 expensing in the current year with the amount that would have been allowable if it was still 2002 (when the 179 limit was $25,000).  Basically, you add back to income 5/6 of the dollar amount of Section 179 expensing in excess of $25,000.

Preparing this Ohio return opened my eyes to the fact that Iowa, while it rightfully ranks very poorly in tax friendliness, is not the only state with mystifying tax rules.

More on Section 179 and Bonus Depreciation

I have had a number of visitors to this blog with questions about Section 179 expensing, which is something I posted about briefly last week (December 10).  I'll go into a little more detail in this post.

When a business purchases an asset that has a useful life of more than 1 year, the tax code gives the business 3 options for deducting the cost of that asset:  depreciation, Section 179 expensing, and bonus depreciation.

Depreciation means the business can deduct a certain amount of the purchase price each year over a number of years set by the tax code for that type of asset.  For example, computers are depreciated over 5 years.  The number of years is set by the code and has nothing to do with how long you actually intend to use the asset in your business. 

Section 179 expensing allows you to write off 100% of the cost of the purchase of an asset in the year of purchase.  For 2010 and 2011, a business can write off up to $500,000 of asset purchases.  If you purchase more than $2 million of assets during the year, your Section 179 deduction will be phased out.  Your total Section 179 deduction is limited to your taxable income for the year; unused Section 179 expenses in one year can be carried forward to the next year.  Please note that most - but not all - property qualifies for Section 179 expensing.  Examples of property that does NOT qualify is leased property and air-conditioning or heating units.

Note for rental property owners:  Section 179 does not apply to rental properties; if you own rental property, you can't use Section 179 expensing.

Bonus depreciation is a sort of hybrid between regular depreciation and Section 179 expensing, where you can claim 50% of the cost of an asset as a deduction, and then depreciate the remainder of the cost.  Bonus depreciation is available to rental property owners.  One caveat on bonus depreciation:  it can only be claimed on assets that are brand new.  (Section 179 can be claimed on used assets, as long as the asset is "new" to your business.)  One other note on bonus depreciation:  the tax bill being debated right now by Congress proposes to allow 100% bonus depreciation on assets purchased between September 9, 2010, and December 31, 2011.  (UPDATE:  this proposed legislation became official in the tax bill passed by Congress.)

Most of the time, a business will just take the Section 179 expense and be done with it.  It provides an immediate deduction and eliminates the need for cumbersome depreciation schedules.  However, Section 179 expenses are limited to the amount of taxable income (as calculated before the Section 179 deduction).  In other words, Section 179 cannot create a business loss.  But regular depreciation and bonus depreciation can create business losses.  Plus, if you expect that your business income will grow in future years but you won't be purchasing assets in those years, it might be nice to have a depreciation deduction available to offset the increase in income. 
As you can see, your depreciation/Section 179/bonus depreciation strategy is part of tax planning and is a good conversation to have with your tax advisor.

Section 179 Limits for 2010 and 2011

The Section 179 expensing limits have been increased for 2010 and 2011.  A Section 179 election allows businesses to elect to expense asset purchases in the year of the purchase, rather than depreciating those assets over a period of years.  For both 2010 and 2011, businesses can elect to expense up to $500,000 of assets in any one year.  (NOTE:  watch legislation this month to see if anything happens with the 2011 limits.)

Section 179 does not apply to owners of residential rental property.  However, rental owners can take advantage of "bonus depreciation," a special election to expense 50% of the cost of an asset and depreciate the remaining 50%.  Bonus depreciation is an option available to businesses, as well.  In some cases, a business may not want to take a Section 179 expense, and instead take bonus depreciation.

Iowa taxpayers should keep in mind that Iowa does not follow along with federal Section 179 rules or with federal bonus depreciation.  Iowa only allows Section 179 expensing of up to $133,000, and does not honor bonus depreciation at all.  This means an Iowa business or rental property owner could very easily have to track multiple depreciation schedules and basis information.