If you’ve ever filed a farm tax return, you likely have a functional definition of depreciation. From a tax standpoint, any time a farmer purchases new equipment, its cost must be deducted (depreciated) year-by-year, over the estimated time period that the equipment will be useful. The same rule applies with newly acquired buildings or land improvements. What you may not be aware of, is that our tax law provides some flexibility in the areas of depreciation.
You may have heard the phrase “Section 179 Expense.” This section of our tax code allows some or all of the cost of eligible first-year assets to be deducted right away – if the farm is profitable, rather than spread out over 7, 10 or 15 years. This can help lower current-year tax, and is a great planning tool. It can also deprive the taxpayer of future depreciation, and can lead to higher tax down the road when depreciation runs low, or if you sell the asset after you’ve accelerated its depreciation.
Generally, assets are placed in service under the Modified Accelerated Cost Recovery System (MACRS), which defines how assets are depreciated. Under MACRS, farm equipment is depreciated over seven years, vehicles over five years, wells over 15 years, and barns over 10 or 20 years (depending on their purpose). This specific information isn’t crucial for farmers to know – a good tax preparer will ensure that the technical aspects of depreciation are handled correctly. It is important for farmers to know that the MACRS Alternative Depreciation System (MACRS ADS) allows farmers to spread the depreciation of an asset across a longer, alternative, time period, possibly aligning the depreciation of a major purchase with its payback period, which can be a major tax-saver.
Consider this hypothetical example: A farmer invested $1 million into new chicken barns, which are normally 10-year depreciable property. The loan against the barns was for 15 years. The loan payments demanded a huge portion of the farmer’s operating cash, and didn’t leave much cash available to pay income tax, which would be the case until the loan was paid off. Depreciation from the barns, and interest expense on the loan, provided very large deductions and kept the farmer’s tax bill manageable, but after 10 years, the farmer had no barn depreciation left, and his loan payments were no longer being applied to tax-deductible interest. The drastic drop in depreciation expense, paired with a decline in interest expense, meant the farmer was looking at a very, very large tax bill. He was also still looking at five years of loan payments before he would have any free cash flow.
This farmer was in trouble, because a planning opportunity had existed in the first year, but he and his tax preparer hadn’t chosen to use an alternate depreciable life for his barns. The tax code would have allowed them to depreciate the barns over 15 years instead of 10 – ensuring that he had enough depreciation to lower his tax bill each year until his loan was paid.
