In the 1800s, businesses treated capital expenses as operating expenses, deducting them in the year that they were paid, which was a simpler method of maintaining the accounts for businesses that, in that era, operated mostly on a cash basis. The need for depreciation became clear with the development of the corporation, where the owners usually did not manage the company, so they needed a more accurate means of ascertaining profitability. This need became particularly acute with the development of the railroads, which required a huge capital expense before any profits could be earned and required massive amounts of money from many investors. Hence, the concept of depreciation developed, where the expense was apportioned over the useful life of the asset. Although the actual useful life depends greatly on the asset itself and how heavily it is used, the tax code — by necessity — classifies the assets in different groups, with a specified lifetime for each group. However, in many cases, obsolescence limits the useful life of many assets than what is afforded by the tax code. Antiques and land can never be depreciated because they do not have an ascertainable class life; usually, they will last indefinitely. Inventory is deducted as the cost of goods sold rather being depreciated.
The profitability of any business is determined by the difference between the revenue that it collects and the expenses that must be paid during a given time period, usually 1 year. However, many assets have a useful life exceeding 1 year, so to more accurately represent profitability, the cost of these assets are deducted over their useful life rather than deducting the total cost when purchased. Otherwise, a business may show greater losses during years of major property purchases and greater profits in the other years, thereby making the determination of profitability more difficult.
The deduction of intangible property is known as amortization while the deduction of tangible property is referred to as depreciation. The tax code specifies not only the methods that must be used for amortization or depreciation, but it also specifies the class life of the property, which, in turn, determines how much can be deducted each year, and the conventions that can be adopted when determining actual depreciation. The amount of depreciation claimed for property reduces the tax basis for that property, which will reduce losses or increase gains when the property is finally disposed of. Although depreciation is treated as an expense, it is not an expense that requires an outlay of cash, which is why it is added back when determining cash flow.
Because depreciation, in many cases, is taken over several years for any given asset, the tax law also requires a description of the property, the methods being chosen to depreciate the property, and the amount of the deduction for each year of its life. However, there are many assets that last longer than 1 year and are inexpensive, such as staplers and chairs. Listing all of this property would be burdensome to the taxpayer, so there is a minimal cost required before it is listed as a depreciable item. Since this cost is not specified by the tax code, the business has some flexibility in choosing the minimum cost. Generally, most items costing less than $500 are not depreciated; those costing more than $1000 are generally depreciated, while those costing in between can be decided by the business. However, listed property, which is property that has both personal and business uses, such as computers and cameras, must be reported and depreciated.
The tax law has allowed various methods of depreciation over the years. The Tax Reform Act of 1986 changed the Accelerated Cost Recovery System (ACRS) that was used before, to the Modified Accelerated Cost Recovery System (MACRS), which extended the useful life of assets over the ACRS system. The MACRS provides accelerated depreciation and eliminates disputes over useful life, salvage value, and depreciation methods. The MACRS is the main depreciation method used to deduct the cost of tangible property over its useful life. However, useful life and depreciation methods are determined by law, while salvage value is treated as 0.
Other methods of depreciation include first-year expensing (aka Section 179 expensing) that allows a deduction of the total cost or large portion of it in the tax year when the property was put in service. Bonus depreciation for eligible property placed in service before 2018 also allows a deduction of 50% of its cost. Both the §179 deduction and bonus depreciation can be claimed for the same property, but the §179 deduction must be subtracted first before calculating the bonus depreciation. However, only a §179 deduction or regular depreciation can be claimed for used items.
Bonus depreciation (aka §168(k) allowance, special depreciation allowance) can be claimed for:
- any property with a class life of 20 years or less,
- computer software,
- buildings that replace or rehabilitate property damaged, destroyed or condemned as a result of a federally declared disaster, and
- qualified leasehold improvements if the property was acquired before 2018.
A bonus depreciation of 50% can be claimed on property placed in service before 2018, and can be claimed in addition to any §179 expensing, but the §179 deduction must be subtracted 1st before calculating the bonus depreciation.
The taxpayer must be the original user of the property, so the purchase of used property does not qualify. Bonus depreciation cannot be claimed for property, such as listed property, used 50% or less for business, which must be depreciated under the alternative depreciation system.
