Okay, so you took the big Section 179 expensing deduction on your vehicle.
How do you keep it?
You might wonder: What do we mean by “keep it”?
In tax law, there is no free lunch. The Section 179 deduction comes with “recapture strings” attached.
This article explains the recapture strings and how you can avoid them. You will learn what happens when you do any of the following:
- Allow your business use to drop to 50 percent or less.
- Trade or otherwise exchange your Section 179 property.
- Sell your Section 179 property.
- Give your Section 179 property to a relative or a non-relative.
Snake in the Grass
When you claim your Section 179 deduction, you make a deal with the government to keep your business use above 50 percent during the “designated” depreciation periods.
If you don’t live up to your agreement, tax law throws out your Section 179 deductions. You then redo the deductions using depreciation without Section 179. Next, you report the difference on your tax return, where tax law recaptures the excess deductions as taxable income and, if you are self-employed, adds the self-employment tax.
The law has two applicable designated recapture depreciation periods, one of which will apply to the asset you expensed wholly or partially using Section 179.
- For listed property, you avoid recapture if you keep business use at more than 50 percent for the depreciation period that applies to the alternative depreciation system (ADS).
- For all other Section 179 property, you avoid recapture if you keep business use at more than 50 percent over the modified accelerated cost recovery system (MACRS) depreciation period.
To see how recapture works, let’s look at one sad story
One Sad Story
In 2018, Jerry Jackson claimed a $53,000 Section 179 deduction on a qualifying pickup truck. In 2020, Jerry’s wife drives the truck and Jerry’s business use drops to zero.
Jerry violated his 50 percent business-use agreement with the government. Now he has phantom income to report (called “recapture”), and he’s going to pay the price for breaking his tax promise on the Section 179 deal.
The pickup truck is listed property. This means that Jerry must recompute his allowable deductions using the ADS straight-line depreciation tables, which will result in the following:
- $5,300 deduction (10 percent of $53,000) in 2018
- $10,600 deduction (20 percent of $53,000) in 2019
In 2018, Jerry deducted his 90 percent business cost ($53,000) using Section 179. But now, with recapture, his ADS straight-line depreciation for 2018 and 2019 totals only $15,900 ($5,300 + $10,600).
So in 2020, the year of violation, tax law recaptures $37,100 ($53,000 – $15,900). Jerry must report the 2020 recapture income on the same form or line on which he (or his corporation) claimed the original $53,000 deduction in 2018.
For example, say Jerry operates as a proprietor who claimed his 2018 Section 179 deduction on Schedule C. In 2020, he reports the recapture income as other income on Schedule C.
Holy smokes! On Schedule C, that means the Section 179 recapture is going to create self-employment taxes. Correct! The original Section 179 deduction reduced self-employment taxes.
On his recapture income, Jerry gets the double whammy: increased income and self-employment taxes.
Listed Property Recapture
If you are going to obtain and retain bonus depreciation, Section 179 expensing, or MACRS depreciation deductions, your use of listed property such as vehicles and airplanes must exceed 50 percent during the depreciation life of the property.
When your use of listed property during the recapture period drops to 50 percent or less, you violate your agreement and trigger the government’s depreciation recapture. Listed property includes:
- passenger automobiles,
- other transportation property, and
- any property of a type generally used for purposes of entertainment, recreation, or amusement.
Traps to Consider
Retirement. Are you going to retire? Will retirement bring your business use to zero?
Children. Do your children drive your business vehicle(s)? Will their driving bring your business use to 50 percent or less?
Spouse. Does your spouse drive your business vehicle for personal purposes? Will your spouse’s mileage drop your business use to 50 percent or less?
Personal use. Are you converting Section 179 assets, such as a vehicle, to personal use? Does the conversion to personal use occur during the recapture period?
You need to consider recapture when doing your tax planning. There are times when you might want the deduction earlier and don’t care about recapture later. The one thing you don’t want is a surprise.
Note on Corporate Assets
If you operate as a corporation and the corporation owns the assets, these are not your assets. Thus, you can’t simply convert a corporate asset to personal use. To get the corporate asset as a personal asset, you must buy it, count it as compensation, or count it as a dividend (all at fair market value).
Gifts Trigger Recapture of Section 179 Deductions
In general, a gift of personal property does not trigger an income tax to either the donor or the recipient. But a gift of Section 179 property does trigger the recapture tax.
Example. In 2020, Jerry gives his fully expensed pickup truck to his daughter. The gift triggers the recapture calculation that you saw above. This puts $37,100 in taxable income from Jerry’s 2020 tax return on the same schedule where he originally claimed the deduction.
No Recapture Tax on Sale
The sale of a business asset does not trigger recapture.
To the extent of prior depreciation and Section 179 expensing, your sale of furniture, equipment, or vehicles produces ordinary income. Unlike recapture income, this ordinary income does not go on your Schedule C, where it would be subject to the self-employment tax. Instead, the income from the sale goes on IRS Form 4797 as income from the sale of a business asset.
Trade-Ins Are Now Sales
The tax code no longer allows Section 1031 (“like-kind”) exchanges on personal property such as your business vehicle.
The trade-in was the most common 1031 exchange of a business vehicle. Now, because of tax reform, the vehicle trade-in is simply the sale of the old vehicle to the dealer, and you report the gain or loss on IRS Form 4797.
When you enter into agreements with the government, make sure you know both the front end and the back end of those deals. The tax law gives you a great up-front break with Section 179 expensing, but you need to think about your back-end strategy to avoid getting the recapture surprise.
The tax code seldom gives you a free lunch.
Your best strategy for Section 179 expensing is to keep the asset working in your business until the applicable recovery period expires—or better yet, since these are depreciable assets, until the asset dies. Then sell or destroy the asset—whichever gives you the best after-tax monetary result.
If you are a partner in a partnership or an individual operating as a proprietorship on Schedule C, keep the sell-and-buy strategy in mind because it can save on self-employment taxes. (Remember, under the Tax Cuts and Jobs Act, the trade-in of a vehicle or other personal property is a sale—Section 1031 no longer applies to exchanges of personal property.)
Remember the traps. Don’t convert a Section 179 asset to personal use without knowing how much recapture you will suffer.
- If you are thinking of retiring or otherwise getting out of your business at some point in the next five years, make sure you know your recapture liabilities.
- If you are letting family members use the assets, make sure you consider the 50 percent requirement.
Plan your exits from individual assets and from your business. Know the Section 179 expensing law. Make it work for you!