Farmers’ Cost Recovery Alternatives for 2008
George F. Patrick, Professor and Extension Economist
The 2008 incomes of many farmers are at record levels. Because of potentially high taxable income, year-end tax planning is critical in 2008. For many farmers this should entail estimating taxable income while adjustments can still be made. Because most farmers are cash-basis taxpayers, flexibility is increased by planning before year-end. Farmers should also understand basic choices available under the Modified Accelerated Cost Recovery System (MACRS). They should also be aware of the 50-percent additional first-year depreciation and expanded Section 179 expensing for 2008. Decisions with respect to which of these cost recovery alternatives to use can be made when the 2008 tax return is being prepared. Because the provisions of Section 179 expensing and 50-percent additional first-year depreciation are different, taxpayers can manage their 2008 deductions by choosing which tool to use with specific assets. This gives farmers greater flexibility in managing their deductions and taxable incomes.
Farmers can recover the cost of assets which last more than a year through depreciation. Depreciable assets are placed in classes and the 150-percent declining-balance method with a shift later in life to straight-line depreciation, to maximize the depreciation deduction, applies to most tangible personal property used in farming. The MACRS classes with examples of property used in farming are:
Three-year MACRS property includes breeding hogs and the tractor units of semi-trailers for over-the-road use.
Five-year MACRS property includes cattle held for breeding or dairy purposes, computers, and some construction equipment. Congress specifically included automobiles, pickups, and other trucks in the five-year class. Special depreciation limitations and recordkeeping requirements, not discussed in this article, apply to passenger vehicles.
Seven-year MACRS property includes most agricultural machinery and equipment. Grain bins, fences, and general office equipment are also included in this seven-year class.
10-year MACRS property includes single-purpose agricultural and horticultural structures placed in service after 1988, fruit trees, and vineyards.
15-year MACRS property includes depreciable land improvements, such field drainage tile, water wells and paved lots.
20-year MACRS property includes farm buildings, such as general-purpose barns and machinery sheds.
For the fastest cost recovery, farmers can use the 150-percent declining-balance method with the mid-year convention indicated in Table 1 for selected classes of assets used in farming. A $10,000 asset in the 7-year MACRS class would have cost recovery of ($10,000 X 10.71%) or $1,071 in the year it is placed in service and ($10,000 X 19.13%) or $1,913 in the second year.
Farmers have considerable initial flexibility with respect to depreciation. Once a farmer begins depreciating an asset using a specific method, that method must be continued for the life of the asset. However, decisions with respect to depreciation methods are made when the asset is placed in service. For example, a 7-year MACRS asset could be depreciated using the percentages in Table 1, the straight-line method over the seven-year life, or straight-line method over the 10-year life for the Alternative Depreciation System. The slower depreciation methods would generally be used by farmers who expect to have higher incomes in future years.
Section 179 Expensing
The I.R.C. Section 179 expensing has been increased almost annually by Congress. Most recently, the Economic Stimulus Act (ESA) of 2008 increased the Section 179 expensing limit to $250,000 for tax years beginning in 2008. Farmers and others in an active trade or business can elect to treat the cost of up to $250,000 of qualifying property purchased during 2008 as an expense (rather than as a depreciable capital expenditure). The higher limit of $250,000 applies to 2008 only and will drop back to $125,000 (with indexing) for 2009.
To qualify for Section 179 expensing, all of following requirements must be met:
1. The property must be tangible personal property used in a trade or business. Farm machinery and equipment; livestock used for draft, breeding, or dairy purposes; grain storage; single purpose livestock/horticultural structures; and field tile all qualify for Section 179 expensing. General-purpose farm buildings, such as machinery sheds or hay barns, are not eligible for Section 179 expensing. Real estate is not eligible for Section 179 expensing. Landowners who rent their land generally do not qualify for Section 179 expensing.
2. The property must be purchased, but both new and used property can be expensed under Section 179. Inherited property or property acquired from a related party (spouse, ancestors, or lineal descendants) is not eligible for Section 179 expensing.
