Watch for a Hidden Pitfall in the Section 179 Deduction

If you made several equipment purchases for your business this year, you should know about the Section 179 deduction that allows you to immediately expense up to the entire cost of the assets you purchased (limited to $100,000 for 2003). But beware of a hidden pitfall within Section 179 — the recapture rule.

If a deduction eliminates money from your income, a recapture puts it back — and then you owe taxes on that unexpected income. But why would you be forced to recapture the money you deducted, using Section 179?

You must recapture your original Section 179 deduction if:

You purchase equipment for $10,000 to be used 100% in your business and you elect under Section 179 to expense the entire cost. During that taxable year, your net income is reduced by $10,000.

In the second year, your personal use of this equipment increases substantially so that the business use is only 25%. As a result, you now have to “recapture” the original $10,000 Section 179 expense (less any normal depreciation that would have been allowed) as ordinary income.

The calculation looks like this in the case of an asset with a seven-year recovery period (the recovery period length determines the amount of depreciation allowed each year):

Unlike wages, this income doesn't come with any federal taxes withheld. The additional income can mean that you have to write a check to the IRS for the extra income tax, and you could even owe interest and penalties if your withholding or estimates don't meet the minimum tax payments required.

Also, you must report the recapture amount on the same tax form that you used to get the original benefit. Thus, a Section 179 recapture amount appearing on Schedule C would also be subject to self-employment taxes (15.3% of net earnings) in addition to income taxes.

Of course, the shorter the recovery period of an asset, the smaller any recapture amount will be, because more depreciation is allowed in the years when business use is above 50%.

To avoid running into this problem when choosing a Section 179 deduction for newly-purchased assets in your business, be sure that the business use will remain above 50% throughout the asset's recovery period. Otherwise, you may find yourself forced to recognize unexpected and unwelcome income and pay unnecessary taxes as a result.

For a general introduction on the tax issues facing business owners, see IRS Publication 334: Tax Guide for Small Business. For more information on deductions for the business use of your auto, see IRS publication 463: Travel, Entertainment, Gift, and Car Expenses. For more information on the Section 179 deduction, see IRS Publication 946: How to Depreciate Property. For information on the recent changes to the Section 179 deduction, see IRS Supplement to Publication 946: How to Depreciate Property.

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