Depreciation is a cost recovery tool that allows the business to spread the capital expenditure and claim the expense against income generated over the years.
Similar to accounting depreciation, tax depreciation also allocates depreciation expenses over multiple periods. Thus, the values of depreciable assets gradually decrease over their useful lives. But, many differences can be noted in terms of eligible property and methods of calculating depreciation.
Under the current tax system, Modified Accelerated Cost Recovery System (MACRS) is the accepted method for calculating depreciation. Also, there are circumstances where you might get benefits from Sec 179 deductions and bonus depreciation and recover all cost at once and at times reduce your taxable income to Zero. Yes, that’s correct.
Let’s have a quick look on what are the eligible properties.
- Property that CAN Be Depreciated :-
You can depreciate most types of tangible property (except land), such as machinery, buildings, vehicles, furniture, and equipment. To be depreciable, the property has to meet all the following requirements.
- It must be property you own.
- It must be used in your business or income-producing activity.
- It must have a determinable useful life.
- It must be expected to last more than 1 year.
- Certain Property that CANNOT Be Depreciated includes Land , Excepted property such as any property placed in service and disposed of in the same year, etc.
Remember, personal property can never be depreciated.
MACRS stands for modified accelerated cost recovery system. It is the current system incorporated in the United States to calculate tax deductions on account of depreciation for depreciable assets (other than intangible assets). Any property placed in service after 1987(basically anything at this point) will be under the Modified Accelerated Cost Recovery System (MACRS).
There are two sub-systems of MACRS:
- General depreciation system (GDS) and
- Alternate depreciation system (ADS)
GDS is the most appropriate and is used for most assets. For certain asset like residential and non-residential real property, any tax-exempt use property, any tax-exempt bond-financed property, all property used predominantly in a farming business, etc. ADS is required. Or any business can elect to use AD for certain class of property.
Steps in Calculation of depreciation UNDER MACRS
Calculating depreciation under MACRS involves the following steps:
- Determine the basis of the depreciable property.
- Figure out the class of the property: properties are generally classified into different classes on the basis of their useful life and a recovery period is determined for each class of property.
- Figure out the required depreciation convention: to simplify the calculation, it has been prescribed by the IRS, whether an asset should be treated as acquired at the mid of the month, the quarter or the year. These conventions are known as mid-month, mid-quarter and half-year conventions respectively.
- Determine the depreciation method to be applied: depreciation is charged on the cost based on 3 different depreciation methods: 150% declining balance, 200% declining balance and straight-line method.
Step 1: Basis of depreciable property:
- Cost as Basis:
The basis of property you purchase is its cost, plus amounts you’ve purchased items like nuisance tax, freight charges, and installation and testing fees.
- Other Basis:
Other basis usually refers to basis that’s determined by the way you received the property. For instance, if you acquired the property in exchange for other property, as payment for services you performed, as a gift, or as an inheritance.
- Adjusted Basis:
To find your property’s basis for depreciation, you’ll need to make sure adjustments (increases and decreases) to the idea of the property for events occurring between the time you acquired the property and the time you placed it in service. These events could include installing utility lines, paying legal fees for perfecting the title, etc.
Step 2: Class of Property:
Different categories of assets have different useful life under GDS. Some are listed below:
|Tractors, racehorses, rent-to-own property, etc……………………………………………………………………………||3 years|
|Automobiles, buses, trucks, computers, office machinery, breeding cattle, furniture, etc……………||5 years|
|Office furniture, fixtures, agricultural machinery, railroad track, etc…………………………………………….||7 years|
|Vessels, tugs, agricultural structure, tree or vine bearing fruits or nuts, etc…………………………………||10 years|
|Land improvements, such as shrubbery, fences, and sidewalks, etc., municipal waste water treatment plant, restaurant property, natural gas distribution line, etc………………………………………||15 years|
|Farm buildings, certain municipal sewers, etc……………………………………………………………………………..||20 years|
|Water utility property, certain municipal sewers, etc…………………………………………………………………..||25 years|
|Residential rental property………………………………………………………………………………………………………….||27.5 years|
|Nonresidential real property ………………………………………………………………………………………………………||39 years|
Please find detailed table for recovery life of assets under GDS and ADS in Appendix-1 of IRS Publication (Click here)
Step 3: Depreciation conventions:
- Mid-month convention- This convention is used for nonresidential real property, residential rental property, and any railroad grading or tunnel bore. Under this convention, you treat all property placed in commission or disposed of during a month as placed in service or disposed of at the midpoint of the month. This means that a one-half month of depreciation is allowed for the month the property is placed in commission or disposed of.
