While electing capital gain treatment under IRC § 631 may be the best way for a Christmas tree grower to save tax dollars, another excellent way to save taxes is by deducting all allowable expenses. Expenses reduce taxable income, resulting in a lower tax bill. This post will discuss the proper tax treatment for different kinds of expenses, as well as ideas to get more bang for your buck.
Ordinary Expenses v. Capital Expenditures
There are two main types of deductible costs:
1) Ordinary Expenses
2) Capital Expenditures
Ordinary Expenses
Ordinary expenses are any “ordinary and necessary” business cost that is completely used in the current year. For a Christmas tree grower, common ordinary expenses include fertilizer, herbicide, labor, advertising, and fuel. These expenses are fully deductible in the year the grower pays or incurs the expense.
Capital Expenditures
In contrast, capital expenditures, such as the purchase of equipment, may not be fully deducted in the current year because the equipment will be used for many years to come. Other common capital expenditures for a Christmas tree grower include permanent land improvements, barns, buildings, and vehicles. The yearly deduction for a capital expenditure is called depreciation.
Deducting Expenses Sooner Rather Than Later
A typical Christmas tree grower prefers to deduct as many expenses as possible in the current year, rather than waiting to deduct them in future years. However, capitalization rules make shifting of deductions tricky. Fortunately, the Internal Revenue Code makes some special exceptions.
De Minimis Safe Harbor
First, the IRS has a rule known as the “De Minimis Safe Harbor Election.” This provision allows a Christmas tree grower to fully deduct the cost of any asset purchase up to $2,500. The De Minimis Safe Harbor Election greatly simplifies bookkeeping and will permit a Christmas tree grower to deduct the full cost of small equipment or other assets in the year of purchase.
Further, an asset’s cost may be deducted under the election regardless of whether it is new or used. However, this treatment under the election is not automatic; a special statement must be attached to the tax return indicating the De Minimis Safe Harbor Election is being made by the grower.
Section 179
Is a Christmas tree grower out of luck if they purchase assets that cost more than $2,500? Not at all! A Christmas tree grower is allowed to immediately deduct the full cost of equipment (or other qualifying asset) purchases up to $1,000,000 (adjusted for inflation). This is known as Section 179 expensing.
One caveat is that a grower can only take Section 179 expense up to their net income from their Christmas tree farming activity. This means that if a grower’s net income from tree farming is $25,000, then the grower would only be able to deduct a maximum of $25,000 worth of equipment purchases under Section 179. If a grower has a net loss, they will not be able to immediately deduct the cost of any equipment purchases under Section 179; however, they may still be able to deduct the equipment cost under the De Minimis Safe Harbor or Bonus Depreciation.
Another limitation is that total equipment purchases for the year cannot exceed $2.5 million; however, only the largest Christmas tree farms need to be concerned with this limit.
Bonus Depreciation
If a grower has a loss from their Christmas tree farm, they can fortunately still take advantage of bonus depreciation. Bonus depreciation is an additional depreciation deduction taken in the year an asset is purchased. The deduction is called “bonus” depreciation because the deduction is in addition to the standard depreciation deduction for that year.
For an asset purchased after September 27, 2017 and before January 1, 2023, bonus depreciation for the entire (100%) cost of the asset may be deducted.
One major benefit of bonus depreciation is that it does not have a net income limitation like Section 179 expensing. The current bonus depreciation rules have effectively rendered Section 179 useless, because bonus depreciation will be more advantageous in almost all circumstances. However, this may change in 2023 (or if Congress changes the law before then) when bonus depreciation is no longer 100%.
Proper Recordkeeping is Essential
As with keeping track of income, proper recordkeeping is essential for making sure all expenses are recorded and deducted on the tax return. At the very least, all receipts should be saved and entered into a formal recordkeeping system or bookkeeping software. There are now many electronic tools available to save receipts digitally, which is convenient and eliminates the need to keep large paper files, which may be lost or destroyed.
If the IRS ever audits your tax return, you will most likely be asked to produce receipts for some of your claimed expenses. Being organized and disciplined now with your recordkeeping will prevent problems in the future and make it less of a hassle in case you are unfortunately selected for an audit.
Conclusion
Hopefully, this article gives you a better idea of how a Christmas tree grower can best take advantage of expenses and capital expenditures. Since every growers’ tax situation is different, a grower should consult with a CPA or knowledgeable tax professional to determine how to best deduct costs on their tax return. As always, feel free to contact me with any questions or comments.
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