3. For property acquired in a like-kind exchange (swap or trade), only the boot portion paid is eligible for Section 179 expensing.
Example 1: Sara Farmer trades an old tractor with an adjusted basis of $35,000 for another used tractor and $50,000 boot. Only the $50,000 is eligible for Section 179 expensing.
4. The Section 179 expensing election is phased out on a dollar-for-dollar basis if over $800,000 of qualified property is placed in service during 2008.
Example 2: Luc Farmer buys $825,000 of machinery in 2008. Luc’s maximum Section 179 expensing allowed would be reduced by $25,000 ($825,000 - $800,000), making Luc’s limit $225,000. An individual is not allowed to elect the full $250,000 and carryover the $25,000 excess.
Only the boot portion on like-kind trades is considered for the $800,000 limit. Thus, if the $825,000 purchase in Example 2 was a like-kind exchange and the boot portion was $775,000, then the full $250,000 expensing could be elected.
5. The expensing deduction is limited to the taxable income from any active trade or business before any Section 179 expensing. A farmer’s and/or spouse’s off-farm wage or business income can be combined with Form 1040 Schedule F for aggregate taxable income. This could permit a Section 179 expense for an asset acquired by a farm business with a loss on Schedule F. Gains or losses from the sale of livestock, machinery, and other business assets reported on Form 4797 are also included in taxable income for purposes of applying this taxable income limitation.
6. The entire Section 179 expensing election can be taken on one large item, reducing the basis for cost recovery. Alternatively, several small items can be completely written off in the year of purchase. Less than the full $250,000 expensing election can also be claimed. The amounts expensed are treated the same as depreciation when the property is sold or traded and for depreciation recapture purposes. If a Section 179 expensing election is made, notations regarding the specific allocations should be made on the depreciation schedule. If no allocations are specified, IRS prorates the expensing election among all eligible assets. Generally, it will be more advantageous to allocate the expensing deduction to longer-lived assets and to assets that are likely to be kept in the business for their entire depreciable life.
Additional First-Year Depreciation
The ESA of 2008 provides for an additional first-year depreciation deduction equal to 50 percent of the adjusted basis of qualifying property placed in service after December 31, 2007 and before January 1, 2009. This additional first-year depreciation is allowed for both regular tax and Alternative Minimum Tax (AMT) purposes.
To qualify for the additional first-year depreciation, the property must meet all five of the following requirements:
1. The original use of the property must start with the taxpayer (property must be new). The tractor acquired in Example 1 would not qualify for the additional first-year depreciation.
2. The property must be MACRS property with a recovery period of not more than 20 years.
3. The taxpayer must purchase the property or enter into a binding contract to purchase the property in 2008. If there was a binding contract to acquire the property before 2008, the property does not qualify.
4. The property generally must be placed in service in calendar year 2008. The deadline is extended for some property with a recovery period of 10 years or more, but only the portion of the basis attributable to expenditures in calendar year 2008 qualify.
5. The taxpayer is not required to use the Alternative Depreciation System (ADS) for the property. A producer with orchards, vineyards or groves who elected not to capitalize pre-production expenses is generally required to use ADS.
Example 3: In July 2008, Able Farmer trades his old tractor with an adjusted basis of $35,000 for a new tractor and he pays $40,000 boot and uses the tractor during harvest. The tractor is new, 7-year MACRS property, purchased and placed in service in 2008. Because the tractor is qualifying property, the additional first-year depreciation deduction is 50 percent of the $75,000 initial basis of the tractor or $37,500. Able can also take regular MACRS of 10.71 percent of the remaining $37,500 basis in the new tractor or an additional $4,016. Total depreciation on the new tractor in 2008 would be $41,516.
An election not to take the 50 percent additional first-year depreciation can be made by a taxpayer on a MACRS class basis. A statement identifying the classes of property for which the election is made and indicating that the taxpayer is electing not to take the additional first-year depreciation on all of the qualifying assets in the MACRS class is attached to the tax return. Note that the election is “all or nothing” by MACRS class of assets. Unlike the Section 179 deduction, a taxpayer cannot claim only a portion of the additional first-year depreciation on an asset.