A taxpayer is not required to use bonus depreciation but the taxpayer must elect out of its use; otherwise, the asset will be treated as if the bonus depreciation had been claimed, thus reducing the adjusted basis of the property. The opt-out option is made per asset class. So, for instance, the taxpayer can opt out on all 3-year property but still claim bonus depreciation for all 5-year property.
Unlike §179 expensing, there is no taxable income or investment limitation on the bonus depreciation allowance. Another benefit is that no alternative minimum tax adjustment is required on claimed bonus depreciation.
Some states do not allow the §179 deduction in calculating state taxes and some also do not allow bonus depreciation.
If profits are forecast to increase in the future, then it may make sense to claim straight-line depreciation over for first-year expensing or bonus depreciation, since it will save more in taxes in later years.
The amount of depreciation that can be claimed each year depends on the useful life of the property, as defined in the tax code:
Depreciation recovery periods apply to 3-, 5-, 7-, 10-, 15-, and 20-year property under the general depreciation system (GDS). The recovery period for residential rental property is 27.5 years and nonresidential real property is 39 years. Straight-line depreciation must be used to depreciate buildings and real estate. Because of convention rules, the actual recovery period is 1 year longer than the statutory property life because only ½ of the annual depreciation can be claimed for the 1st and last year, so, for instance, 5-year property must be depreciated over 6 years.
- 3-year property generally applies to tools and devices used in manufacturing. However, computer software is also 3-year property.
- Most business equipment is 5-year property but also includes general-purpose trucks and trailers, cars, light duty trucks with an unloaded weight of less than 13,000 pounds, taxis, and buses. Leasehold improvements eligible for the 5-year recovery period must be depreciated using the straight line method.
- 7-year property includes office furniture and fixtures, cellular phones, fax machines, refrigerators, dishwashers, and machines for the production of jewelry, musical achievements, toys, and sporting goods. If property is not assigned to a specific class by law, then it is considered 7-year property.
- 10-year property includes water transportation equipment, barges, tugs, vessels, machines used for the refining of petroleum or the manufacture of tobacco products and some food products, single-purpose agricultural and horticultural structures, and trees or vines that bear fruits or nuts.
- 15-year property applies to land improvements such as fences, sidewalks, box, shrubbery, roads, and bridges, and other property with the class life of 20 to 25 years.
- 20-year property includes farm buildings and municipal sewage treatment plants.
Half-Year and Mid-Quarter Conventions; 40% Rule
To simplify calculating date intervals for depreciation over several years, the tax code requires the use of conventions that assumes that depreciable property was acquired at specific times of the year. The most common convention is the half-year convention, which assumes that the asset is acquired in the middle of the year. Hence, for the 1st year and last year, only ½ of the allowable annual depreciation can be deducted.
If more than 40% of the value of property acquired during the year, other than certain real estate, is placed in service during the last quarter of the year, then a mid-quarter convention applies, where the property acquired during the year are grouped by the quarter in which they were acquired. Hence, acquisitions made during the:
- 1st quarter are allowed 10.5 months of cost recovery, since the mid-quarter would be the middle of February, 1.5 months after the year began;
- 7.5 months are allowed for the 2nd quarter;
- 4.5 months for the 3rd quarter, and
- 1.5 months for the 4th quarter.
When an asset subject to the mid-quarter convention is disposed of, then the cost recovery is determined from the middle of the quarter to the end of the year. To determine whether the mid-quarter convention applies, the value of the property minus any Section 179 deductions and minus any basis attributable to personal use must exceed 40% of the total property acquired during the year.
The 40% rule does not apply to the purchase of residential rental property, nonresidential realty, or assets that are placed in service but then disposed of before the end of the tax year.
Modified Accelerated Cost Recovery System (MACRS)
The MACRS system applies to the following classes of property: 3-, 5-, 7-, 10-, 15-, and 20-year property. Realty that is held as a capital investment must be depreciated using the straight line method. Residential buildings are depreciated over 27.5 years and nonresidential real property placed in service after May 12, 1993 is depreciated over 39 years. The percentage of the adjusted basis that is actually deductible is listed in IRS tables.
