Appreciating Depreciation

Congress and the president got it right with this year’s changed depreciation rules.

Columns From: 6/1/2008 Modern Machine Shop, ,

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Peter Zelinski

A person could be forgiven for being cynical about tax incentives offered during an election year. However, Chris Lyle, finance manager for machine tool supplier Makino, says that Congress and the president got it right with this year’s changed depreciation rules. He and tax advisor Anthony Schweier recently hosted an online presentation of the new tax rules that is now viewable on MMS Online.

The economy feeds off of confidence or starves from the lack of it. Bad news in other parts of the economy (such as housing) does not necessarily have to translate to reduced manufacturing activity overall—unless manufacturers who are worried about such a decline make the fear self-fulfilling. A productive tax incentive would therefore encourage continued investment through the skittish times by reducing the cost impact of the investment during the period when confidence is wavering.

Depreciation offers a better way to do that than a straight tax break, Mr. Lyle says. First, changing depreciation does not change the overall tax; it just moves it around. Second, while a tax break is cash that can go anywhere, depreciation requires a company to commit to the U.S. economy by installing equipment here. That commitment practically guarantees additional activity, because of the labor necessary to run the equipment and the raw material necessary to feed it.

Thanks to the depreciation rule changes, there are now three components of the tax savings that a plant or shop might realize on a new machine put to use this year. They are:

  • “Section 179” depreciation, under which companies can fully expense $250,000 in tangible property on an investment of up to $800,000. These figures double the previous Section 179 allowance.
  • New “bonus depreciation,” which consists of a 50-percent deduction on qualified new equipment purchases.
  • The existing standard deprecation. First-year standard depreciation on a machine tool is often 14.29 percent.
    The depreciation is applied in the order above to determine the total tax savings. For example, new equipment totaling $750,000 that is bought and installed this year qualifies for $250,000 in Section 179 depreciation, plus 50 percent of the remainder in bonus depreciation ($250,000) and 14.29 percent of what is left in standard depreciation ($35,725). The combined $535,725 write-off represents an estimated $187,500 in tax savings realized the first year.

Don’t get hung up on the $800,000 limit, Mr. Lyle says. The previous limit of $400,000 created a disincentive to invest as that limit was approached, because the depreciation shut off abruptly. This year’s bonus depreciation was meant to offset that effect, plus the Section 179 depreciation after $800,000 now phases out gradually. As a result, the chance to make cash flow positive during the first year continues all the way up to investments of $1 million, Mr. Lyle says.

That positive cash flow results from this fact: The first-year tax savings are so high, they can exceed the equipment’s payments. The equipment must be leased to realize this effect, and the large tax savings do reduce the savings available in later years (because this is depreciation). However, this chance to turn cash flow positive in the first year creates an opportunity to essentially subsidize a new machine during its least productive time—the initial period when the shop is still learning how to use it.

The window on this opportunity is likely to close. With a new Congress and a new president next year, the depreciation rules may not be renewed.

The impending sunset actually creates one of the major sources of uncertainty about the new rules, Mr. Lyle says. To qualify, a machine must be “in use” by the end of the year, but what does “in use” mean? Having possession and making payments on the machine may be enough, or it may not be. Makino has been advising its own customers to be making chips with the machine before expecting to take the write-off.

The presentation on MMS Online addresses other important questions. For example, what if your fiscal year doesn’t coincide with the calendar year? The presentation covers that. To learn more about the new depreciation rules and the opportunities they present, visit the MMS inMotion Multimedia Presentation: Economic Stimulus Package.

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