Recapture ─ Selling Business Assets

Recapture ─ Selling Business Assets

The most common way to dispose of equipment used in your business is by selling it. When you sell that asset, however, you will create income from the proceeds you realized on the sale.

If you have taken any Section 179 deductions or depreciation on the equipment, you may be subject to what is called a recapture tax. Don’t let this scare you. It is not as bad as it sounds. It simply means a portion of the income you receive from the sale may be taxed as ordinary income, which you might have assumed anyway. Let’s see how it works.

First we need to figure your tax basis in the item. You figure this by subtracting any Section 179 deductions or other depreciation you have taken on that item over the years, from your investment in it. (Your investment is usually what you paid for it when you purchased it.) The result is your tax (or adjusted) basis.

If you never took any Section 179 deductions or depreciation on the item, you figure your tax basis using the amount of depreciation that would have been allowable had you depreciated it using the straight-line method. Consider the number of years and the amount you could have taken based on the year you purchased and put the asset into use in the business.

How much money did you receive from selling the asset? Subtract your tax basis from the amount received (amount you sold it for). The result is your total loss or gain.

Any amount of profit produced from selling an asset, above your tax basis, up to the amount you were allowed to depreciate, is taxed at ordinary income tax rates. Any amount over that is taxed at (generally more favorable) long-term capital gains rates, unless you have Section 1231 losses from previous years which need to be figured first. (Chapter 8 – Taxes for Online Sellers)

This and other information may be found in the book listed below.

Simon Elisha, author, Taxes for Online Sellers—
A How-To Guide for Individuals on Federal Tax for Internet Sales
ISBN: 978-0-9796328-0-8
http://www.taxesforonlinesellers.com/
Copyright 2007 -2008

Depreciation ─ Conventions

Depreciation ─ Conventions

When choosing to depreciate a business asset, you need to choose both a method and a convention. A convention simply refers to figuring how much of the item’s basis you may depreciate the first year, based on when during that year you purchased and put the item to use in your business. This article will explain the differences between the half-year convention, the mid-quarter convention, and the mid-month convention.

Half-Year Convention (H/Y) ─ Under the half-year convention, your item is treated as though it was purchased and placed in service at the mid-point of the first year, no matter when during that year the purchase was actually made. Therefore, only half of the otherwise allowable depreciation amount is able to be deducted during the first year.

The half-year convention is standard with all depreciation and must be used unless the mid-quarter convention rules apply. (Except in the case of depreciating the business use of your home, in which case the mid-month convention applies the first year. This is explained below and in Chapter 10.) The half-year convention is built into depreciation tables found in IRS Publication 946.

Example: Using the straight-line method of depreciation (because it’s easier for me to demonstrate the half-year example using S/L), Morgan is able to depreciate her office desk (seven year property), used 100% for business, over a seven year recovery period. Her basis in it (the amount she paid) is $700. She is able to take equal, $100 deductions each of the seven years. Because of the half-year convention, however, she may only deduct half of that in the first year.

Year One - $50
Years Two through Seven - $100 each year
Year Eight - $50

Morgan may continue to take a deduction into an additional year (year eight) beyond the desk’s recovery period (seven years) in order to fully depreciate it.

Mid-Quarter Convention ─ Under the mid-quarter convention, all property placed in service during a particular quarter of the year is treated as having been acquired at the mid-point of that quarter. Depreciation tables with the mid-quarter convention built in may be found in IRS Publication 946.

The mid-quarter convention only applies if more than 40% of the combined bases of property is placed in service during the last three months of the tax year. Section 179 deductions are not included when figuring this amount.

You can avoid the mid-quarter convention in a couple of ways. Plan your purchases, so over 40% of the cost of them doesn’t get spent at the end of the year, by buying early or waiting until January. You could also choose to use Section 179 to expense some of your end of the year equipment purchases. Those items’ bases would then not be a part of your calculation of the 40% mark.

Mid-Month Convention ─ When you depreciate the business percentage of your home office, you will use the mid-month convention in the first year. This means you may only deduct expenses beginning in the month you first began using the home for business purposes. This not only includes using mid-month depreciation tables, but it also means you may only deduct other business-related expenses for the home from that month forward. See IRS Publication 587 for more information on taking a home office deduction.