Example 4: Meg Farmer purchases a $10,000 farm office computer (5-year MACRS property) and $200,000 tractor (7-year MACRS property). Both are new and placed in service in 2008. Additional first-year depreciation would be $5,000 on computer and $100,000 on the tractor. Meg could take $0, $5,000, $100,000 or $105,000 of additional first-year depreciation depending on her elections.
Planning 2008 Cost Recovery
For assets acquired before 2008, the method of cost recovery and Section 179 expensing, if any, would generally have been determined when the assets were placed in service. Cost recovery in 2008 on these assets would be determined by multiplying the appropriate cost recovery percentage from Table 1 by the depreciable basis of the asset. Thus, there are essentially no tax management options with existing assets.
Because the provisions of the Section 179 expensing and additional first-year depreciation are different, taxpayers can manage their 2008 deductions by choosing which tool to use with specific assets. For example, as discussed previously, the 50 percent additional first-year depreciation applies only to new assets whose original use starts with the taxpayer. Because the “all or nothing” aspect of the additional first-year depreciation, a taxpayer may elect not to take the additional first-year depreciation and use Section 179 expensing instead.
Example 5: Harry Farmer purchased a new tractor for $80,000 and traded a planter with an adjusted basis of $10,000 and $20,000 boot for a new planter in 2008. Both the new tractor and new planter would be eligible for additional first-year depreciation of $40,000 and $15,000, respectively. The $80,000 tractor and $20,000 boot on the planter would also be eligible for Section 179 expensing. Depending on his income, Harry might elect to forgo the additional first-year depreciation on the tractor. Because the tractor and planter are both 7-year MACRS property, Harry would also have to forgo the additional first-year depreciation on the planter. However, Harry could take up to $100,000 in Section 179 expensing on the tractor and planter to manage his taxable income.
Both additional first-year depreciation and Section 179 expensing represent an acceleration of cost recovery and are treated as depreciation. Taking these deductions on assets with longer recovery periods would generally increase the present value of the tax savings. At a 6 percent discount rate, the present value of $100 received in five years is $74.40 and $55.80 in ten years.
Some assets, such as machinery sheds, shops and general purpose barns, are eligible for the additional first year depreciation, but do not qualify for Section 179. For like-kind exchanges, only the boot portion is eligible for Section 179 expensing, but the entire basis of the new asset is eligible for the additional first year depreciation.
Example 6: Sally Farmer has a machinery shed and shop built for $80,000 in 2008. The machinery shed is not eligible for Section 179 expensing, but as 20-year MACRS property is eligible for $40,000 of additional first-year depreciation and $1,500 ($40,000 X 3.75%) of MACRS depreciation for a total of $41,500 in cost recovery.
Section 179 expensing deduction is limited to the income from active trades or businesses as discussed in item 5 under the Section 179 expensing deduction. If the expensing election exceeds the taxable income limitation, the excess election amount is carried forward and can be deducted, subject to the Section 179 dollar and taxable income limitations, in the next tax year. In contrast, an additional first-year depreciation deduction in excess of taxable income creates a net operating loss (NOL). A farmer can carry the NOL back 5 years and then carry the NOL forward up to 20 years. Alternatively, the farmer can elect to forgo the NOL carry back period. Good tax management will generally avoid carry forward and NOL situations.
The additional first-year depreciation and Section 179 expensing, combined with regular MACRS depreciation, provide many tax management options for 2008. There are trade-offs between the present value of tax-savings in one year due to rapid write-offs versus tax-savings being spread over several years. These tax management tools can be used after the end of the tax year and can help farmers achieve their tax management objectives.
This publication is intended for general educational purposes only. For information on specific tax situations, consult a competent tax advisor. Thanks to Alan Miller for his helpful comments.
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