As we approach tax time, the question begs and pleads to be asked: How rapidly do you depreciate farm equipment? And since you have probably answered, “As rapidly as possible,” the next question becomes, what impact does that have on your machinery management? Oh, you didn’t want that question asked? We’ll take it back, if you continue reading….

There are several methods of depreciation according to agricultural economists Greg Ibendahl at Mississippi State and Jonathan Norvell at the University of Illinois whose analysis of depreciation indicates that producers are probably taking advantage of the tax law, rather than replacing machinery when the economics dictate. In fact the new IRS Section 179 which allows depreciation to be taken all in the first year, may have resulted from heavy lobbying by the farm equipment makers trade groups!

Recent tax law changes have frequently become a route toward economic development, such as speeding up depreciation of equipment in the areas of the south devastated by Hurricane Katrina. In other words, faster depreciation and faster purchase of more new equipment to put more money into the local economy. But politics aside, what does the economics justify for your farming operation, and when is the appropriate time to replace that piece of equipment?

Ibendahl and Norvell say, “Most assets have an optimal lifespan.” And their point is that your profitability may suffer if that optimal lifespan is not reached. “Therefore, depreciation is a procedure to match the decline in asset value to the yearly expense taken.” On the other hand, if you speed up the depreciation, you have more profits early from your tax return, “This has the effect of increasing the net present value of profits. Therefore, accelerated depreciation should reduce the optimal lifespan of an asset. The important question for producers is if this gain is actually enough to change the optimal expected lifespan of farm machinery.”

Typically, a depreciation schedule begins with a purchase at mid-year, with heavier depreciated value early, and lesser depreciated value later on, with expiration in mid-year eight. A new form of depreciation is Section 179, which Ibendahl and Norvel explain, “as long as a farmer does not acquire more than $400,000 in section 179 eligible property, he or she can take up to the $100,000 in 179 deduction expenses.” Additionally, there is also “a special 50 percent depreciation allowance for qualified new property placed in service after May 5, 2003.”

Beyond the desire to manage your taxes with the help of accelerated depreciation, should be the management of your equipment. The economists say, “Assets must be replaced when they wear out but often the optimal replacement occurs earlier because either the productivity drops off or the repairs and maintenance become increasing prohibitive.”

Ibendahl and Norvell evaluated four types of depreciation schedules: 1) the typical 7 year standard, 2) the new 50% option, 3) the Section 179 alternative, and 4) a schedule that matched the tax depreciation with the economic depreciation of a mid-sized tractor. What they found was, “Trading tractors in year 12 is optimal for the all the depreciation methods, even when there are no tax benefits to depreciation. This figure is based on the expected value of the yearly distribution.” They conclude that your profitability will improve if machinery is replaced at an optimal age, rather than when it had been fully depreciated. Additionally, lenders can better help farmers manage their debt and Extension specialists will be able to better provide better recommendations to farmers about machinery management. “Finally, the results should show if accelerated depreciation laws do help farm input suppliers sell more to farmers. The accelerated depreciation is a benefit to farmer as it lowers their yearly cost (mainly due to getting money earlier rather than later). However, the accelerated depreciation methods do not affect the year the asset should be sold.”

Summary:
Tax laws periodically are changed to allow taxpayers, including farmers, to benefit from special political objectives. Accelerated depreciation schedules may help reduce one’s tax liability, or encourage more economic development in a region with more equipment purchases. While these are legal, they may not foster the best machinery management, and even though a piece of equipment may be fully depreciated before its useable life, that does not mean it should automatically be replaced.