When individuals go into business for themselves, they often lack the funds to buy the tools and equipment needed to serve customers. So, they make do with what they have and use personal items they already own to get the job done. This is especially true for individuals in the construction and automotive trades who have invested years perfecting their craft and, in the process, have amassed small warehouses full of tools and equipment that become part of their business. Real Estate Agents may not need a shop full of tools to get their jobs done, but when they first go into business, many will use their personal phones, cameras, office furniture, vehicles, and other items to serve their clients.
Property Converted to Business Use: In taxation, using personal property in a business is called converting personal items to business use. Property converted to business use is deductible, but there are special rules concerning the deduction’s calculation. In this article, we’ll discuss these rules as they apply to sole proprietorships.
Rule One - Don’t Forget! The number one rule for deducting items converted to business use is to remember you did it! To get the deduction you must document the property that becomes part of your commercial endeavor. Every time I work with a newly formed business, I ask for a listing of all personal assets used by the enterprise. Many owners are surprised by this question. They have not considered the possibility that such items can cut their taxes. For some businesses the list of converted items can be many pages long, take quite a while for the owner to compile, and result in a massive tax cut! Most Real Estate Agents will not have pages of converted assets, but the list can still result in a sizable, tax-saving deduction. Remember: Every $1,000 deducted can save up to $400 in tax!
Rule Two - Determine Depreciable “Basis”: Depreciable basis is a tax term that means the amount of the asset’s value that can be depreciated. For personal items converted to business use, the item’s depreciable basis is the lower of:
1) Your adjusted basis in the property (another tax term – for 95% of readers, your adjusted basis in personal property will be the amount initially paid for the item), or
2) The fair market value of the asset at the time of conversion to business use.
An item’s fair market value is the amount you could sell it for in an arms-length transaction (such as trade-in value, price sold at a yard sale, price if purchased used from a dealer, price if sold online). Because the vast majority of newly purchased items lose value as soon as removed from their package, the vast majority of converted items will be valued at their Fair Market Value at the time of conversion to business use.
For example, let’s say you have a laptop you paid $1,200 for a few years ago. Today, the day you start to use the laptop for business, you can buy that same computer used for $450. Your “basis” for depreciation will be $450, the lesser of what you originally paid for the laptop or its fair market value on the day of conversion.
Rule Three – Determine Business-Use Percentage: After determining the conversion basis of the asset, you will need to arrive at a percentage of business use for the asset. This will be easy for converted assets used exclusively for business – business use will be 100%. But what if the asset is not used 100% for business? If this is the case, an easy way to determine the asset’s business-use percentage will be based on the amount of time the asset is used in the business.
Let’s continue with the example of a laptop. After starting your business, you use it an average of four hours per day for the business and one hour per day checking personal email and social media. What is your business-use percentage? Four out of five hours per day is business use, or 80% (4 hours of business use / 5 hours of total use = .8).
For some assets, however, time may not be the most reasonable determinate of business-use. For example, a realtor uses a previously owned camera to take pictures of listings but also continues to use it to capture family events. For this asset, a more accurate business-use percentage would be the proportion of photos taken for business.
The key to determining a business-use percentage is to be reasonable and to have some form of documentation to prove your allocation. It is highly doubtful that an auditor will demand a log showing every minute of business vs. personal use for your laptop or every picture taken with your camera to double-check your business percentage. On the other hand, it’s equally doubtful a claim of 100% business use will fly for a computer loaded with personal docs or a camera full of family photos.
It’s also important to note that your business-use percentage may change from year-to-year as the business use of the asset changes.
Rule Four – Determine Depreciable Cost: The depreciable cost of an asset is the value of the asset that can be depreciated in a given year. The depreciable cost is equal to the asset’s depreciable basis (the lower of the original price paid or the fair market value of the asset discussed in Rule Two) multiplied by the asset’s percentage of business use for that year.
To revisit the laptop example: The laptop was initially purchased for $1,200 but was only worth $450 when converted to business use, making its depreciable basis $450. The computer was used for business an average of four out of five hours per day during the year, or 80% of the time, making the business-use percentage 80%. The depreciable basis of $450 times 80% business use results in a depreciable cost of $360. This is the amount that will subject to depreciation for that tax year.
Note: If you’re not familiar with the term depreciation, a basic definition is that the asset’s Depreciable Cost is expensed as depreciation a little each year over its depreciable life (a number of years based on the type of asset).
Cannot Expense Converted Assets: Assets converted to business use must be depreciated and cannot be expensed, even if the items are super-low in value. Also, most converted assets do not qualify for Section 179 Expensing, which allows owners to write off the asset in the year of purchase. Section 179 assets must be purchased and placed in service during the same year. So, to qualify for Section 179 Expensing the asset must be purchased and converted to business use in the same year.
Special Whoop for Bonus Depreciation: The Tax Cuts and Jobs Act of 2017 (TCJA) made sweeping changes to the United States Tax Code. One beneficial change for small business owners is that USED property purchased after September 27, 2017, now qualify for bonus depreciation. Bonus depreciation allows a percentage of a qualifying property’s value to be expensed as depreciation in the year purchased or placed into service. From September 28 through December 31, 2022, the bonus depreciation percentage is 100%!
Converted items now qualify for bonus depreciation. To qualify, however, the original purchase date for the converted property must be after September 27, 2017.
Summary and Invite: We hope this article has helped you understand the tax savings that can occur when personal use property is converted to business use. If you’d like to learn more about cutting your most significant expense, TAXES, check out our Real Estate Agent Tax Cut Library. The Real Estate Agent Tax Cut Library includes over eight hours of video broken into twenty-nine searchable volumes and covers every possible deduction a Real Estate Agent can take on their tax return. Our Broker Version will help your entire agency cut their taxes! We also invite you to browse our courses.