Is it true that if I buy an expensive truck I’ll save a lot on taxes?
So you might have heard rumors of business owners making large purchases at the end of the year to save on taxes, and wonder if the stories are really true. So the truth is that yes there are purchases that you can make that will greatly reduce your income tax expense in the year of the purchase. However, the real question is whether or not this is actually a good idea. The answer is it depends. There is no clear answer for a number of reasons, and here we’ll try to dig into four of the major concepts to consider before making a purchase.
Let’s start with a little bit of background. There are essentially 4 ways to deal with large asset purchases for businesses on an income tax return: Straight line depreciation, Accelerated Depreciation, Bonus Depreciation and 100% depreciation (aka Section 179). I have listed these 4 types of depreciation in the order of the longest time period to receive a complete deduction on your income tax returns to the shortest period of time. Not all types of depreciation are available for all types of assets so before making a purchase it is important to discuss with your tax adviser what can be done.
Nothing is Free
The first thing to recognize is that nothing is free. If you think that you’re going to spend $40,000 on a new truck, and that the new truck will save you $40,000 in taxes you are wrong. It doesn’t work that way. The most important concept is to purchase things that are actually needed. Most US taxpayers have an an effective tax rate of 13.5% (The motley fool) so the average American would receive a tax deduction of $5400 for the $40,000 purchase. That’s great but you will always be entitled to that tax deduction no matter when you buy.
What is the time value of money?
The second concept is that by purchasing the asset at the end of the year somehow it will actually save you more money than purchasing it at the beginning of the following year. So there is a bit of truth to this because a dollar today is worth more than the same dollar tomorrow. To maximize the concept of the time value of money the goal is to shorten as much as possible the period from when you expend your hard earned money and when you receive the benefit of the purchase offsetting income that is earned in your company. So if we consider the $40,000 purchase and the average interest rate available right now if the money were to sit in your account for 1 year. According to bankrate.com for November 2018 the average interest rate on bank accounts this month is 2%. So if you were to invest the $5400 in savings on your tax return for the 1 year that you could earn $108. If you had to wait to 5 years to get it back with straight line depreciation then it would be worth $270. Interesting but not huge savings.
Cash is king
If you were to finance 100% of purchase of the $40,000 truck in December of year 1, and were able to use Section 179 depreciation on your tax return for year 1, then you would receive the on average $5400 tax benefit of the purchase just a few months later in April of year 2. This would maximize the time value of the tax savings, but over the course of the next 5 you’ll still have to pay back the $40,000 in principal borrowed from the bank. This is problematic because with the average car loan interest rate at 4.93% that will cost you $5225 in interest over the 5 year loan. Also you’ll receive no tax deduction for that cash out put in future years. Essentially you’ll have to pay tax on approximately $8000 in income for the each of the next 5 years, but you won’t have the $8000 in the bank because it was paid back to the bank. These types of operations can get some business owners in trouble because if there are enough of these purchases then the profit ratios of the business are no longer sustainable to maintain the cash flow of the business.
Tax Bracket Management can be beneficial
More significant tax savings can come with managing marginal tax brackets. In 2018 the two biggest marginal tax rate jumps are from 12% to 22% and from 24% to 32%. So if there is marginal income that is being taxed at that higher rate, and it is foreseen that in future years the higher rate won’t apply then it makes good sense to attempt to lower one’s tax bill as much as possible in the current year. This takes careful planning, good records and of course is a risk because no one can guarantee what will happen in the future. Likewise if this year was challenging and profits are down, but they are expected to rebound next year then it makes sense to save some of the deductibility for future years were more benefit will be received. This type of planning can only be done on a case by case basis, and requires a deep understanding of the tax law’s applicability to the particular situation.