- Mid-quarter convention- Use this convention if the mid-month convention does not apply and the total depreciable bases of MACRS property you placed in service during the last 3 months of the tax year are more than 40% of the total depreciable bases of all MACRS property you placed in commission during the entire year. Under this convention, you treat all property placed in commission or disposed of during any quarter of the tax year as placed in service or disposed of at the midpoint of that quarter.
- Half-year convention –Use this convention if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, you treat all property placed in service or disposed of during a tax year as placed in commission or disposed of at the midpoint of the year. This means that for a 12-month taxable year, a one-half year of depreciation is allowed for the year the property is placed in service or disposed of.
Step 4: Depreciation Methods:
MACRS provides three different depreciation methods under GDS and one depreciation method under ADS.
- The 200% declining balance method over a GDS recovery period.
- The 150% declining balance method over a GDS recovery period.
- The straight line method over a GDS recovery period.
- The straight line method over an ADS recovery period.
Understanding different methods of depreciation:
- 200%/150% declining balance method:
It is a form of accelerated depreciation where “200/150” means 200/150% of the straight line rate of depreciation, while the “declining balance” refers to the asset’s decreasing carrying value with the amount of accumulated depreciation each year. MACRS declining balance changes to straight-line method of depreciation when that method provides an equal or greater deduction.
It is a way to figure depreciation for property that ratably deducts the same amount for each year in the recovery period. The rate (in ) is determined by dividing 1 by the number of years in the recovery period.
Applicability: You can check the applicability of different methods using the applicability table published by IRS in this context. Please click here and refer Table 4-1. Depreciation Methods.
Also, IRS provides MACRS table which can be directly used for the calculation of depreciation.
Using the MACRS Percentage Tables
To help you work out your deduction under MACRS, the IRS has established percentage tables that incorporate the applicable convention and depreciation method. These percentage tables are in Appendix A of the IRS publication. Appendix A contains the MACRS Percentage Table Guide, which is meant to assist you locate the correct percentage table to use for depreciating your property. Please click here to refer the same.
- MACRS must be used (few exceptions) for tangible assets placed in service after 1986.
- An economic useful life is not considered. Property is placed in classes.
- Salvage value does not apply.
- There is no distinction between new and used property.
- MACRS does not apply to Intangibles, Property that the taxpayer properly elects to depreciate under a depreciation method not expressed in terms of years (i.e., units-of-production method), Motion picture film and videotape, Sound recordings.
- You begin to depreciate your property once you place it in service for use in your trade or business or for the assembly of income. You stop depreciating property either when you have completely recovered your cost or other basis or when you retire it from service, whichever happens first.
- Meaning of Placed in Service: Property is placed in service when it is ready and available for a specific use, whether in a business activity, an in-come-producing activity, a tax-exempt activity, or a personal activity. Even if the property isn’t in use, it is in service when it is ready and available for its specific use.
Section 179 depreciation
You can select to recover all or part of the cost of certain qualifying property, up to a limit, by deducting it in the year you place the property in service. This is the section 179 deduction. In other words, in lieu of using MACRS (or in combination with MACRS), you can elect to deduct upto certain limit (currently up to $1,020,000) of qualified new or used property placed in service in tax year.
Steps in Calculation of Sec 179 depreciation
Calculating depreciation under Sec 179 involves the following steps:
- Determine the cost of qualified property which needs to be depreciated.