This and other information may be found in the book listed below.
Simon Elisha, author, Taxes for Online Sellers—

A How-To Guide for Individuals on Federal Tax for Internet Sales

ISBN: 978-0-9796328-0-8

http://www.taxesforonlinesellers.com/

Copyright 2007 -2008

Depreciation ─ Choosing a Method

Depreciation ─ Choosing a Method

Depreciation is a way you are allowed to deduct the normal wear and tear of business assets (equipment, computer software, automobiles, office furniture, etc). You may claim an item which: you use in your business, wears out over time, AND has a useful life exceeding one year. Because the item is expected to wear out over time (longer than one year), time frames have been assigned to different classes of items, depending on how long that item is expected to be useful in your business. These time frames are called classifications or class life.

Some common classifications:

3 years: off the shelf computer software
5 years: cars, trucks, trailers, computers and peripherals, copiers, calculators
7 years: office furniture, fixtures, unclassified personal property
(See IRS Publication 946 for more detailed lists.)

When depreciating an item, you will need to choose both one method and one convention.

Methods:

Declining Balance─The General Depreciating System (GDS) is the standard, accelerated method of depreciation under MACRS. Using the GDS 200% declining balance (200DB) method (150% for 15 and 20 year property) means you get to deduct more of the item’s value in the early years of its recovery period.

Straight Line─The Straight-Line (S/L) method of depreciation allows you to deduct the value of your item equally over the recovery period.

Alternative Depreciation─The Alternative Depreciation System (ADS) uses the straight-line method of depreciation over a specified number of years. The recovery period for ADS is usually a little longer than used under general or straight-line depreciation methods. (Comparison charts found in the book.)

Choosing a Method

The year you purchase and put your item into use in the business is generally the first year you will take depreciation deductions. That first year is when you will choose what method of depreciation to use. It is standard to use the GDS 200% declining balance method for computing most of your business property. Sometimes, however, you are required to use a different method (usually when business usage is 50% or less on listed property).

You may generally elect to use either the ADS or Straight-Line method for business assets, instead of an accelerated method. The catch to doing so is you must make that election for all property of the same class life put into use in the same year.

Example: If Morgan made the election to depreciate her office desk (7 year property) using the straight-line method, she would also have to use the straight-line method for all other 7 year property purchased and put into use in the same year.

Once you choose a depreciation method, you need to stick with it for that particular item until it is fully depreciated (unless you are required to change, as with business usage dropping to 50% or less).

Listed Property
In order to use an accelerated method of depreciation for listed property, you must use the equipment more than 50% for business purposes. If you use the item 50% or less for business purposes, listed property must be depreciated using the Alternative Depreciation System.

If you initially use your listed property over 50% for business, but then in drops in a later year, previous accelerated depreciation deductions are subject to recapture. The amount recaptured is the amount previous deductions exceed the depreciation that would have been allowable under ADS. (See Chapter 8 of the book for a thorough explanation on recapture.)

This and other information may be found in the book listed below.

Simon Elisha, author, Taxes for Online Sellers—
A How-To Guide for Individuals on Federal Tax for Internet Sales
ISBN: 978-0-9796328-0-8
http://www.taxesforonlinesellers.com

Copyright 2007 -2008

Listed Property - What It Is

Listed property consists of items the IRS considers having the potential for personal use. Computers, vehicles, and cell phones all fall into this category. For these items, you must keep detailed records of personal versus business use.

Just keep a notebook next to the computer, for instance. Whenever the item is in use, jot down when and for how long, and whether it was business or personal use. This may sound tedious, but during an audit, you will have to produce these records.

It is the very same concept as keeping mileage journals for your vehicle. In fact, because automobiles fall under listed property, it is why you have to keep mileage records.

If in doubt whether something is considered listed property, keep records. If you question whether or not the IRS thinks you could be abusing the tax deduction, they probably do, too. More explanation of which items are considered listed property is given in IRS Publication 946.

Note: In order to use an accelerated method of depreciation for listed property, you must use the item more than 50% for business purposes. If you use it 50% or less in the business, listed property must be depreciated using the Alternative Depreciation System (ADS).

This and other information may be found in the book listed below.
Permission to use or excerpt with proper attribution.
Simon Elisha, author, Taxes for Online Sellers—
A How-To Guide for Individuals on Federal Tax for Internet Sales
ISBN: 978-0-9796328-0-8
http://www.taxesforonlinesellers.com

Section 179 - Do You Qualify?

What is Section 179? Section 179 is called a loophole by some. For anyone with any tax experience, however, it is as standard in the IRS world as claiming mileage. Section 179 (Form 4562) allows people claiming items (meeting the criteria listed below) to simply expense certain things instead of depreciating them. This means you get to claim all of the money paid for the item in the year you purchase it and put it to business use (assuming 100% business use). Depreciation makes you spread that benefit out over multiple years.

In order to use Section 179:

● You must have taxable income of at least the amount you expense. This taxable income can come from the business, another business claimed by you, other wages and tips, and even your spouse’s wages and tips if married filing jointly.