MACRS rates depend on the property's recovery period and whether the half-year or mid-quarter convention applies. There are 2 MACRS rates: the 200% declining balance (DB) rate and the 150% declining balance rate. The 200% rate yields higher deductions in the early years and applies to all property with an asset life of 7 years or less, although the taxpayer can elect the 150% declining balance rate. When the annual deduction under the 200% declining balance rate becomes less than the straight line rate, then it is replaced by the straight line rate applied to the remaining basis of the property. The depreciation rates for each type of property are listed in IRS tables and must be used for the entire recovery period. Computer software can also automatically calculate the rates without using the tables.
If the property is disposed of before it is fully depreciated, then a half-year of depreciation can be claimed, just as if the taxpayer held the asset until the end of the recovery period.
If mid-quarter convention property is disposed of before the recovery period, then a full year of depreciation must be multiplied by a percentage that applies to the quarter in which the property was disposed:
- 1st, 12.5%
- 2nd, 35.5%
- 3rd, 62.5%
- 4th, 87.5%
So if you have property for which a full year of depreciation would be $1000, but you dispose of it in the 2nd quarter of the year, then you multiply $1000 by 37.5% to arrive at your deductible amount of $375.
150% Declining Balance Rate Election
A taxpayer can choose to use a 150% declining balance rate for 10 year class property or other property with a shorter recovery period. The 150% declining balance rate yields a lower deduction in the earlier years, but a taxpayer may want to choose it since it is the method that must be used for the alternative minimum tax (AMT). So if the taxpayer is going to be subject to the AMT, then using the 150% rate will negate the need for adjusting it for AMT purposes.
The 150% election, which is irrevocable, must be made for all property in the same asset class that was placed in service in the same tax year.
If a taxpayer is expecting higher income in future years, then he may want to choose a straight-line depreciation rather than accelerated recovery methods, since it will yield a larger deduction in future years. There are 2 systems under which straight-line depreciation can be claimed: the general depreciation system (GDS) and the alternative depreciation system (ADS). Some assets, such as cars, have the same class life under either system. However, for most property, the recovery period is longer under ADS than it is under GDS. For instance, office furniture and fixtures are 10-year property under ADS rather than 7-year property under GDS. The election is made on Form 4562, Depreciation and Amortization. The election for straight-line deduction is irrevocable and must apply to all property within a specific asset class placed in service in the same tax year. The ADS recovery period is the same as the GDS recovery period for cars, light trucks, and computers: 5 years. Personal property that does not have a statutory class life is 12 years under ADS.
The straight line method must be used in calculating the deductible depreciation for residential rental real estate and nonresidential real estate. Residential real estate includes property where 80% or more of the gross rental revenues are from dwelling units, such as condos or apartments. Hence, it does not include real estate that temporarily houses people in transit, such as hotels. Real estate is depreciated using the mid-month convention so that the property is considered either acquired or disposed of in the middle of the month. The cost recovery is calculated by multiplying the applicable rate as determined by IRS tables by the cost recovery basis.
Although real estate must be depreciated by using the straight line method, the taxpayer may also elect to use the straight-line depreciation for personalty, but this election must be made for an entire asset class for any given tax year. For example, the straight-line depreciation method can be chosen for all 3- and 7-year property.
Nonresidential real estate and residential rental property can use a 40-year straight-line recovery period under ADS. The ADS election for real estate can be made per property.
ADS must be used for automobiles and listed property used in business 50% or less. ADS must also be used for:
- calculating earnings and profits;
- tangible property used mostly outside of the United States during the tax year;
- tax-exempt use property;
- tax-exempt bond-financed property; and
- any imported property covered by an executive order.
Any personal property that does not have a statutory class life, such as digital cameras, is considered 12-year property.
There is no AMT adjustment if straight-line depreciation is used for regular tax purposes on any tangible personal property or real property that was placed in service after 1998. For tangible personal property placed in service before 1999, straight-line depreciation must be calculated using the class life under ADS; for real property placed in service before 1999, the straight line method must be used for a recovery period of 40 years.
Depreciation is calculated based on the adjusted basis of the property:
Acquisition Cost and Original Tax Basis = Purchase Price + Direct Costs of Buying
Example: You buy furniture for $1,000 and pay $70 in sales tax. Your acquisition cost and original basis in the furniture is $1,070.
Adjusted Basis = Acquisition Cost – §179 Deduction – Bonus Depreciation – Previous Allowable Depreciation
Example: You buy a computer, which is 5-year property, for $10,000, your total acquisition cost.
Case 1: You claim the entire $10,000 as a §179 deduction. Therefore, your basis in the property is now 0, so no additional depreciation can be claimed on the property.