- Limit the deduction to the extent of the applicable limits – dollar limit and business income limit
- Take the maximum deduction for the asset, which can be the total cost of the asset as restricted by the limits calculated in step 2
- Any cost not deductible in first year under section 179 because of this limit can be carried to the next year.
Step 1: Qualified Property:
To qualify for the section 179 deduction, your property must meet all the subsequent requirements.
- It must be eligible property, such as building, machinery and equipment, office equipment, storage facilities, off-the-shelf computer software, etc.
- It must be acquired for business use.
- It must have been acquired by purchase.
- It must not be property described specifically to be Not Qualified, such as Land and Improvements, leased property, property used predominantly outside the United States, property used by governmental units or foreign persons or entities, all with certain exceptions.
How Much Can You Deduct?
Your section 179 deduction is generally the cost of the qualifying property. However, the entire amount you’ll elect to deduct under section 179 is subject to a dollar limit and a business income limit. These limits apply to each taxpayer, not to each business. However, there are certain limitations in case of Married Individuals under Dollar Limits or for a passenger automobile.
Step 2: Dollar Limit:
The total amount you can elect to deduct under section 179 for most property placed in service in tax years generally cannot be more than $1,020,000. If you acquire and place in service more than one item of qualifying property during the year, you can allocate the section 179 deduction among the items in any way, as long because the total deduction isn’t quite $1,020,000.
Situations affecting dollar limit. Under certain circumstances, the general dollar limits on the section 179 deduction may be reduced or increased or there may be additional dollar limits. The general dollar limit is affected by any of the following situations.
- The cost of your section 179 property placed in service exceeds $2,550,000.
- Your business is an enterprise zone business (an increased section 179 deduction is available)
Costs Exceeding $2,550,000
If the cost of your qualifying section 179 property placed in service in a year is more than $2,550,000, you must generally reduce the dollar limit (but not below zero) by the amount of cost over $2,550,000. If the cost of your section 179 property placed in service during 2019 is $3,570,000 or more, you cannot take a section 179 deduction.
Example, In 2019, Jane Ash placed in service machinery costing $2,600,000. This cost is $50,000 more than $2,550,000, so she must reduce her dollar limit to $970,000 ($1,020,000 − $50,000).
Step 3: Business Income Limit:
The total cost you’ll deduct annually after you apply the dollar limit is restricted to the taxable income from the active conduct of any trade or business during the year.
SPECIAL depreciation ALLOWANCE (BONUS DEPRECIATION)
Once your Section 179 limit has been reached, bonus depreciation kicks in. With bonus depreciation, you can deduct a substantial portion of an asset’s cost in the first year instead of depreciating the cost over many years. This means, if you’ve purchased over $2.55 million in new-to-you equipment, you can still depreciate rest of the asset in the first year.
Temporary 100 percent expensing for certain business assets (first-year bonus depreciation)
You can take a 100% special depreciation allowance for property acquired after September 27, 2017, and placed in service before January 1, 2023 (or before January 1, 2024, for certain property with a long production period and for certain aircraft). Your property is qualified property if it meets the following.
- Tangible property depreciated under MACRS with a recovery period of 20 years or less.
- Computer software.
- Water utility property.
- Qualified film, television, and live theatrical productions, as defined in sections 181(d) and (e) of the Internal Revenue Code.
- A specified plant for which you made the election to apply section 168(k)(5) for the tax year in which the plant is planted or grafted (explained later in Certain Plants Bearing Fruits and Nuts).
- It is not excepted property.
Bonus depreciation must be taken in the first year that the depreciable item is placed in service. However, businesses can elect to not use bonus depreciation and instead depreciate the property over an extended period if they find that advantageous.
Depreciation calculations can get very complicated very quickly. Ensuring you receive the total tax deduction available to your business requires a fundamental understanding of how asset depreciation works. Since this is a non-cash expense, there is a lot of scope of assumptions and choices. Hence this is a very important tax tool as well. It is therefore recommended to seek professional help to get the best benefits and reduce the tax burden to minimum.
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