Today, I’m talking about…
What is depreciation? Depreciation is used for assets. When you buy an asset, and what I mean by “asset” is when you make large purchases that can be used over multiple years, that is considered an asset. When you do this, the default rule is you have to take the expense over several years.
Now, there’s some certain exclusions in the tax code that allows you to immediately expense those large purchases. One of those exceptions is bonus depreciation. Bonus depreciation allows you to take a certain percentage, a big percentage of that purchase, in the first year. Previously, it was 50%, but with the new tax law, that is now 100%. That could be a huge savings, depending on who you’re talking to and what your circumstances are.
To qualify, in the past, it used to be for bonus depreciation it has to be a new property, but now with the new law, you can actually use it for used properties too. So it’s not just for new. You can actually buy a property that was already owned by someone, as long as it’s not a related party, where you actually buy it used. It’s used to you, but it’s new to somebody else who’s not related to you.
Now, let’s talk about Section 179. The new law also made changes to the Section 179 deduction, which is an alternative to taking bonus depreciation. The big thing about why someone might want to do a bonus depreciation versus Section 179 is because when you have a loss, you can’t take Section 179 deductions. Someone with a lot of expenses already might prefer to take the bonus depreciation versus the Section 179. In the old law, it used to be the maximum you were allowed was $500,000, but now you’re now allowed a million dollars. That’s a lot of asset purchase in one year. This is phased out when your investment in property starts to exceed $2.5 million. When you’re spending a lot on property, then it begins to phase out.
With Section 179, you can also use it on assets that are new or used. It used to be with bonus depreciation, I used… Remember, I said it they used it to before in with new assets, so people who bought used assets have used Section 179, but now, bonus depreciation offers both, so in that area, they don’t defer anymore. You might actually see more people moving towards the bonus depreciation versus the 179, just because of the less limitations.
And also, the new law also expands Section 179 to include tangible potential property used for lodging and improvements made to non-residential real property, as long as the improvements are placed in service at after the date of the building was first placed in service. This law is applicable to tax years beginning after the December 31, 2017.
Now, let’s do some math in Excel to see when it makes sense to do the depreciation over the number of years versus taking the Section 179 minus bonus depreciation. Let’s make the assumption that this taxpayer’s net taxable income is $60,000. And at this taxable income, they have the 15% tax rate. Now, if they expect their income to grow at a very high rate, where their tax rate jumps next year, then taking the regular depreciation will make sense, because that way, when they have bigger expenses, they can take it away out of their more higher taxable income. That saves them money, versus like, let’s say here, they weren’t able to take the depreciation because they took all the Section 179. Everything was all taken in one year. Let’s see, they got four assets and they took all the depreciation in one year. You can see how their tax rate keeps going down when they take that, because their taxable income goes down, their tax goes down. At a 15% rate, you can see how taxes are going down when they’re taking less depreciation.
At the same time that they save more money in the first year, the second year, they get to pay 21% on all of their net income because they’ve taken all of the depreciation in the prior year. The income grew from $60,000 to $78,000, which is 30%. Now, let’s see what happens if they chose not to take the Section 179 or of bonus depreciation. You can see here, they paid more taxes here, but they’re also paying less taxes here, and this less tax is actually more because this is less taxes paid based on the higher tax rate. When you’re dealing with depreciation to figure out “Should I take the bonus?” or “Should I take Section 179?” or “Should I depreciate it with time?”, you want to stop to think to see if your income is going to grow over time, ’cause if it’s going to grow over time, you’re better off just go ahead and taking it year by year, ’cause you save more money over the years. Well, while if you’re going to make a loss, it just makes sense to take depreciation, because with the Section 179 anyway, you can’t take it below loss. And what’s the point of taking your depreciation faster when there’s really no expenses, there’s no real income that you can write off? That makes no sense.
Now, let us look at the return of investment. Before you run out and buy assets because you can take all this depreciation or Section 179 and bonus depreciation, like, “Woo-hoo! I have one million dollars, I can deduct from my taxes,” I would like you to pause, stop, and think for a second. Just because you have a tax benefit does not mean you have to run out taking advantage of it because, over the long run, it might not be what is best for you. But for one of the things you want to do when you buy an asset is to estimate your return of investment, ’cause when you buy an asset, you’re making a large purchase. That’s money you will have to take a loan for, or even if you’re using your equity to buy the asset, that’s cash that’s going out of your business.
You want to make sure you sit down and think about either, one, the projected tax savings you will get from those assets or two, the increase in revenue. For example, let’s buy an efficiency machine. And maybe I’m in the printing business. My old machine was printing 100 cards a minute, 100 cards an hour, and then with this new machine, I can print 600 cards an hour with half the labor. Well, I can compute my tax savings on that because one, I’m more than doubling my production, and reducing my labor costs. So, I have to compute my tax, my savings, my cost savings.
Let’s say my cost savings is like… My increase in revenue, ’cause I already have… Like right now, I’m so backed up. My customers are like, “We need cards! We need cards! It’s almost Christmas time. Get us some cards!” I know I can sell those cards. It’s not like I’m going to have extra capacity. I’m going to sell these cards, so I know that by buying this machine, my revenue could increase by $100,000. And at the same time, my revenue’s increased by $100,000, one of my employees is going to leave anyway, so once they leave, I don’t have to replace them. I was paying them $20,000.” That’s plus $20,000.
This machine, in the first-year loan, that’s $20,000. I know I can make $120,000 when I buy this machine. Now, this machine cost me a million dollars. The bank has already told me they’ll give me a long for 8%, which is fine. I’m like, that’s cool. I know, like over the next five years, at least I’ll make a $120,000. Now, let me compute what my return on investment is.
To do these this, I’m going to do, compute two rates. Well, the first one with the net present value. The net present value is the today’s value of future stream of income. In other words, this $120,000 over the next five years and this one million today, the net present value of that over the next five years will be, in this case, negative -$482,000 so I’m losing money. The value of this cash when we account for the time value money is – $482,000. This investment is obviously a bad one. The Internal Rate of Return is -15%. The Internal Rate of Return is what makes the net present value zero, so which means I’m losing 15%, approximately about 15% on this investment, so it’s obviously not a good deal for me.
Let’s look at, let’s say, the asset cost $500,000, half that. Of that, I do have an Internal Rate of Return of 6%, but the bank said they’re going to give me an interest in 8%, so I’m losing money. My net present value of all this cash flow is -$19,328 so at even at $500,000, that asset is still not good. To get to zero net present value, to break even, I need to have at least a 6% interest rate. When I begin… For me, for me to really, for this investment to make sense, I have to go lower than 6%. In other words, my interest rate has to be lower than 6% because my break-even rate is 6%. If my break-even rate is 6%, if I get a loan, anything above that 6%, I’m losing money. If the bank can give me a 4%, we can see this investment begins to make sense based on the rate of return.
The point I’m trying to make here is, do not run out and buy an asset just to get a deduction. Make sure the asset makes sense. Yes, because it’s very easy for you to see, look on the internet, have a sales person come to you and promise you the world of what this is going to do. And you have to stop and think, “Well, for the volume I’m doing, does it make sense? What is my return of investment? What’s my net present value? What’s my Internal Rate of Return? How much interest rate will it make sense for me to go ahead and buy this asset?” Because even though it might say save you increase your volume and save you cost, but the truth is, you might not even be at a level where you can actually benefit from the savings. You’re actually losing money and spending more and then it looks like what it seems like should have increased your cash flow, actually decreases your cash flow. So just be careful. That’s the point I’m trying to make. Be careful.
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