Case 2: In the year of your purchase, you claim $5,000 as a §179 deduction and a 50% bonus depreciation on the remaining $5,000, resulting in an adjusted basis in the computer of $10,000 – $5,000 – ($5,000 × .5) = $2,500. Remember, bonus depreciation can only be calculated on the adjusted basis after subtracting the §179 deduction first. You depreciate the remaining basis over the next 6 years, using the half-year convention, multiplying the $2,500 remaining basis by the applicable MACRS rate obtained from IRS tables for that year.
|Year||MACRS Rate |
Case 3: You decide to depreciate the computer using only the MACRS.
Case 4: Same as Case 3, but you convert the computer from business use to personal use in April of the 4th year or you sell it at that time. Then you can only claim ½ of the deduction for that year ($1,152 × .5 = $576). If you wait until July, you can claim the full annual deduction of $1,152.
Case 5: You decide to use straight-line depreciation as your only depreciation method:
Converting Personal-Use Property to Business Use
To reduce its startup costs, many businesses convert property that was used personally to business use, such as a computer, or a homeowner converts a room to a home office. Converted property can be depreciated, but it is restricted. No first-year expensing is permitted. When an item is bought brand-new, the basis for depreciation is the cost of the item. However, for converted property, depreciation is based on the lower of the property value when converted or its adjusted basis. In most cases, personal property will not have an adjusted basis, since depreciation or any other expenses cannot be deducted on personal-use property. Therefore, upon conversion to business use, the initial depreciation must be based on the property value at conversion. On the other hand, if a room is converted into a home office, then the depreciation is based on the percentage of the home used for business. Because real estate tends to appreciate, the lower of the current value or its adjusted basis will probably be the adjusted basis, so the initial depreciation will probably be based on the business use percentage × adjusted basis. For both personalty and realty, depreciation after the 1st year will be based on its adjusted basis.
Example: You buy a computer for $2000, then convert it to business use in a later year, when the value of the computer is $500. Therefore, the initial depreciation will be based on the $500 value.
Example: You convert a room into a business office that occupies 10% of the home, when the value of the home was $225,000 and its adjusted basis is $200,000. Therefore: adjusted basis of the home office = $200,000 × 10% = $20,000.
Claiming and Reporting Depreciation
For property placed in service during the current tax year, Form 4562, Depletion and Amortization (Including Information on Listed Property) must be used for claiming depreciation in the 1st year that the property is placed in service, so that essential information can be provided about the property:
- month and year when placed in service,
- depreciation basis,
- recovery period,
- convention selected,
- depreciation method, and
Consequently, bonus depreciation and §179 expensing must also be claimed on Form 4562. Afterwards the amount of depreciation can just be listed on the appropriate line in Schedule C, Profit or Loss from Business.
An employee claiming auto expenses must use Form 2106, Employee Business Expenses to claim depreciation for a motor vehicle used for business. Form 8829, Expenses for Business Use of Your Home must be used to claim depreciation for a home office in which the self-employed worker owns the home. Depreciation of rental buildings is reported on Schedule E, Supplemental Income and Loss. For buildings placed in service in the current tax year for which the taxpayer is claiming rental income on Schedule E, Form 4562 must be used to claim depreciation on the buildings. If the buildings were placed in service before the current tax year, then the depreciation is simply entered directly on Schedule E. If rental losses are claimed on Schedule E, then the depreciation may have to be included on Form 8582, Passive Activity Loss Limitations to determine net passive activity income or loss.
Listed property is property used for business that is also often used as a personal item, which includes cars and computers. The depreciation of listed property must always be claimed on Form 4562 for every year that depreciation is claimed.
When a depreciable item is sold, the amount of the proceeds must be reported. If the sale price exceeded the remaining tax basis in the property, then the difference must be reported as ordinary income; if the sale price was less, then the difference can be claimed as a loss. Note that the depreciated basis must be used even if the taxpayer did not claim any depreciation on the property, in which case, the tax basis would have to be reduced by the amount of depreciation that could have been taken. If the item sells for more than the original tax basis, then the difference between the sale price and the original tax basis is treated as a capital gain.
Depreciation recapture is reported as Other Income on the taxpayer's business return, which, for most business owners, is Schedule C, Profit or Loss from Business.