● You can either expense (Section 179) or depreciate, not both, on the same item in the same year. Though there are special rules enabling you to depreciate the remaining amount of an item in future years you weren’t able to fully expense this year.

● You must use the item more than 50% for business purposes. If you use it less than 100% for business, you can only claim the percentage of the purchase price based on the percentage used in business (business percentage).

● You should still use that equipment 50% or more for business purposes over the number of years you would have otherwise been allowed to depreciate it (class life─explained on page 60 in book).

Section 179 does NOT apply to:

▪ Real estate
▪ Inventory
▪ Gifts or inheritance
▪ Property purchased from a relative
▪ Items you already owned in a previous year and are converting to business
▪ Heating and air conditioner units

Basically, if you purchase equipment for your business, Section 179 gives you a way to deduct the cost in one year, instead of little by little over multiple years. There are some further limits and rules associated with Section 179 explained in more detail in the book. I simply do not have the room to go into all the detail here.

This and other information may be found in the book listed below.
Permission to use or excerpt with proper attribution.
Simon Elisha, author, Taxes for Online Sellers—
A How-To Guide for Individuals on Federal Tax for Internet Sales
ISBN: 978-0-9796328-0-8
http://www.taxesforonlinesellers.com/

Basis, Business Basis, Tax (Adjusted) Basis - Defined

Basis: Generally the cost of your item, increased by sales tax and improvements.

Business Basis: Multiply the basis of your item by the percentage you use the item for business purposes. The result is your business basis of the item.

Tax Basis (Adjusted Basis): Your basis, reduced by any Section 179 or other depreciation you have ever taken on the item for tax purposes.

Examples:

Joel has a computer. To figure his basis, he needs to know what he paid for it (plus sales tax). He paid $1000. $1000 is his basis.
(Improvement) He adds a larger hard drive to the computer for a cost of $100. His basis is now $1100 (1000 + 100).

Joel only uses the computer , with the larger hard drive, 70% for business purposes. His basis is $1100. But, his business basis is $770 (1100 - 70%).

When he is ready to sell the computer, he will need to know his tax, or adjusted, basis. Over the years, he has depreciated the computer using straight-line depreciation. The amounts he has taken thus far, add up to $440. He subtracts that from his $1100 basis. His tax basis becomes $660.

His basis is $1100. His business basis is $770. His tax basis is currently $660.

If Joel had never taken any deductions on his computer, his tax basis would be his basis, reduced by the amount he could have depreciated it using straight-line depreciation tables.

This and other information may be found in the book listed below.
Permission to use or excerpt with proper attribution.
Simon Elisha, author, Taxes for Online Sellers—

A How-To Guide for Individuals on Federal Tax for Internet Sales

ISBN: 978-0-9796328-0-8

http://www.taxesforonlinesellers.com

Finding Business Percentage When Expensing or Depreciating Items on Taxes

Deducting expenses on your taxes is straight-forward in many circumstances. For instance, if you pay advertising costs for your business, simply total the receipts and list the figure under advertising on your Schedule C. If, however, you are depreciating or expensing an item, which you don’t use 100% for business purposes, you will need to find your business percentage.

Business Percentage: Business Time used divided by Total Time used equals Business Percentage. Your answer will be a decimal number. Multiply that decimal by 100 to find your business percent. Total Amount Paid times Business Percent equals the amount you may deduct.

Let’s look at an example:

Kathy wants to claim actual expenses on her vehicle this year. She keeps track of her mileage. She notes she has driven her car a total of 20,000 miles this past year. Of that 20,000, only 2000 of the miles were for business purposes.

Kathy divides the 2000 business miles by the 20,000 total miles.

2000/20,000 = 0.1
0.1 x 100 = 10

Kathy used her vehicle 10% for business purposes this year. She may now deduct 10% of the total, actual costs for her vehicle.

Her receipt totals are:

Gasoline = $4000
Tires = $200
Repairs = $650
Insurance = $250
Registration = $76
Interest = $150

Total = $5326

Kathy may multiply her total expense ($5326) by 10% to arrive at the amount she may deduct in actual expenses for her vehicle ($532.60) on line 9 of her Schedule C.

Finding your business percentage works the same general way whenever you are figuring how much you may deduct for any item or service not used exclusively in business.

Permission to use or excerpt with proper attribution.
Simon Elisha, author, Taxes for Online Sellers—

A How-To Guide for Individuals on Federal Tax for Internet Sales

ISBN: 978-0-9796328-0-8

http://www.taxesforonlinesellers.com/