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Don't Be Trapped by Business Assets

It's a smart business practice to place new equip­ment into service before the end of the year. Reason: Under the “mid-year convention,” business assets placed in service during the year are treated as if they had been placed in service on July 1 for purposes of computing depreciation deductions. It doesn't matter when the assets are actually placed in service. In other words, you may be able to claim the equivalent of a half-year's worth of depreciation—even if you use the equipment for only a few days in December.

Caution: There is a “hidden tax trap” if you place “too much” equipment in service at year-end. In effect, your annual depre­ciation deduction may be drastically re­duced.

However, some astute tax planning now can avoid this pitfall.

A special tax rule is triggered if the cost of business assets placed in service during the last quarter of 2006 exceeds 40% of the cost of all assets placed in service during the year. (Note: Real estate is not counted for this purpose.) In that case, your depreciation deductions for all assets placed in service during the year are figured under the “mid-quarter convention.”

How it works: The depreciation deduction for the equipment is based on the equiv­alent of one-half of the quarterly pe­riod the property is placed in service (plus a full amount for any subsequent quarters). For instance, a company that places equip­ment in service during the last three months of the year—in either October, November or December—is entitled to 1½ months worth of de­pre­ciation. On the other hand, equipment purchased earlier in the year—January, Feb­ruary or March—may be entitled to 10½ months worth of depreciation (1½ months for the first quarter and nine months for the next three quarters).

Example: XYZ Inc. buys a new machine in October costing $10,000. Under the latest de­pre­ciation ta­bles, the equipment is depreciated over a seven-year period. The first-year de­duc­tion is normally $1,429 under the half-year convention. However, the machine is the only equip­ment XYZ places in service during the year. Since more than 40% of the cost of equipment for the year is placed in service during the last quarter, XYZ must use the “mid-quarter” rule. Result: The de­preciation deduction is reduced to $357.

What can be done about this? Depending on your situation, it may be tax-wise to purchase equipment earlier than usual and make sure it is placed in service before the last quarter of the year. Just a few days before October 1 can make a big tax difference.

Also, you may be able to currently deduct qualified assets under the Section 179 election. The maximum Section 179 deduction for 2006 is $108,000. It applies to assets placed in service anytime during the year. The assets are removed from the last-quarter calculation.

Reminder: Although taxes certainly are important, there may be other extenuating factors. The basic idea is to maximize the tax benefits for business assets you plan on buying in any event.

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